When you pay the monthly premium for your homeowners policy, you expect it to provide adequate coverage for everything in your home, including appliances and personal effects. However, some homeowners are surprised that their insurance policy does not provide enough compensation to replace damaged or destroyed personal items.
Replacement cost coverage ensures you receive benefits for your personal items damaged in a covered peril. What makes replacement cost coverage unique is that it provides coverage worth the current market value of your items rather than what they would be worth minus depreciation.
Approximately 1 in 20 insured homes have a claim each year, so it’s essential to ensure you’re properly covered. Read on to learn how replacement cost works and whether it’s right for you.
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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.
Replacement Cost in Auto Insurance
With auto insurance, replacement cost coverage comes into play if your vehicle is declared a total loss, also known as being totaled. 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. Each insurance company may have its own threshold for determining what qualifies as a totaled vehicle.
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.
Replacement Cost vs. Actual Cash Value
Before deciding whether you need replacement cost or actual cash value (ACV) coverage, it’s essential to understand the differences and the similarities. While both types of coverage provide reimbursement for damaged, destroyed, or stolen items, the method of reimbursement is different.
Replacement cost coverage provides you with 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 the item’s age and condition. This typically gives you a smaller reimbursement amount and may require you to spend some money 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.
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, assume that your policy has a $500 deductible. In this case, 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 same 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.
Pros and Cons of Replacement Cost Over Actual Cash Value
When comparing replacement cost and actual cash value coverage, it’s essential to understand the pros and cons of each. Replacement cost coverage offers additional protection and can help limit out-of-pocket expenses if an incident occurs. However, this coverage also comes with an additional cost. ACV coverage allows you to pay a lower premium for your policy, but the reimbursement amount is lower if you have a covered incident.
Typically, replacement cost coverage may be advantageous if you believe your risk of having a covered incident is high, you have many high-value items, or many of your items are old and heavily depreciated. If you are on a budget and trying to keep your premium costs down, you may consider opting for ACV coverage instead. Remember that if a covered incident occurs, you may incur some out-of-pocket costs when you replace your items.