Cash Value vs. Replacement Cost Home Insurance

Do you know the difference between “actual cash value” and “replacement cost” coverage? The difference has a significant effect on how much your insurer will pay out after a loss to your home.

Suppose a tree falls on your house, causing severe damage to your kitchen. Your kitchen appliances are 10 years old. New appliances will cost $3,000. With replacement cost homeowners’ coverage, your insurance will pay to replace your appliances at no cost to you. Under an actual cash value policy, the insurer deducts depreciation from the settlement you receive. With depreciation, your 10-year-old appliances could be worth $1,500 or less. If you had an actual cash value policy, that’s the amount you would receive from the insurer.

Actual cash value is defined as the cost to repair or replace damaged property, minus depreciation. Actual cash value can mean the market value of the damaged property — how much it would sell for just prior to being damaged.

Replacement cost covers the cost to repair or replace the damaged property with materials of the same type and quality, without considering depreciation. If you had an old KitchenAid dishwasher, the insurance company would pay for a new KitchenAid.

Replacement cost policies give you better coverage, so you pay more for them. Nonetheless, when you buy a replacement-cost policy, policy limits still apply. If you insure your home for $200,000 and it is totally destroyed, the policy will pay only up to $200,000, regardless of what it costs to rebuild. Insurance companies also sell enhanced replacement cost coverage to protect insureds from potential coverage gaps:

Extended replacement cost provides additional insurance limits — generally an additional 20-25 percent — to pay for extra expenses associated with a total loss. This extra coverage is important if your home is destroyed in a major disaster, such as a firestorm or tornado, because building costs will probably be higher than normal.

Guaranteed replacement cost is similar to extended replacement cost, but the policy has no cap on how much it will pay to replace insured property with similar materials. This coverage can be especially important for homes that have historic, hard-to-restore features.

How Much Insurance?

In order to qualify for extended or guaranteed replacement cost coverage, insurance companies usually require customers to be fully insured. There are two ways they try to make sure they collect enough premium to pay claims:

• Insurance-to-value calculator: Insurers will periodically ask their customers to fill out a form that describes their homes: number of stories, year built, type of roof, etc. The insurer uses the information to calculate a value, which becomes the minimum amount of insurance the customer must buy.
• Inflation adjustment: The insurance company annually evaluates inflation and “suggests” an appropriate increase in property values that is reflected in the renewal premium.

Some insurance companies state that they are not responsible for a customer being underinsured, even if the property limit was determined using their calculator. Insurance buyers should use their judgment to determine if they need more insurance. For instance, one homeowner in California was only required to buy $315,000 in coverage. However, he knew what similar homes in his area cost to build, and he increased his coverage by $200,000.

Most homeowners’ policies have an insurance-to-value clause, which requires the homeowner to insure the property to at least 80 percent of its replacement value. If the owner fails to do this, the insurance company has the right to require the insured to pay part of the claim, in proportion to the amount of underinsurance, after a major loss. What would happen if our California homeowner had not increased his coverage, and if his home sustained $400,000 in damage? The insurance company might determine that his home should have been insured for $500,000. Since he was underinsured, the insurance company could require him to pay a portion of the repair cost, as co-insurance.

Overinsured? Underinsured?

With falling home prices and low inflation, you may feel your home is overinsured. Don’t confuse market value with the cost to rebuild or repair your home. Even if the market value of your home has declined, building costs have not. In the current soft market, you may find a contractor who is willing to negotiate on labor, but material costs — especially for lumber — have continued to increase.

More homes are underinsured than overinsured. If you have owned your home for a long time, if you have stayed with one insurance company for several years or if you have made significant improvements in your home, you may be underinsured.