UPDATED: Mar 13, 2020
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Replacement Cost, or Actual Cash Value?
There are lots of confusing terms and jargon when it comes to insurance, and homeowners insurance is no exception. Two terms that seem to mystify many consumers are “Replacement Cost” and “Actual Cash Value”. If they are confusing you too, then you’re not alone. But if you don’t learn the difference, it may end up costing you a lot of money. We’ll delve deeper into the differences below, as well as offer useful suggestions that can help you save money on your annual premium.
When you file a claim with your homeowner’s insurance company, they have one of two ways of determining how much money they will pay out (assuming your claim is honored): replacement cost, and actual cash value. To understand the difference between these two amounts, we’re going to use a hypothetical damaged refrigerator as an example.
Let’s say that, due to some faulty wiring in your home’s electrical system, your fancy, expensive refrigerator gets fried and rendered useless well before the warranty runs out. Since there was nothing wrong with the appliance itself, your warranty may not apply to this particular situation, so you’ll have to file a claim with your homeowners insurance company in order to get compensation for your fridge.
If your claim is honored, and your insurance company replaces your appliance at replacement cost, then your insurance company will basically be buying you a new fridge. Obviously, they’re not going to let you run wild at Home Depot and pick out the fanciest, most expensive fridge you want. Another important aspect of replacement cost is that the claim funds must go to repairing or replacing your damaged property with a comparable device, comparable material(s), and must be used for the same purpose. So just like you can’t replace your broken, mid-range fridge with nicer, more expensive one, you also can’t take your awarded claim funds and purchase a new propane grill instead of replacing your broken refrigerator.
When it comes to replacement cost payouts, most insurance companies assign this designation to the Part A coverage of your typical HO-3 policy by default. Part A is the coverage that protects your dwelling (or external structure) of your home. Therefore, if a hail storm damages your roof, a neighbor kid throws a baseball through your window, or a large tree falls into the side of your house, you should receive enough money to repair the damages and make your home as good as new. Keep in mind though that because you are receiving a higher payout per claim, your annual premiums will be higher than if you applied actual cash value. As far as your insurance company is concerned, this helps even out the shared responsibility between you and your provider. Also, don’t forget that the more claims you file, especially for damages insured with replacement cost coverage, the higher your annual premium will be.
Actual Cash Value
Actual cash value, obviously works a little bit differently; otherwise, why have two different designations for the same thing? As far as their similarities go, both have to do with how much money you will receive in the event that an insurance company honors your claim. Unfortunately, with actual cash value, you won’t receive as much.
Again, let’s go back to the hypothetical example of the fried refrigerator. This example is especially relevant for personal property, such as a fridge, because major appliances are protected under Part C of the typical HO-3 policy, which covers personal belongings. And most insurance companies will assign actual cash value payments to Part C coverage claims.
In our actual cash value example, unless your fridge was brand new and got electrocuted the day you bought it, your claim payout is going to be the replacement value of your fridge minus its depreciation. For those who don’t know, “depreciation” is the loss of monetary value that an object incurs as a result of age and/or wear and tear. So the older your piece of property is, the less you will receive for your claim. In some cases, especially that of a really old fridge, you may receive so little from your insurer that it doesn’t make financial sense. After all, if you have a $500 or $1,000 deductible, why file a claim on a 10+ year old appliance that may be valued at less than your deductible? It would make more sense to take that deductible money – plus whatever savings you’ve earned from having a higher deductible in the first place – to pay for a new appliance out of pocket.
How These Valuations Affect Your Premium
Like many things in the insurance world, there is an inverse relationship between how much financial responsibility you take on, and the amount of money you pay in premiums. Most insurance companies will give you the option to change your policy (often called a “rider” or an “endorsement”) from actual cash value payouts to replacement cost payouts or vice versa. But the more money you ask your insurance company to pay by adding replacement cost endorsements to your policy, the higher your premiums will be. At the same time, you will be paying lower premiums for actual cash value coverage, but you might find yourself in financial trouble if you have to file an expensive claim on an older home. Most companies, by default, assign replacement cost coverage to your dwelling and actual cash value coverage to your personal property to strike a balance between these two situations. That way, you get an ample amount of coverage for the most affordable premium.
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