What Is Replacement Cost?
Replacement cost refers to the amount it would take to replace or repair an insured item or property at its current market value without factoring in depreciation. Usually, you will see replacement costs on homeowners insurance and other property insurance, as well as auto.
The purpose of replacement cost is to replace buildings or personal property with similar kind and quality. Often, this is more coverage than actual cash value (ACV) since ACV takes depreciation into account. Replacement cost valuation tends to be more expensive than ACV, but it can be worth the peace of mind you get knowing your items will be replaced.
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How Does Replacement Cost Work?
Replacement cost is the amount of money needed to repair an item back to its previous condition or replace it with a new item of the same type and quality. This coverage can be elected on auto and homeowners insurance policies, with different operations depending on your selection.
How Is Replacement Cost Calculated?
Calculating the replacement cost of a home’s structure is necessary to determine the dwelling coverage amount. When evaluating a home’s value, insurance carriers typically consider a home’s characteristics, including the square footage and building materials, and add in other factors, such as the labor costs in your local area.
When a homeowner makes a replacement cost claim, either for the building’s structure or other covered items, the insurance company needs to calculate the amount of each payment. The first check is issued for the actual cash value minus your deductible, and the second is a reimbursement for the recoverable depreciation.
For example, assume someone stole your television, which has a current replacement cost of $900 and an actual cash value of $750. Also, consider that your policy has a $500 deductible. The first payment is based on the ACV minus your deductible ($750 – $500 = $250). After you prove that you’ve replaced the TV and the cost was $900, the insurance company sends a second check for recoverable depreciation for $150.
When you have a replacement cost policy, the insurer pays you the amount it would cost to replace your totaled vehicle with the exact vehicle, minus your deductible. Typically, auto insurance pays the entire amount at once and does not require policy owners to prove that they used the funds to purchase another vehicle.
Types of Insurance That Use the Replacement Cost Method
The most common types of insurance policies for which you will experience replacement costs are homeowners and auto. Be sure to read your policy because it is not guaranteed that you have a replacement cost policy.
Replacement Cost in Auto Insurance
With auto insurance, replacement cost coverage comes into play if your vehicle is declared a total loss. This typically happens when a vehicle has suffered so much damage that the cost to repair it exceeds a certain percentage of its current market value.
If your vehicle is totaled, the insurance company funds you to replace it. With replacement cost coverage, reimbursement is based on the current cost of purchasing another car of the same make and model. There is no deduction for depreciation, so you receive the vehicle’s total price minus your deductible.
Without replacement cost coverage, the reimbursement is equal to the vehicle’s current market value, which includes a depreciation deduction. For example, assume you totaled a $50,000 vehicle that had depreciated by 25%. Without replacement cost coverage, the reimbursement of $37,500 (75% of $50,000) minus your deductible may not be enough to purchase a comparable replacement vehicle.
Replacement Cost in Home Insurance
With homeowners insurance, replacement cost coverage may come into play if your home or possessions are damaged or destroyed. When you elect replacement cost coverage, the insurance company reimburses you for the amount needed to replace the item with a new item of the same type and quality or repair it to its previous condition (whichever is less).
This may be advantageous if many of your items are older, and you may want to replace them with newer models. For example, if your 8-year-old stove is damaged in a fire without replacement cost coverage, you receive a check for the actual cash value of the stove. After the depreciation deduction, the amount you receive may be significantly less than the cost of replacing the stove with a new stove, leaving you to pay the difference out of pocket.
Should You Choose Replacement Cost?
Replacement cost coverage does provide some peace of mind if you are worried about your possessions being damaged, lost, or stolen, but it is not the right choice for everyone. Consider replacement cost if the following apply to you:
- You want to get the full value of your items. Even if they are old and may have depreciated over the years, replacement cost will replace them with like kind and quality regardless of price, up to the limit on your policy.
- You own a lot of new items. If you have new items that you recently purchased, replacement cost is beneficial because you will get their full market value.
- You want to save money on replacing items. You don’t want to have a lot of out-of-pocket expenses at claim time, and one great way to avoid them is to have replacement cost coverage on your policy.
Advantages
- Value of items: Replacement cost covers the entire cost of replacing damaged or lost items at current market prices up to your limit of coverage.
- New replacement: Regardless of the item’s age or depreciation, you will receive brand-new replacements as long as you have enough coverage.
- Better coverage: In comparison to actual cash value, replacement cost offers more extensive coverage, minimizing your out-of-pocket expenses if you have a claim.
- Replacement of property: In property insurance, whether commercial or homeowner’s, having replacement cost ensures full funding for the reconstruction or repair of the property.
Drawbacks
- Higher premiums: Insurance premiums are often higher for replacement cost coverage than actual cash value.
- Overinsurance risk: You could overestimate the value of your possessions, resulting in unnecessary expenses and overpaying for insurance.
- Policy limits: If you have any items of high value, coverage might be limited by policy limits, which could result in gaps in coverage anyway, so it is crucial you periodically review your limits.
- Increase of fraud: Unfortunately, sometimes a claim can bring out the chance of a policyholder embellishing how many personal items they had or what the value was.
Alternatives to Replacement Cost
While replacement cost may not be for everyone, luckily, there are some alternatives if you find yourself wanting to research and see what is best for your unique situation.
Replacement Cost vs. Actual Cash Value
While both replacement cost and actual cash value provide reimbursement for damaged, destroyed, or stolen items, the method of reimbursement is different.
Replacement cost coverage provides the amount needed to replace an item with a new item of the same style and quality. ACV coverage reimburses you for an item’s current value, considering the impact of factors such as age and condition. This typically gives you a smaller reimbursement amount and may require you to spend some out-of-pocket when you replace your items.
Replacement Cost vs. Recoverable Depreciation
Replacement cost coverage covers the gap between an item’s actual cash value (ACV) and the replacement cost. This gap is known as recoverable depreciation.
Insurance policies typically pay out replacement cost claims in two stages. The first payment is for the actual cash value of the items, which includes a depreciation deduction. The insurer may require you to submit proof that you’ve replaced the items or are under contract for repairs before providing a second payment for the recoverable depreciation.
Replacement Cost Endorsements
There are endorsements you can add to your current policy, including:
- Guaranteed replacement: Regardless of the policy limit, guaranteed replacement cost coverage ensures that the insurer will replace or rebuild damaged property at a total cost. An example would be if your homeowner’s limit was $300,000, but rebuilding your home will cost $350,000. Guaranteed replacement cost would ensure you have enough coverage. You should consider this if you live in a disaster-prone area.
- Extended replacement: Extended replacement cost differs from guaranteed replacement cost in that it usually provides extra coverage, but only for a certain percentage. A common example is 20%. So, if your home is insured for $100,000 and you have extended replacement cost at 20% the actual limit available is $120,000.
Putting It Together
Replacement cost is a valuation method used by insurance companies where your items or property are replaced up to the limit on your policy, regardless of their value. It is important to note if you have replacement cost or actual cash value and that you periodically review your policy limits to avoid gaps in coverage. If you have a lot of newer or higher-value items, you may want to consider replacement cost coverage.