What is Replacement Cost vs Actual Cash Value?
For individuals looking to take out homeowner insurance, they need to know the difference between replacement cost vs actual cash value. The terms refer to the coverage options available to homeowners. When buying a homeowner insurance plan, homeowners are interested in paying the lowest possible premiums while maximizing their coverage should the insured loss occur.
The insurance coverage that a person chooses will provide different protection values and can affect premiums differently. Homeowners should understand the coverage options and the protection they receive under each option.
What is Replacement Cost?
Replacement cost is defined as the amount of money that is required to replace whatever is damaged or destroyed at today’s cost. The replacement cost is more popular than the actual cash value because it restores the policyholder’s situation closest to what it was before the peril occurred. The insurer provides the policyholders with money to replace the damaged items at current prices.
Sometimes, the replacement cost is paid in two batches. In the first batch, the insurer pays the actual cash value of the replacements or part of the replacement cost. In the second batch, the insurer will pay the remaining cost after the repairs have been completed, and documentation of the repairs had been sent to the insurer.
How Replacement Cost Works
The replacement cost coverage option insures up to the amount that it would cost to build a similar home, and in case of personal property, the replacement cost covers up to the amount it will cost to purchase the same item. Since the homeowner will have to repurchase the land on which the house sits, the replacement cost excludes the value of the land.
When taking this coverage option, homeowners should get an appraiser to find the value of the insured home or personal properties. They can price the value of unique or valuable items such as fine art, entertainment space, jewelry, etc., and even come up with the value of building materials such as windows, doors, roofing, granite, etc. that will be required in reconstructing a similar home.
Some insurance companies may provide a replacement cost policy that has stipulations for replacement cost reimbursements. For example, certain items in the insured property may need to meet certain criteria to qualify for replacement cost reimbursement. For example, certain built-in appliances like a dishwasher or freezer may have a life span of a given period, which, if exceeded, will not qualify for replacement.
Also, if the roofing shows visible signs of wear and tear, the insurer may choose not to cover it for its replacement costs. Special personal properties such as expensive art and hand-milled artifacts may only be covered up to a certain limit unless they are itemized under a scheduled personal property endorsement.
What is Actual Cash Value?
The actual cash value refers to the market value of an item or property, or initial value of the house, with depreciation cost considered. Appraisers obtain this value by deducting the depreciation cost from the replacement cost of the item or home. An insurance coverage based on the actual cash value is the cheapest to buy because claim payments are lower than the replacement cost coverage option.
The coverage compensates you for the value of the item as it is being sold in the public market, and it leaves the policyholder in a tougher position because he or she will not be able to purchase the same item without adding out-of-pocket money.
How Actual Cash Value Works
The actual cash value of an item or property is determined by taking the initial purchase price of the item or its current market value, less the depreciation costs for the wear and tear over the ownership period.
Policyholders get depreciated claim checks for insured items, such as electronics, furniture, and other items, in the event that the insured loss occurs. The depreciation cost is based on the estimated lifetime of an asset minus the percentage of value for each of the years since the time of purchase.
For example, let us assume that John bought a new laptop for $1,000 two years ago, and the useful life of the computer is expected to be five years. The actual cash value of the laptop will be as follows:
Actual Cash Value = $1000 x (2/5 x 100)
= $1000 x 0.04
= $1000 – $400
It means that the actual cash value of John’s laptop is $600, which is the price of the laptop if it is sold in a garage sale today.
How Do They Differ – Actual Cash Value vs Replacement Cost
When a policyholder suffers a loss due to the occurrence of a covered event, the actual cash value may result in reimbursements that are lower than the replacement cost. The actual cash value takes into consideration the depreciation costs due to wear and tear. It means that the policyholder will receive significantly less than what it would cost to buy a similar item. The policyholder will be forced to pay off the replacement costs as an out-of-pocket expense.
On the other hand, the replacement cost will enable the policyholder to rebuild the house from scratch based on the current prices of materials and labor. The policyholder will also be compensated for the personal properties damaged in the covered loss and will replace the covered items with similar items based on the current market rates for similar items.
Replacement cost also provides extra protection above the policy’s limit against material and labor cost increases. Therefore, replacement cost is a better homeowner insurance coverage option than the actual cash value because it restores the policyholder’s situation to what it was before the covered loss occurred.
CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: