Homeowners and renters insurance have one important purpose: to protect the insured’s finances against covered damages and loss. Home insurance policies typically provide one of two methods for assigning value to losses you suffer from a covered peril: actual cash value or replacement cost.
Say your television is damaged beyond repair in a house fire. With actual cash value, the insurance company would reimburse you for the same amount you could sell the used TV for in a marketplace. So, accounting for depreciation, you likely could not purchase the newest version of that same television. With replacement cost, the insurance company would reimburse you for the amount it costs to buy a newer version of the same TV at current prices.
While it typically costs more, replacement cost coverage is an option that you may want to consider when purchasing homeowners insurance for better financial protection.
What is replacement cost?
The value of most things depreciates over time, including your personal belongings and the materials used to build your home originally. A standard HO-3 home insurance policy will usually include replacement cost coverage for your dwelling and other structures, which means that the insurance company will pay for the covered structures to be rebuilt with materials at current costs up to your coverage limit. The same policy will usually only cover your personal belongings at actual cash value, or their current market value, including depreciation, unless you opt to pay more for an endorsement including replacement cost coverage for belongings.
Replacement cost coverage could be helpful for something like a home security system because you would then be able to replace a security system damaged by a covered peril with the most current version without additional out-of-pocket costs. Keep in mind that coverage for your personal belongings will have certain coverage limits. If you have a lot of expensive items, you may need to purchase scheduled personal property coverage.
Guaranteed or extended replacement cost coverage
There are a couple of special types of replacement cost coverage that you could consider as well.
Guaranteed replacement cost coverage helps pay for rebuilding or replacing your assets lost in a covered peril, even if the current cost is higher than the coverage limits. For instance, if your dwelling coverage only covers $250,000, but the cost to rebuild your destroyed home ends up being $300,000, guaranteed replacement cost could cover the rebuild even though it exceeds the policy limits. Typically, this kind of coverage allows the insurance company to set the guaranteed replacement cost and automatically increase it as needed, so you should keep in mind that there will be limits even with this kind of coverage.
Extended replacement cost coverage considers a certain percentage, often 25 to 30 percent, over the coverage limits specified in the policy. For example, if your coverage limit was $200,000, but the cost of rebuilding your home is $250,000, an extended replacement cost endorsement that covers up to 25% more than the policy limits would fully cover the cost to rebuild. So it is similar to guaranteed replacement cost coverage but instead specifies an actual percentage amount over your coverage limit that caps what your insurance company is willing to pay.
These endorsements are typically significantly more expensive than standard dwelling or personal property coverage. But if you want more complete protection over the long term, they may be options worth considering. Speak with a licensed insurance agent at your home insurance company to determine if these types of coverage may be right for you.
How replacement cost is determined by insurance companies
Replacement cost does not usually correlate with how much you paid for your home. Insurance companies look at figures such as building materials and labor costs for your area when underwriting your policy, not at market values.
To get reimbursed for replacement cost after a loss, you may have to prove to your insurer that the lost property is worth what you claimed as the replacement cost value. Presenting receipts for bigger-ticket items is vital. An inventory checklist showing all the items you own, a good description and value will also be helpful for getting a claim paid.
If you cannot provide receipts, photos or other documentation for your home, you may be able to go with the alternative “Scope of Loss” to maximize the amount of replacement cost value reimbursement you will receive. You will need to hire a contractor to write a comprehensive report detailing all the items that need repairs or replacement and recommendations on what aspects of the rebuild are a higher priority.
Actual cash value vs. replacement cost
Now that you have a better idea of the meaning of replacement cost insurance when it comes to renters or homeowners coverage, it is time to point out the biggest difference between actual cash value coverage and replacement cost insurance.
Replacement cost value coverage allows you reimbursement for the new version of items to replace older ones. Actual cash value coverage costs less than replacement cost value insurance but pays for the goods you lost at a lower, depreciated price.
In an actual cash value policy, if your 5-year-old granite countertops need replacement, your insurance company will depreciate the countertops accordingly, and you will be reimbursed a lower value than what you originally paid for them. With a replacement cost value policy, you will be able to purchase comparable granite countertops at the current price, up to your coverage limits.
Actual cash value vs. market value
Actual cash value and market value are not the same, especially when it comes to home insurance. Market value is the amount an appraiser deems a home or property is worth or the amount that someone is willing to pay for that home or property. It is based on what the current market is willing to pay. Homeowners insurance companies do not use market value for homes or belongings but instead use the actual cash value as a common standard for reimbursing the insured for belongings lost or damaged under a covered peril. Replacement cost is fairly standard in home insurance policies for rebuilding structures damaged by a covered peril.
Frequently asked questions
Is actual cash value coverage better than replacement value insurance?
Choosing the way you would like your insurance carrier to reimburse you in case of loss depends on the age and quality of your property, as well as how much home insurance you can afford. Replacement cost coverage is usually included in standard home insurance policies for your dwelling or structures. It is not usually included in the same standard home insurance policy for your personal belongings but can typically be added as an endorsement at additional cost.
Replacement cost coverage might be a better bet for some people since you will be reimbursed for new versions of the lost items. Actual cash value coverage is less expensive but means that the value of your property will depreciate according to age, resulting in less money in your pocket to replace the items lost or damaged.
How much homeowners insurance should I buy?
The amount of home insurance you need will differ for everyone. You might want to start by researching local building costs to determine how much it might cost to rebuild your home if it were destroyed. It might also be a good idea to research coverage options and get multiple quotes for the same types of coverage from multiple companies. If you aren’t sure how much coverage to request, consider speaking with a licensed insurance agent about your needs.
What happens if the cost to rebuild my home is higher after a hurricane?
When disaster strikes, a shortage of materials and qualified contractors is typical. As demand for rebuilding increases, so do prices. If you have extended or guaranteed replacement cost coverage, your homeowners insurance policy may cover the increased costs. Otherwise, your home insurance will only cover your structures and belongings up to the specified limits of your policy. And only for damage caused by covered perils. Keep in mind that standard home insurance policies do not cover flooding. If you live in an area prone to floods, you may want to consider purchasing flood insurance.