Much like everything else we buy, insurance comes with a lot of options.
And just like everything else, you can go the economical route and give up a little quality and miss out on some bells and whistles, or you can pony up a few more bucks and get the whole shebang.
The terms “replacement cost” and “actual cash value,” or ACV, are loss valuation methods insurance companies use to determine how much money they will pay out in the event of a covered cause of loss (claim) after any deductible is applied.
NOTE: Replacement cost for your physical home and for the contents of your home is two different policy endorsements. If you want your personal items to be replaced at their cost to purchase new, you must request that separately.
It is highly recommended that you purchase replacement cost coverage if your budget permits. Why? Let’s take a look at an example of how you will be reimbursed as a result of a homeowner’s insurance property damage claim. Remember, this works the same for almost any property damage, including physical damage coverage to your auto.
Let’s say, for example, your $200,000 home burns down as a result of an electrical fire caused by your clothes dryer. How you would be reimbursed differs by the loss settlement method you agreed to and paid for:
Actual Cash Value Settlement
Had you purchased ACV coverage, you (and your lender if you had a mortgage) would be paid the actual cash value of your home at the time of the loss. ACV is calculated as the replacement cost of your home minus depreciation. Depreciation is the loss in value of a piece of property over time.
$200,000 replacement cost – $30,000 in depreciation = $170,000 ACV
You would receive a check for $170,000. The lender gets their share of the money first. You can easily see how you would not receive enough money to rebuild your $200,000 home. In fact, you’d be exactly $30,000 (how much your home depreciated since its purchase) short. This is not a good position to be in.
Also note, if your ACV was $170,000, and you owed $180,000 on the mortgage, you would be stuck with a $10,000 bill owed to your lender. This is why mortgage lenders often require replacement cost coverage on a mortgaged home!
A home typically costs quite a bit more to rebuild at today’s prices than it did when you purchased it. Homes are often built in large numbers in certain developments, which drives down the construction costs. For this reason, you would likely want to purchase a replacement cost policy.
Replacement Cost Value Settlement
Had you purchased replacement cost coverage, you would receive the entire $200,000 in the event your home burned down. The depreciated value of your home is not a factor in the settlement you receive from your insurer.
NOTE: Replacement cost policies typically contain a co-insurance clause.
The coinsurance clause may require you to insure the property in question for at least 80% of its replacement cost. Replacement costs can fluctuate over the course of an insurance policy. For our $200,000 home, you would be required to carry at least $160,000 in coverage for the dwelling.
If you insured your home for only $150,000 because that’s all you owed on the mortgage, and suffered a total loss, you would incur a financial penalty for having it underinsured. The penalty usually consists of having to cover a certain percentage of the underinsured potion of the home value. This clause protects the insurance company from issuing replacement cost policies where the home is insured for much less than it would cost to rebuild.
Extended Replacement Cost Coverage
Some insurers offer an endorsement (extra addition) to their homeowner’s insurance policy that adds an additional 25% to 50% extra replacement cost coverage in the event it’s necessary. This is often referred to as extended replacement cost.
Our same $200,000 home would qualify for an additional $50,000 in replacement cost coverage if you chose the 25% extended coverage. So if it cost $250,000 to rebuild your home exactly the way it was, you’d be covered. Of course, this option costs a little more, but is clearly worth it.
Insurers do not use your home’s market value as a loss valuation method. Do not make the mistake of confusing your home’s ACV with its market value. The terms have different meanings when it comes to insurance. For example, your home may have a replacement cost of $200,000, an ACV of $170,000 due to depreciation, but due to a lagging economy for instance, a market value of only $150,000.
Market value fluctuates and is not a number that can be calculated using a mathematical formula or by calculating the costs of labor and materials to rebuild. The market value of your home changes at the whim of who would be willing to buy for a certain price at any given point in time.
Functional Replacement Cost
If you live in an old Victorian home, your insurance company would probably not offer you a replacement cost policy. Why?
The cost to rebuild your home may greatly exceed its ACV. The cost to recreate outdated construction techniques from the early 1900’s, when the home was originally built, can be staggering. Your Victorian home’s value may be $300,000. However, to pay someone to rebuild it using the exact techniques and materials used in the original construction may exceed $500,000.
Clearly this isn’t a good deal for the insurance company, and you would likely not want to pay for $500,000 of insurance coverage for a home that’s only really worth $300,000.
Functional replacement cost valuation means your insurer will cover the replacement cost to build your home using the most up-to-date techniques and materials available at a lower cost in today’s market.
As the example above demonstrates, it’s clear why you would want to have the replacement cost valuation property insurance policy. For what amounts to a small additional insurance premium, you are fully covered in the event of a partial or total loss.