You have a fire in your home and it destroys the structure of the home in several rooms and also a few home furnishings such as a sofa and television. You put in a claim with your homeowners insurance company to cover this loss. Suddenly you are faced with terminology such as replacement cost and actual cash value. What do these words mean? They can be confusing for many people, so we will explain here in more detail the meaning behind these insurance terms.
After you have a covered loss to your home, there are several different methods by which your insurance company may calculate the amount it will pay you. The two most common methods are called replacement cost and actual cash value. Both types of coverage help with the costs of rebuilding your home or replacing items after a covered loss. There are other types of methods, but here we will only focus on replacement cost and actual cash value. What is the difference between replacement cost and actual cash value when it comes to homeowners insurance?
What is Replacement Cost?
Payment based on the replacement cost of damaged or stolen goods is usually the most favorable from your point of view because it compensates you for the actual cost of replacing property using today's prices. It allows you to put yourself in the same position you were in prior to the loss. It provides you with the necessary money to replace your items with another items of like kind.
Most standard homeowners insurance policies will cover your home -- the actual structure itself -- at a higher limit than what you would have probably paid to buy or build it. Why? Because it will cost more to build a brand new home on your property in the event that the current structure is currently destroyed. The structure of your home is covered on a replacement cost basis.
The same cannot be said about the contents inside your home. Most standard homeowners policies offer the default coverage of actual cash value for personal property. However, you can choose to replace your property at replacement cost for an additional premium.
Replacement cost is NOT replacing your formica counter tops with granite, or replacing your linoleum floor with tile, if your kitchen is destroyed. It will only replace the damaged property with another item of like kind, using today's prices at the time of loss.
What is Actual Cash Value?
Actual cash value is the depreciated value of an item of property at the time of the loss. This type of settlement does not allow you to replace what you have lost. Instead, it compensates you for the value of an item as if it were being sold at a garage sale. In fact, average cash value is defined as replacement cost minus depreciation.
Claim Scenario #1
Your home and furnishings were destroyed during a recent wildfire. You made a claim to your insurance company and have met your deductible. Now you want to replace the damaged furnishings. Last year, you bought a sofa for $2,000. The amount of money you will receive to replace the sofa depends on the type of coverage you have.
- If you have replacement cost, the company might pay you $2,100 because that is what it would cost to buy a similar soda using today's prices.
- If you have actual cash value, the company might pay you $1,500 because that is the actual cash value of the sofa today after taking wear and tear into account.
Claim Scenario #2
Suppose you have an eight-year old air conditioning compressor that is damaged by lightning and needs to be replaced. You made a claim to your insurance company and have met your deductible. Eight years ago you paid $4,000, but now it costs $6,000. Suppose also that the average life span of an air compressor is 16 years.
- If you have replacement cost on your policy, then the insurance company will base the claim payment on the $6,000 cost.
- Since the compressor is 8 years old, it has 50% of its life left. The actual cash value would be the 50% of the $6,000 cost, or $3,000.
Which is Preferred?
Homeowners insurance policyholders will usually prefer payment based on the replacement cost of damaged or stolen property because it compensates a policyholder for the actual cost of replacing property and not some depreciated value.
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