More on Home Insurance
More on Home Insurance
Published February 24, 2021|6 min read
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Replacement cost is a term used to describe the amount it would cost an individual or business to replace an existing asset with a similar asset at today’s market prices. The term is used in the finance and real estate industries, but it’s most commonly associated with the property insurance industry, particularly homeowners insurance.
In homeowners insurance, replacement cost is the amount it would cost to rebuild your home from the ground up, to the way it was before it was damaged or destroyed. If your personal belongings are damaged or destroyed, homeowners and renters insurance can also help cover the cost of replacing your items with something similar.
Replacement cost coverage is one of two loss settlement valuation methods that insurance companies use to determine how much you’re owed on a claim
In homeowners insurance, replacement cost is the amount it would cost to rebuild your home — or replace stolen or damaged belongings — without deducting depreciation from the claim reimbursement
Actual cash value coverage is a loss settlement valuation method that factors property depreciation into the claim payout. Actual cash value coverage generally costs less than replacement cost coverage, but offers far less effective protection
Replacement cost coverage insures your home and personal belongings at the amount it would cost to repair or replace the damaged property without deducting for depreciation. That means if your 10-year-old roof is damaged in a storm and needs to be replaced, you’ll be reimbursed for the cost of a new roof that’s similar to the existing one, not the cost of a 10-year-old roof.
The amount of home insurance in your policy should be based on the replacement cost value of the home, not its market value or purchase price or the remaining balance on your mortgage. In other words, replacement cost only factors in costs associated with constructing a house from the ground up, not the value of the land the home is built on. For that reason, the amount of insurance on your home will often be less than its fair market value.
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When you buy homeowners insurance, what you’re typically getting is a replacement cost policy.
On the other hand, personal belongings — like furniture, clothing, and appliances — are generally covered at their actual cash value by default, although replacement cost coverage can be added for your personal property via coverage endorsement.
Most home insurance companies will require that you insure your house for at least 80% of its true replacement cost value as a prerequisite for getting a full replacement cost claim payout. If your house is insured below the 80% threshold and you file a dwelling coverage claim, you’ll only be reimbursed for the depreciated value of the damaged property. For that reason, you’ll want to be certain that your home’s insured value is as close to its true replacement cost as possible.
There are a few ways you can estimate your home’s replacement cost value:
Contact a local appraiser or contractor who specializes in replacement cost estimates
Use an online replacement cost estimator
Multiply the square footage of your home by the local construction costs per square foot
Personal property coverage amounts are typically set as a percentage of your policy’s dwelling coverage, with most companies giving you the option of setting your coverage at 50% or 75% of your home’s insured value. While you don’t get to choose a specific personal property coverage amount, it’s important to have a ballpark value of everything you own to better steer you toward a coverage percentage.
One effective way to figure out the replacement cost of your personal belongings is to set up a home inventory. Many insurance companies offer home inventory forms of their own, and there are several web and mobile apps that make it easy to keep track of and add up the value of your personal belongings.
Before getting paid out for a homeowners insurance claim, you’ll first need to pay your policy deductible, which is the out-of-pocket amount you’re responsible for paying before the insurance company covers the remainder of a loss. That means if your policy deductible is $1,000 and your home incurs $10,000 in covered losses, you’ll pay $1,000 before your insurance company reimburses you the remaining $9,000.
While most homeowners insurance sold today is of the replacement cost variety, there are some insurance companies that provide actual cash value coverage for both the dwelling and personal property sections of the policy. That means the amount you're reimbursed for a claim is the depreciated value of the damaged or stolen property.
In other words, actual cash value is calculated by factoring in the age and condition of the insured asset, whereas replacement cost is calculated by factoring in the amount it’d cost to replace an insured asset with a new one of similar type and quality.
When determining an actual cash value claim settlement on insured property, your home insurance company will subtract a certain percentage from the property’s replacement cost to arrive at a reimbursement amount. Normally, this percentage is based on the age of the insured property.
Take for instance a guitar that you purchased new for $2,500 five years ago. The guitar is unfortunately stolen, so you file a home insurance claim. If the guitar is insured with actual cash value coverage, your insurer would reimburse you $2,500 minus five years of depreciation. If your insurance company subtracts, say, 10% of an item’s replacement value for every year old it is, you’d only get a $1,250 claim payout toward a replacement guitar.
Replacement cost coverage claim settlements are a little more cut and dry. If your property is damaged or stolen, your claim check will reflect the value of property of similar type and quality, without depreciation being factored in.
Keep in mind that the replacement cost settlement that you get can be more or less than what you initially paid, depending on if construction costs or whatever you’re replacing went up or down in price.
That $2,500 guitar, for example, may actually cost $3,000 today. If that’s the case, then your insurance company should pay you the $3,000 to replace it.
One thing to bear in mind is the initial amount you receive from your insurance company is typically the actual cash value, or depreciated amount, of the damaged property. Once you repair or replace the property cited in the claim, your insurance company will pay out the remaining amount.
Your home is likely your most important financial asset, so you’ll want to make sure that the structure itself and everything inside are fully protected in the event of a disaster.
With replacement cost coverage for your home and personal belongings, you can rest assured knowing that you won’t have to pay an exorbitant amount out of pocket in the event of a covered loss. While actual cash value coverage is enticing due to its lower cost, the nominal short term savings simply aren’t worth the amount you’re risking.
Most insurance companies also offer extended replacement cost dwelling coverage, a coverage add-on that automatically increases the coverage on your home if the loss is greater than its initially insured value.
Most companies offer extended replacement in increments of 25% and 50% of your home’s dwelling coverage limit, meaning if your home is insured for $300,000 and you have 25% extended replacement cost, then your home is essentially insured for $375,000.
Extended replacement cost is essential for homes in severe weather and natural disaster-prone areas, as rebuild costs tend to skyrocket after catastrophes.