There are two basic methods for calculating the payment you’re owed on a property insurance claim: actual cash value and replacement cost value. What’s the difference? Actual cash value (ACV) discounts your reimbursement based on the age and condition of your property, and replacement cost value (RC or RCV) does not. Why does that matter? For starters, a policy that calculates reimbursement using replacement cost will usually pay more on a claim (and cost more in premiums) than one that uses actual cash value. But there are plenty of other ways in which ACV and RC could affect your recovery. Continue reading to understand how.
Let’s start with some context. Actual cash value and replacement cost are concepts that matter when you’re trying to calculate the amount of your insurance reimbursement. They don’t help to determine how much damage occurred to your property or whether that damage is covered by your insurance policy. Instead, they become relevant once you’ve established that you suffered property losses that are covered by your insurance policy. At that point, the question isn’t whether you’re owed money under your insurance policy, but how much you’re owed. The answer to that question–how much–will depend in part on whether your insurance policy calculates reimbursement using actual cash value or replacement cost value (or something in between).
In theory, the difference between actual cash value and replacement cost is relatively simple: ACV factors in the age and condition of your property, and RC does not. In accounting lingo, discounting the value of property due to age is called depreciation, and you may see that word used to describe how ACV reimbursement works. Indeed, the most common method for calculating ACV is simply to determine the replacement cost of an item and then subtract depreciation. (Other methods for calculating ACV include market value and the so-called broad evidence rule, but they’re less common). Regardless of how you describe it, the end result is the same: you generally receive more money on a claim calculated at replacement cost than one calculated at actual cash value.
If you get ACV and RC mixed up, the terms themselves help to explain their meaning.
- The “actual cash value” of property means the actual value of the property as it existed just before it was damaged or destroyed. So when your insurer reimburses you based on an item’s actual cash value, it’s paying you the amount that the covered property was worth immediately before the loss, not necessarily the amount that it costs to replace it.
- The “replacement cost” of property is just that — the cost of replacing the damaged or lost property. So when reimbursing based on replacement cost, your insurer should pay you whatever it costs to replace the covered property, regardless of what the actual value of the property was just before it was damaged or lost.
Imagine a windstorm ruins your belongings in your living room, including the couch you bought five years ago for $1000. Let’s assume the windstorm is a covered peril and the ruined belongings (including the couch) are covered property under your homeowners insurance policy. Also, your total losses exceed your deductible. So you have coverage, and you make a claim.
How much should your insurance company pay you for the ruined couch? It depends on whether your policy specifies that reimbursement will occur based on actual cash value or replacement cost value.
If your policy reimburses based on ACV, then your insurer will offer to pay you what it thinks that particular five-year old couch is worth — say, $400. In that scenario, your insurer discounts your reimbursement by $600 to account for the couch’s depreciation in value over the last five years. If, on the other hand, your policy reimburses based on RC, then your insurer should offer you the amount that’s needed to buy the same make and model of couch, regardless of the price. If the exact make and model is no longer available, your insurer needs to pay you an amount for a couch of “like kind and quality” (more on that below).
Structures vs. Belongings
Your insurance policy may call for either ACV or RC reimbursement depending on the type of property covered. Homeowners policies generally provide separate coverages for the physical structures on your property (Coverage A and Coverage B) and your personal belongings (Coverage C). It’s not uncommon for your policy to distinguish between these coverages when specifying how it will reimbursement you. For instance, your policy could state that it reimburses damage to your dwelling and other structures (Coverages A and B) at replacement cost and losses to your personal belongings (Coverage C) at actual cash value.
Review your policy to understand how reimbursement is set. A good starting place is a subsection that usually entitled “loss settlement.” Be sure to review your endorsements too. Endorsements like premium endorsements may augment your policy from ACV reimbursement to RC reimbursement.
The Hybrid Approach — Recoverable Depreciation
Insurance policies often combine elements of both RC and ACV into a formula that’s known as recoverable depreciation. Under recoverable depreciation, you get paid in two installments. For the first installment, your insurer pays you the actual cash value of the damaged property as soon as you can adequately prove your damages and establish coverage. For the second payment, your insurer will pay you the the remaining amount needed to reach replacement cost coverage, but only once you prove that you’ve actually repaired or replaced the damaged or lost property.
Let’s say you have a ten-year-old roof that is severely damaged by a hail storm and needs replacing. The quote you receive from a qualified contractor for the replacement is $25,000. The replacement is covered, so the only question is how much the insurance company will pay you. If your policy calls for recoverable depreciation, then your insurer will cut you a check for the actual cash value of the roof — say $10,000 — as soon as you adequately prove the damage to your roof.
What about the remaining $15,000 it costs to replace the roof? With recoverable depreciation, you can’t get the remaining $15K until your contractor completes its work to replace the roof. If you’re lucky, your contractor may delay collecting final payment from you until you receive the $15K from your insurer. Or you may have signed an assignment of benefits that puts the contractor on the hook for the $15k. Yet another possibility still is that your insurer is requiring you to use a preferred contractor, in which case you don’t have to pay the $15k out of pocket. But if none of those scenarios apply, then you may have to front $15K before your insurer will fully reimburse at replacement cost for the damage to your roof.
Like Kind and Quality
Calculating reimbursement, especially at replacement cost, can be tricky when the exact item or material that’s covered by your policy is no longer available. Going back to the example of your ruined five-year-old couch, what if the manufacturer discontinued that couch only a year after your purchase? How would you determine the replacement cost for an item that can’t be replaced?
