The best way to be a better consumer of insurance products is to know what your are buying. Insurance terminology may seem vague and/or confusing, and it might be easier to just sign on the dotted line, pay your premium and get on with your life.
However, those vague or confusing terms can have a huge impact on how your claim is paid, and what you are able to accomplish with your claim payment after a loss. Two such terms in property insurance are replacement cost and actual cash value.
What Is Replacement Cost?
Most property policies today are written on a replacement cost basis. Replacement cost is defined as the amount needed to replace an item with like kind and quality without deduction for depreciation.
In terms of structure replacement, often the cost to replace an older structure with one of like kind and quality in today’s market would cost more than it did when the structure was built. Labor costs are higher, materials typically cost more, and a new structure may be required to have features that were not required when the original structure was built (an excellent reason to have ordinance or law coverage).
For replacement of business or personal property, replacement cost value can be all over the map. An older electronic item may be replaced with like kind or quality for a fraction of the original cost. Some artwork and antiques may increase in value over time.
What replacement cost does: replaces the item with like kind or quality up to the face value of the policy.
What replacement cost does not do: the replacement cost of the item will not exceed the face value of the policy (unless the policy has been endorsed to cover this).
When writing your policy, your insurance broker may have tools available to help you determine the replacement cost value of homes and other items. However, the insured property value is ultimately decided by the policyholder when the policy is written. The most accurate way to determine replacement cost value is by appraisal, which should be performed every 2-3 years to be certain that items are properly insured.
What Is Actual Cash Value?
Actual cash value (ACV) is most commonly defined as replacement cost value less depreciation. In most cases, the older an item is, the less it is worth for reimbursement. An item may also lose value based on heavy usage.
Actual cash value is most commonly used in auto insurance. As you’ve probably heard, your vehicle begins to depreciate as soon as you drive it off the sales lot, so your car decreases in value the longer you own it and the more you use it. (Endorsements may be available with some insurers to insure you auto on a replacement cost basis, so ask your broker.)
ACV is also used in the valuation of work tools and equipment, which, like vehicles, decrease in value with age and usage.
How is depreciation determined? There are many guides used for determining depreciation, including an IRS guide. Many industries have depreciation guides that are specific to their industries. While depreciation guides are typically used for tax purposes, they may also be used to determine depreciation for insurance reasons.
In the event of a claim it is important to understand how depreciation will affect your claim payment, so talk with your broker or claim adjuster to get more details. In some cases, items may depreciate beyond their ability to be properly insured, and may require replacement with newer items. They may also be left off the policy entirely.
If your items are insured at actual cash value, the claim payment will never exceed the face value of the policy, and may, in fact, never reach the face value if items are not properly appraised and insured on a regular basis.
Which Valuation Is Right For You?
Insurance industry standard for most property policies today is that the coverage is written on a replacement cost basis. This maximizes the claim value for the policyholder and is less complicated for the insurance company. This effectively takes the decision out of the policyholder’s hands.
However, some underwriters may choose to write certain items as replacement cost and others as ACV, especially if the item or structure is older, has more wear and tear, or cannot be insured on a replacement cost basis due to quality and availability of like materials.
You can elect to insure for ACV if you do not plan to replace the structure or items in the event of a claim. This is a handy way to control insurance costs, but may result in claim payment shortfalls in the event of a total loss.
Your insurance broker is your partner in maximizing insurance benefits for your home or business. Discuss items that need to be insured, the necessity of these items and any future plans with your broker to determine which valuation is right for you.