The distinction between 'Actual Cash Value' (ACV) and 'Replacement Cost' is one of the most important concepts in homeowners insurance. Do you know what the difference is? If you have home insurance, you should. Let us break it down for you.
What “Replacement Cost” Means
Replacement cost is the amount it would cost to replace your destroyed, damaged or stolen items with the exact same item, or similar ones, after a loss. The replacement cost is often calculated as the initial amount you paid for the item. If the item you bought is no longer available, replacement cost policies will pay you initial price of the item you bought in order to find one similar. If the item you purchased is still available but at a reduced price, your claim may reflect this change in value.
A replacement cost claim may sometimes be paid out in two installments. Often, the insurer will send one payment for the ACV of the item/component or half of its total replacement cost. Once you have performed repairs or bought a replacement, you can send the documentation to your insurer to recover the remaining reimbursement.
Actual Cash Value (ACV) Explained
Actual cash value (ACV) refers to a policy that covers your home and possessions for market value at the time they are lost or stolen. Since your items are used, “market value” means that depreciation will be factored in when your insurance company pays you for your claim.
How Insurers Calculate Depreciation
Different insurance carriers will have different ways of calculating depreciation. One of the most common methods is to calculate the item’s value as a portion of its life expectancy.
For instance, a roof predicted to last 30 years will be assumed to have zero value at the end of that timespan. So, if the roof is somehow destroyed 15 years after installation, the ACV will be half of the original cost of the roof.
Another way to look at the “lifespan” model is to divide one by the life expectancy of your item to find the annual depreciation rate. An item with a 10 year lifespan will depreciate by 10 percent or .1 a year. Use this figure multiplied by the years you used your item to calculate its depreciation.
Aside from life expectancy, your insurer may use market data to determine the replacement cost. For example, if your twenty year old bay window assembly was destroyed by a storm, your carrier may try to find a wholesaler who offers twenty year old bay window assemblies and ask how they would price them.
This method requires more effort, but insurers may have access to a pricing network or depreciation estimation software that accomplishes the same task. Either way, you are able to take into account the condition of the item rather than assuming that all of your belongings have the same useful life.
Replacement Cost Trumps ACV
For almost every home owner, a replacement cost policy would be preferable. Coverage like this will pay the true retail cost of replacing lost, ruined or stolen possessions. With expensive electronics, actual cash value usually just will not suffice when you are trying to replace what you have lost. For example, a laptop purchased for $2,000 three or four years ago would actually be worth far less than that now. An insurer will likely write you a check for $700 or so to cover the actual cash value of the item. Finding another comparable laptop at that price would prove challenging, if not impossible.
The truth is that after a disaster or major loss, you are looking to replace your items. Since you are almost never likely to find a store or market that sells the exact same TV and couch that you used to own, in the exact same condition at the ACV price, replacement cost coverage just makes more sense.
One reason that many people opt for ACV policies over replacement cost policies is that the price of the policy will reflect this coverage difference. In most situations, the better coverage of replacement cost policies can make homeowners much happier with their policy after a loss occurs. Depending on how many valuables you have, paying a little extra to get the upgrade might be worth the money. You could also usually offset the extra cost by raising your deductible. After all, home insurance is there for most people to protect them from major catastrophes, not everyday accidents.
Valuable, Antique or Collectible Items
Even with a replacement cost policy, your most valuable belongings will only be covered for a portion of their value. Items like jewelry or electronics typically have a $1,000 cap on per-item claims. With art, antiques or collectibles, this amount could be as little as $2,500 for your whole collection.
Another problem is that with certain rare items, the true replacement cost may have actually gone up since your initial purchase. Insurers will rarely accommodate this appreciation in value, instead opting to pay for your initial purchase value. Thus, an autographed jersey by an athlete who recently died may only be worth the $50-$100 you paid for the jersey itself and the person to sign it at after meeting them. In actuality, this item could be worth thousands of dollars and be nearly impossible to replace.
For items like these, you can purchase special “floaters” or riders to cover your most valuable or irreplaceable possessions. Other times, you can purchase a separate policy especially made to cover rare and valuable collections.
Why an ACV Policy May Be a Bad Idea: An Illustrative Example
Joe and Flo Smith live in a home with their two children. The home was recently appraised at $200,000, and it was built 30 years ago without any major upgrades or renovations since that time. An ACV insurance policy covers the home and their belongings.
One night, a frayed wire in the master bedroom wall sends a spark that catches the insulation and wall stud on fire. The fire spreads quickly through the walls up to the ceiling of both the master bedroom and the adjacent guest room.
Fortunately, the smoke alarm goes off and the family evacuates safely. A local fire station responds quickly and puts out the fire before it can spread to the roof or other rooms. While the house is still very much intact, there is a large region damaged by fire, smoke and water from the fire department.
When the Smith family files a claim, an insurance claims adjuster comes out and estimates that the damage will take $25,000 to fully repair, which represents the replacement cost. However, since the estimated structural lifespan of the home in its pre-fire condition was 60 years, the depreciation has a big impact on the ACV claim offer. After the calculations are performed, the adjuster can only write a check for $12,500. Joe and Flo will now have to pay directly out of pocket for the remaining half before they are able to restore their home to a livable condition.
Worse, when calculating all of the various possessions damaged, the family is faced with an even bigger deficit. The adjuster estimates that the destroyed items like the beds in both rooms, a large TV, a couch and some other furniture have a replacement cost of $10,000. Once they factor in all of the various depreciation calculations, the Smith family may end up with as little as $3,000 to $5,000 to cover all of these ruined “big ticket” items.
A vivid example like this illustrates why after a disastrous situation, ACV insurance can do too little to reduce the financial burden of recovering.
Making Sure Your Insurance Coverage Works For You
When speaking to an agent, you must be absolutely clear about the kind of policy they are offering you. Make sure that you get every cent of coverage you need to prepare for common and likely catastrophes.
Obviously, the most important thing home insurance covers is your actual home. In many cases, opting for limited coverage of your possessions paired with complete coverage of your dwelling could possibly make the most sense. Take an inventory of your possessions and decide what is right for you and your family.
Whatever coverage you pick, always be sure to speak with multiple agents and verify that you are receiving the best rates for your coverage, and that your coverage is adequate.
