The Difference Between Replacement Cost and Actual Cash Value

Although there are various methods an insurance company may employ to determine the amount it will pay its insured clients for a loss, it typically will come down to two: replacement cost and actual cash value. 

On the surface, the difference between replacement cost and actual cash value is not substantial, since both are based on today’s cost to replace the damaged property. In reality, however, it can make a significant difference in the amount a policyholder will receive in compensation for losses.

Which is better: replacement cost or actual cash value?

Compensation based on the replacement cost of damaged or stolen property is generally the most favorable figure from the insured’s point of view, as it pays for the actual cost of replacing property. 

For example, if a mountain bike is stolen, a replacement cost policy will reimburse the owner for the entire cost of replacing it with the same kind of bike. The insurance company will not take into consideration that the user competed in off-road events that caused the bike to be ridden over dirt trails, rocks, and tree stumps, all of which caused extreme wear and tear.

In contrast, actual cash value, sometimes referred to as market value, is equal to the replacement cost minus any depreciation. It represents the dollar amount that one could expect to receive if the item were sold in the marketplace. 

Insurance companies calculate the depreciation based on a combination of objective and subjective criteria. In the example of the stolen mountain bike, the company would estimate the wear and tear from off-road racing and deduct it from its replacement cost.

Insurance replacement cost vs. actual cash value

Policyholders can always refer to their policy for their insurance company’s definition and explanation of the term “replacement cost.”

Meanwhile, “actual cash value” is not as simple to define. Courts have sometimes ruled that the term stands for “fair market value,” which means the amount a buyer would pay a seller if neither were under time constraints. However, the majority of courts have upheld the insurance industry’s established definition: actual cash value is the cost to replace with new property of the same kind and quality, minus depreciation. 

Determining replacement cost is critical

Knowing a home’s replacement cost is important for consumers who purchase homeowners’ insurance.  Simply stated, the replacement cost is the amount it would take to rebuild a damaged or destroyed home with similar materials. It’s directly linked to the amount of coverage the homeowner selected, and it’s the amount an insurer will pay if the owner files a claim.

It’s a rather common mistake for homeowners to base the replacement cost of their home on its current market value. Rebuilding costs seldom equal market value. For instance, a house might sell for $300,000 but could be rebuilt for $200,000 in labor and materials. If it’s destroyed, the insurer will cover the cost to rebuild—not the market value.

Homeowners should keep in mind that the market value of a home includes the value of the land on which it sits. Only in the case of some older homes does the cost to rebuild exceed the market value.

Even though it might not be necessary to base coverage on the higher market value figure, the greater danger lies in being underinsured. Approximately three out of every five homes in this country are underinsured by at least 20 percent. Accurately estimating replacement costs is essential since any shortfalls in coverage could come out-of-pocket after a loss.

How to calculate the replacement cost

Coverage levels have an impact on personal possessions since personal property coverage is a percentage (usually 50 to 70 percent) of the structures limit. So, not having enough insurance on your home could mean your possessions are also underinsured.

Two primary factors could affect the cost to rebuild a home:

  1. The age of the house: Some older homes have features that are difficult or very expensive to replace. For example, items such as vintage chandeliers, custom molding, and plaster walls will be more costly than standard lighting, molding and drywall. Also, if the old house had outdated wiring and plumbing, the cost to rebuild could exceed the present market value.
  2. Building codes: Once again, this caveat will apply mostly to older homes. Although a homeowner is typically not required to upgrade each time building codes change, if their home is destroyed and must be rebuilt, then today’s building codes will apply.

In most cases, an experienced insurance agent can calculate the replacement value of your home accurately. If a homeowner wishes to verify the figure—or disagrees with it—hiring a professional appraiser is always an option.

While appraisals are best left to the experts, homeowners can do a replacement cost calculation to get a rough estimate. It requires some research to determine the building cost per square foot in the region—on average between $100 and $155 per square foot nationwide–and then to multiply that number by the home’s square footage.

Summing up the difference between actual cash value and replacement cost

  • Actual cash value is based on the market value, or the initial cost, of the home and personal property with depreciation considered.
  • Because depreciation is included and claim payments are lower, an insurance policy based on actual cash value is the least expensive.
  • Insurance companies may calculate depreciation differently.
  • Most standard policies cover the replacement cost of the structure and the actual cash value of the personal property.
  • Replacement cost coverage gets a homeowner closest to their living situation before a covered loss occurred.
  • A contractor or appraiser will usually provide a more accurate figure on a home’s replacement cost

Let us help you get it right the first time

Speak to our team of experts at NSI Insurance Group to help you determine the type and amount of structure and contents insurance that’s right for you. We are an independent insurance agency in Miami, Florida, representing the finest and most reputable insurance companies nationwide.

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