Typically, the answer is that any couch of “like kind and qualify” will qualify for replacement cost reimbursement. Did you buy your couch on Amazon for $200? Then even if it’s no longer available, don’t expect a reimbursement that upgrades you to a $1,000 couch. But inversely, if you spent $3,000 on a Crate & Barrel couch that is no longer available for purchase, you shouldn’t accept an insurance settlement of $1,000 to replace your couch.
Every policy is different, so you should check yours to understand the specifics. For instance, because it can be difficult to replace truly unique items with something of like kind and quality, your policy might exclude antiques and collectibles from replacement cost coverage.
The 80% Rule
If you were to look for the reimbursement provision in your insurance policy (again, under the “Loss Settlement” subsection), you might come across something like this:
Covered property losses are settled as follows: . . . Buildings covered under Coverage A or B [are reimbursed] at replacement cost without deduction for depreciation, subject to the following:
a. If, at the time of loss, the amount of insurance in this policy on the damaged building is 80% or more of the full replacement cost of the building immediately before the loss, we will pay the cost to repair or replace, without deduction for depreciation, but not more than the least of the following amounts:
(1) The limit of liability under this policy that applies to the building;
(2) The replacement cost of that part of the building damaged with material of like kind and quality and for like use; or
(3) The necessary amount actually spent to repair or replace the damaged building.
If the building is rebuilt at a new premises, the cost described in (2) above is limited to the cost which would have been incurred if the building had been built at the original premises.
b. If, at the time of loss, the amount of insurance in this policy on the damaged building is less than 80% of the full replacement cost of the building immediately before the loss, we will pay the greater of the following amounts, but not more than the limit of liability under this policy that applies to the building:Insurance Services Office, Inc., Homeowners 3–Special Form (HO 00 03 05 11)
(1) The actual cash value of that part of the building damaged; or
(2) That proportion of the cost to repair or replace, without deduction for depreciation, that part of the building damaged, which the total amount of insurance in this policy on the damaged building bears to 80% of the replacement cost of the building.
What?? If you’re confused, we don’t blame you–it’s a very confusing provision, albeit one that is relatively common in homeowners insurance policies. The reason for the confusion (beyond the legalese) is something known as the 80% Rule.
First, some background. In other types of insurance (for example, medical insurance), you may be familiar with the need pay co-insurance. Co-insurance is an arrangement where you and your insurer split the costs of insurance payments according to a predetermined percentage. So if you have 10% co-insurance requirement for your medical insurance, you would pay 10% of the cost of medical care (even after paying any deductibles), and your insurer would pay the remaining 90%.
Co-insurance arrangements like the one above aren’t as common in property insurance. But without some kind of co-insurance requirement, policyholders would reduce their total coverage amounts to lower their premiums, knowing that total-loss events are very rare. This presents a problem for insurance companies, who don’t want to miss out on the higher premiums. To solve this “problem,” insurers added policy language that penalizes you if your total coverage is less than 80% of the value of your insured property.
The “penalty” for the 80% Rule is a co-insurance requirement. Specifically, if your policy limits are less than 80% of the value of the property you’re insuring, you have to pay co-insurance on a claim for that property (in addition to your deductible). The amount of your co-insurance share is the percentage shortfall between your actual coverage and the 80% coverage you were supposed to have. Paying co-insurance on a large claim is not where you want to be. So remember, as long as your policy limits are at least 80% of the value of the property you’re insuring, you won’t have to pay co-insurance, and you don’t have to worry about the 80% Rule adversely affecting you.
Suppose the replacement cost of your home (that is, building minus possessions) is $500,000. Under the 80% rule, your policy limits for your home must be at least 80% of $500,000, or $400,000 (.8 x $500,000 = $400,000). In other words, you need at least $400,000 in coverage on your $500,000 home to meet the 80% rule.
If your actual coverage on your home is $450,000, then there’s no co-insurance, and your insurer will pay 100% of a claim on your home (after your deductible and before you hit policy limits). But if you only have $300,000 in coverage, then you will pay co-insurance on your claim. To determine how much co-insurance, you divide the amount of coverage you actually have ($300,000) by the coverage you’re supposed to have ($400,000), which in this scenario equals .75, or 75% (300,000/400,000 = .75). That percentage marks your insurer’s responsibility on the claim. So in the scenario above, if a windstorm caused $100,000 in covered damages beyond your deductible, then your insurer would pay you $75,000, and you’d be on the hook for the remaining $25,000.
If math makes your head spin, don’t worry, just talk to your agent or broker to confirm that the 80% Rule isn’t an issue for your home. If you’re in the process of purchasing insurance, your agent or broker should help you pick a policy that meets the 80% requirement. If it’s been awhile since you last updated your insurance, you might want to check back with your agent to confirm you’re coverage hasn’t dipped below the 80% mark. As time passes, the replacement value of your home creeps upward, and recent inflation (especially for building material and labor) only accelerated that trend.
To sum it up, ACV is cheaper than RC when you’re buying insurance but also pays less than RC when you have a claim. The reason is that while ACV factors in depreciation based on an item’s age and condition, RC covers the full cost to replace the item, regardless of its age. For these reasons it’s crucial to ensure your policy aligns with your preferences and financial needs.