Shuman Roy is an entrepreneur, business owner, and musician. He started RoysNoys, LLC in 2013 as a music production and education service company. He also offers small business consulting and advisory services to help businesses get from start-up mode to turn-key operations. Shuman earned his M.B.A from the Stern School of Business in 2001 and has an undergraduate degree from Manhattan College in ...

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Joel Ohman is the CEO of a private equity-backed digital media company. He is a CERTIFIED FINANCIAL PLANNER™, author, angel investor, and serial entrepreneur who loves creating new things, whether books or businesses. He has also previously served as the founder and resident CFP® of a national insurance agency, Real Time Health Quotes. He has an MBA from the University of South Florida. Joel...

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Reviewed by Joel Ohman
Founder, CFP®

UPDATED: Oct 27, 2021

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Every day in America, insurance agents find themselves answering this very question…and for good reason.

Homeowners are bowled over when a property they purchased for $200,000 is required to be insured for $300,000 or more.

You may be wondering how this is possible, especially in a market where home prices are falling daily.

Your Home Has Three Different Values

Every home has three different values at any given time. It is necessary to recognize all three to understand the insurance company’s calculations…especially the difference between actual cash value and replacement cost.

1. Market Value – This is the value any one individual or entity would pay you at any given time for your home. It fluctuates wildly based on the economy…shocker, right?

2. Actual Cash Value – This is the current value of the cost of materials like wood, nails, drywall, roof, brick, etc. The actual cash value of your home, known as ACV, decreases by the minute. Each day that passes, the physical materials which make up the construction of your home depreciate – do not confuse this with the value of a home depreciating.

3. Replacement Cost Value – This is the estimated cost to rebuild your home from scratch; including today’s material and labor costs, removal of debris from the initial loss, cost of permits and architectural drafting, among other things.

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How does the insurance company calculate replacement cost of a home?

Insurance companies have the most accurate data regarding what a home costs to rebuild. How? Well, they‘re the ones who pay to re-build every home that has ever been destroyed (assuming it was properly insured).

That said, no matter how unique a home is from a decorating standpoint, it can only vary in location, size, and the materials used to construct it. Once the location, size and construction materials are known, the process is pretty simple.

Your insurer compares your home to the thousands, if not millions of similar homes they have rebuilt and estimates the cost to rebuild yours accordingly.

For example, if your home has 2,000 square footage, built mostly with semi-custom materials and fixtures, and located in Dallas, Texas, there isn’t much rocket science left. Odds are your insurer has rebuilt or repaired a few hundred similar homes in the area, so the cost estimate in part is based on the company’s prior experience.

If my home has decreased in value, why should I have to insure it for more?

This is another common question that insurance agents encounter on a regular basis. The insurance company isn’t the slightest bit interested in the current market value of your home. They stick with measurable constants, such as the current cost of labor and building material costs, plus depreciation costs based on the functional life and of any piece of property.

Those of you who are thinking, “my house isn’t worth XYZ,” or “I couldn’t sell my house for half that,” are already thinking on the wrong track when it comes to insurance. There are key factors that go into determining the entire cost, so please do not enter this thinking that there will definitely be a fair market price.

You certainly didn’t call your agent and ask them to increase your insurance premium because your home was worth more in 2003-2005, did you? Furthermore, you certainly wouldn’t want your insurance company adjusting your premium every six months based on the most current economic conditions.

When your home was built, there were probably dozens, if not hundreds of other homes being built in the same neighborhood. Applying the concept of bulk purchase price, the starting price to build your home would have been greatly discounted because of all the contractors and builders working in the area. There is a difference between market value today versus back then.

An individual who has built a custom home on their own plot of land will gladly tell you the cost is astronomical compared to having “The Victorian – Model 3” built on lot 207-b in a tract housing development. The individual condition of personal property will have different construction costs and rebuilding costs. Again, there are multiple factors to consider.

So what’s the verdict?

Taking this information into consideration; it should be obvious which loss cost valuation method you should choose to insure your home.

Replacement cost coverage is the safest way to insure your home if you love it enough to rebuild it with “like” materials in order to restore it to its pre-damaged condition. Your lender will likely require that you have a replacement cost homeowner’s policy anyways for liability, which, due to various expenses, a lot of folks can’t really refuse to buy. Thankfully, it is also the most effective.

Regardless of if you need an additional type of coverage or homeowners policy, doing your own research can make you your own most valuable asset, pun intended!

If the home is in poor shape (which may make it ineligible for replacement cost coverage), you own it outright, or it is just not worth the value to insure for replacement cost, you may choose an actual cash value policy.

This doesn’t necessarily mean the insurance company will write you a check for whatever number you pull out of thin air to insure your home for. In the event of a loss, an adjuster will come to (what was) your home and estimate its actual cash value, which is your replacement cost minus depreciation.

In a worst case scenario, this may lead to a court battle between you and the insurer to determine how much money they owe you. It can be tricky navigating with insurance companies and laws, so hopefully receiving a payment (if there is any owed) goes smoothly!

Read more: How are homeowners insurance rates determined?