Insurance is an important tool that helps cover the cost of damage to or loss of your most important possessions, such as your vehicle or your home. Ensuring you have sufficient coverage can help protect you financially if a covered loss occurs.
When choosing your insurance coverage, an important consideration is whether to opt for replacement value or actual cash value (ACV) reimbursement. Replacement value considers the total cost of replacing the item today, while actual cash value subtracts depreciation, leaving you with a smaller benefit.
However, just because ACV provides a smaller payout when you file a claim does not mean it’s automatically the lesser of the two types of reimbursement. ACV tends to be more affordable than replacement cost, and it may also make more sense for insuring certain items.
How Does Actual Cash Value Work?
Actual cash value provides coverage for the market value of an item as of today. For example, say you have a 10-year-old television that is stolen or damaged by a covered incident. ACV coverage would provide reimbursement for the current value of that specific TV, rather than what it would cost to replace it with the newest model. This means even if you bought the TV new for $300, if it is only worth $75 today, your ACV policy would pay $75.
Actual Cash Value in Auto Insurance
When you have an accident or your vehicle is damaged by a covered incident, the insurance company determines the cost to fix it. If this cost exceeds a certain percentage of the vehicle’s value, the insurer deems the vehicle a total loss, or “totals” it. In this case, the insurer determines your payment amount by estimating the current replacement value of the vehicle and making depreciation deductions based on the vehicle’s make, model, year, accident history, wear and tear, mileage, and other factors.
Since vehicles tend to depreciate quickly, when you choose ACV coverage, the amount your insurance carrier pays you could be less than the amount you owe on your loan. In that case, having gap coverage can help cover the difference between the amount you owe and your vehicle’s actual cash value.
Actual Cash Value in Home Insurance
A homeowner’s insurance claim on a policy with actual cash value coverage works in much the same way as with auto insurance. For example, assume your 8-year-old refrigerator was destroyed during a kitchen fire and you file a claim with your insurance company. Even if a new replacement refrigerator costs $2,000, if your exact 8-year-old refrigerator is only worth $500 today because it is a now outdated model, your insurer would send you a check for $500 (minus your deductible).
The same concept applies to larger-scale claims. For example, if your 10-year-old roof is destroyed in a windstorm, the insurance company pays an amount that’s reduced for the roof’s age and condition prior to the damage, rather than the full amount it costs to put on a new roof. If you have not yet met your deductible, this is subtracted from your payment amount as well.
Actual Cash Value vs. Replacement Cost
Replacement cost coverage will replace your damaged, stolen, or destroyed item with a brand-new item of the same kind and quality, even if that new item is a newer model. On the other hand, actual cash value provides you with an amount equal to the depreciated value of the item.
When comparing the two options, remember that while replacement value provides a higher coverage amount, it also comes with a higher insurance premium. On the other hand, ACV may save you money on your premiums, but if your property is stolen, damaged, or destroyed, you will receive a lower benefit amount.
Which option is preferable depends on how you intend to use it. For example, if you are looking to insure your car, you may want to consider replacement cost if the car is fairly new, in good condition, and you do not plan to change vehicles any time soon. However, if the car is already older, in poorer condition, or you plan to change from a sedan to a van to accommodate a growing family, ACV may make more sense. This is because with an older vehicle, the value is already significantly lower and if you intend to replace the vehicle entirely anyway, it may save you more money in the long run to pay lower premiums and risk the lower payout.
Actual Cash Value vs. Recoverable Depreciation
Recoverable depreciation is the difference between replacement costs and actual cash value. When you choose a policy with ACV coverage, the depreciation is not recoverable, and the insurance carrier pays the reduced amount. However, if you have replacement cost coverage, the depreciation is recoverable.
Insurance carriers typically pay replacement cost reimbursements in two phases. The first check covers the depreciated value, or actual cash value, of the items. Then, once you have replaced or repaired the items, the carrier sends a second check for the recoverable depreciation. Insurers split payments in this way to prevent fraud and incentivize policy owners to spend the money on making repairs or replacements as intended.
How Is Actual Cash Value Calculated?
While you may think you have an idea of the value of your items, insurance companies will not simply accept your estimates. Instead, actual cash value in insurance is calculated with a specific formula. The process begins with determining the item’s replacement cost. This is equal to the amount it would cost to buy a new item of the same kind and quality or repair the item, whichever costs less. Next, the insurer calculates depreciation by determining the amount of time left in the item’s useful life. Finally, they multiply this percentage by the replacement cost to calculate the actual cash value.
For example, assume your couch was destroyed in a fire, and that the following details apply:
- Your couch was 6 years old
- A new couch of the same kind and quality is $3,200
- The life expectancy of a couch is 10 years, so your couch had 40% of its useful life remaining
When calculating actual cash value, the insurance company multiplies the replacement cost by the percentage of expected life remaining. In this case, $3,200 x 40% = $1,280. With an actual cash value policy, you would receive a check for $1,280.
On the other hand, if you had replacement cost coverage, the carrier may send you an initial check for $1,280 and then send a second check for $1,920 — the recoverable depreciation — after you replace the couch, ultimately providing you with the full replacement cost.
Pros and Cons of Actual Cash Value Over Replacement Cost
Once you understand the difference between ACV and replacement cost coverage, you’re still tasked with deciding which option to select for your insurance coverage. This may vary depending on your needs.
Since ACV coverage typically comes with lower premiums, this can be a good option if you’re on a budget. Also, if you do not have many expensive items to insure, this coverage may be all you need. However, keep in mind that with ACV coverage, the appraiser determines the depreciation deduction based partly on the condition of the items. If your possessions are in excellent shape, you may be asked to prove this or forced to accept the assessment the appraiser provides.
Replacement cost policies may be advantageous if you have many older or high-value items or live in a high-risk area. Replacement cost coverage comes with higher premiums, but you may pay significantly less out of pocket to repair or replace your possessions if you suffer a loss.