Replacement cost is one method insurers use to determine the value of insured property when calculating reimbursement in the event of a loss. Specifically, the replacement cost is the amount to replace damaged property with the same kind and quality of materials without accounting for depreciation.
Learn what replacement cost is, how it is determined, and how it compares to the actual cash value method.
Definition and Example of Replacement Cost
Replacement cost is the amount your insurance policy will pay to repair, replace, or rebuild your damaged property based on current costs without accounting for age, wear, and tear. The goal is to restore your property to its original condition with materials of similar value and quality.
- Alternate name: Replacement cost value
- Acronym: RCV
Let’s say your roof was damaged by a storm and needs to be entirely replaced to the tune of $12,000. If your insurance policy pays replacement cost, the entire amount to get your roof back to the shape it was in before the storm (minus your deductible) should be covered.
Replacement cost coverage doesn’t account for depreciation, or how much your roof was worth before the storm destroyed it. Your insurance company would pay a replacement cost of $12,000, in this case, no matter how old the roof is.
Insurance companies may require you to purchase enough insurance to cover at least 80% of your home’s replacement value to fully cover your losses. For example, if your home is worth $500,000, you would need to have coverage of at least $400,000 for the insurance company to cover claims at replacement cost.
How Replacement Cost Works
You have the option to insure your property for either the replacement cost or the actual cash value. Unlike replacement cost, actual cash value reimburses you for what your property is worth today. The actual cash value takes what it would cost to repair your property now minus the loss of value (depreciation) due to condition, age, and current usefulness.
Most people purchase a replacement cost policy when they obtain homeowners insurance. This policy typically provides more coverage than an actual cash value policy since the amount of insurance you purchase is based on what it would cost to replace your property—regardless of depreciation.
But even if you have replacement cost coverage, an insurance company may first reimburse you for the actual cash value. Once you repair or replace the items damaged, you would provide the insurance company with receipts to be reimbursed for the difference. This is called recoverable depreciation.
Insurance companies have the option to replace or repair damages through preferred vendors since they can often do it at a lower cost.
Some insurance companies offer an extended replacement cost policy, which will pay a certain percentage over the policy limit to rebuild your home. If building costs increase unexpectedly, this will give you access to additional funds to cover the overage.
An insurance company may not issue you a replacement cost policy if you own an older home or if the total cost of replacing your property exceeds what the property is currently worth. In either of these cases, an insurance company may offer you a market value (or actual cash value) policy instead. This type of policy will cover the costs to replace the damaged property minus depreciation.
Replacement Cost vs. Actual Cash Value
|Replacement Cost||Actual Cash Value|
|Does not account for depreciation||Accounts for depreciation due to age, condition, wear, and tear|
|You pay a higher monthly premium||You pay a lower monthly premium|
Replacement cost and actual cash value are two ways that insurance companies reimburse you for property damage after a covered loss. Both valuation methods determine reimbursement for replacing, rebuilding, or repairing items after a covered loss. However, actual cash value reduces the amount by considering an item’s depreciation, while replacement cost does not.
- Replacement cost is one way to determine how much it costs to repair or replace damaged property with comparable materials (with respect to things like make, model, and quality).
- Actual cash value is a second method insurers use for establishing the value of insured property.
- You’ll typically pay a higher monthly premium for a replacement cost policy since it offers more comprehensive coverage than an actual cash value policy.