When shopping for insurance, it is common to hear about premiums, deductibles and coverage types. But what about how you’ll be paid after a property loss? Actual cash value and replacement cost are the two most common methods insurance companies use to determine what they will cover in the event of a claim. The coverage options you select on an insurance policy are even more important than the premium and deductible. Which should you choose? Let’s start with defining what actual cash value and replacement cost are.
If your insurance quote or policy is based on actual cash value that means if a claim is filed, the insurance company will pay out the actual value of the property. This is the cost of the property brand-new, minus depreciation.
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If your insurance quote or policy is based on replacement cost, the coverage amount will equal the amount it will cost to replace the damaged asset new with like materials and quality.
How does actual cash value work?
When a claim is made against an actual cash value policy, the insurance company will most often assess what the insured asset would cost to replace new and then deduct depreciation to determine the coverage amount.
Some insurance companies will instead determine the fair market value of the property in its damaged state. The fair market value will be the coverage amount.
Actual cash value coverage considerations
Under this type of policy, there are some things you should keep in mind. If you file a claim on a car, for example, the insurance company will determine the replacement value of that car and deduct somewhere around 10 percent of the car cost each year.
Using this example, if the replacement value of your car is $20,000 and you have driven the car for 2 years, the actual cash value will be around $16,200. This means you will not be covered enough to replace the car with the same value and quality you had.
How does replacement cost work?
When comparing actual cash value vs. replacement cost, the big distinction is that replacement cost ensures you will be covered for the full replacement value of the property at today’s cost.
Replacement cost helps you make sure you can replace the item without worrying about depreciation or other price changes.
Replacement cost coverage considerations
Although we consider the amount minimal for the value, replacement cost coverage often costs more than actual cash value coverage.
We consulted with a State Farm Insurance representative to get an example of the difference in premium costs on an actual cash value vs. replacement cost policy. In our example, we considered a small dwelling and its contents with a replacement value of $96,000. Under a replacement cost policy, the premium was $924.34. Under an actual cash value policy, the premium was $799.13 with coverage up to $83,900. These numbers will vary based on your location and the property you are insuring.
Extended and guaranteed replacement cost coverage
Replacement cost policies typically offer two coverage options. We recommend checking with your insurance agent to find out they offer extended replacement coverage or guaranteed replacement coverage.
If you add extended replacement coverage to your policy, the insurance company will pay anywhere from 25% to 50% over the insured amount. If you are insuring the $96,000 dwelling and it is destroyed and will cost you $120,000 to rebuild, the additional $24,000 will be covered by your insurance.
If you add guaranteed replacement cost coverage, the insurance company will cover the amount it costs to fully replace your property. So, if you experience a total loss on your $96,000 dwelling but find out it will cost you $200,000 in today’s dollars to fully rebuild that same dwelling, the guaranteed replacement cost coverage will cover the replacement entirely.
Which is better?
Replacement cost policies offer superior coverage levels than actual cash value policies. While it is important to assess your individual needs before determining which policy to choose, it is almost always a safer option to go with a guaranteed replacement cost policy if your budget allows for the extra premium.
It may cost you a bit more on the premium but it is important to remember why we have insurance to begin with. The purpose of insurance is to protect our property and financial well-being in times of damage and loss. You may not really be saving money in the long run if you don’t have adequate coverage in the case of property damage or loss. Replacement cost policies offer greater protection in times of property damage and loss.
However, some insurance is better than none. If all you can afford is an actual cash value policy, that may be the right option for you. Similarly, if you have the money to replace your items without as much help from the insurance company, you might feel comfortable paying for an actual cash value option. Consider your needs, budget, savings account and the replacement costs you would need to pay to determine which is right for you.