Replacement Cost vs Actual Cash Value: Insurance Terms to Know

When insuring your home or commercial building, you have a several options. You may hear terms like, Replacement Cost, Actual Cash Value, Market Value or Functional Replacement. While each of these options have their pros and cons, most people will choose either Replacement Cost or Actual Cash Value. So, what do these terms really mean? Let’s take a look so that you can make the best decision when purchasing property coverage.

Replacement Cost

Many people believe if they buy a Replacement Cost policy, and they have a total loss of their home or building that the insurance company will replace it no matter what it costs to rebuild. Unfortunately, that is not always true. The truth is, at the time of loss the insurance company will replace your home or building on the same premises with another structure of comparable material and quality up to the limit of insurance stated on the policy.

That last part is very important to understand. Every company will insure your building based on a Replacement Cost Estimate of your structure, either done by them or a third party. They will use that estimate to determine the limit of insurance for the policy. This limit of insurance is the most they will pay for any one loss. In turn, this will determine how much you will pay for your building’s coverage. However, they will not pay more than that amount. If the replacement cost estimate is not correct, you can find yourself not being able to rebuild.

It is always a good idea to find out the average per square foot cost of construction in your area to see if the estimate is adequate for your structure. This can be done by calling a reputable contractor or a building association in your area. It is also important to tell your agent about any additions or remodeling projects you do on your building in order to keep the estimate and insurance limits adequate.

Now that we know what replacement cost is you might want to know how it differs from Guaranteed Replacement Cost or Broadened Replacement Cost. Many home and commercial insurance companies will have endorsements under one of these two names. While guaranteed replacement cost sounds better than broadened, it is generally the same thing. Most of the time these endorsements will give an extra amount of insurance above the limit shown on the policy. For example, your Replacement Cost limit is $200,000. If you were to add one of these endorsements to your policy, it would pay an extra $20,000 above that limit to replace your structure if needed. If you decide to add this to your policy, make sure your agent explains exactly what it does and the percentage above the limit of insurance it provides. There is no industry standard for this, and it can vary from company to company.

Actual Cash Value

Actual Cash Value is more difficult for many people to understand. The industry definition is the cost to replace the structure with like kind and quality, less depreciation. The depreciation part is what is most difficult to understand. If your house would cost $100,000 to replace with a new structure or similar type and quality and it was 30 years old, we would take $100,000 and subtract the depreciation of 30 years. You may be wondering what that number might be. Well, that depends on many factors. The main factor is how the structure was built. For example, a wood frame structure will not last as long as a steel or concrete structure. Therefore, a wood frame building will depreciate quicker. In our example, you might have an Actual Cash Value limit of insurance of $70,000 for the $100,000 replacement cost.

The most important thing to remember is that an Actual Cash Value policy will never provide you with enough money to replace your building or repair it without you spending an additional amount out of pocket.

You might be wondering why anyone would want to use this option. There are lot of reasons. If you purchase a building at an auction for $40,000 and the replacement cost is $200,000. It will be a lot cheaper to insure it at Actual Cash Value of $120,000, and you still protect your investment. Also, there are times when you may not wish to replace a building. In a Replacement Cost policy agreement, you must replace the building in order to receive the full limit of insurance for your claim. However, you do not have to replace your building with an Actual Cash Value policy to get the limit of insurance for you claim. Probably the most common reason people purchase an Actual Cash Value policy is to secure coverage on older structures that have not been extensively remodeled or updated. Many companies will only insure these types of buildings on an Actual Cash Value basis.

Do you want to learn which of these two types of polices are right for you? Call one of our advisors today.