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Home Insurance Basics: Actual Cash Value vs Replacement Cost

WRITTEN BY: Amelia Ciffone

UPDATED: MAY 24, 2022 | 1 MIN READ

Insurance agent introducing property insurance policies to homeowners.

The next time you find yourself examining the declarations page of a home insurance policy be sure to read the fine print to learn about how you would be reimbursed in the future for property loss.  Generally, on the declarations page of an insurance policy it will explain whether your specific policy covers the Replacement Cost of a personal item or simply it’s Actual Cash Value. This minor distinction may not seem like a big deal now but the disparity in cash reimbursement may be the difference between being able to replace your home or not! 

If you’re not cautious it’s easy to end up with an insurance policy that won’t replace your home or belongings at the cost that you would have personally valued them at.

After reading this article you’ll have learned about:

  • How Actual Cash Value is Calculated
  • Depreciation and its Relationship to Actual Cash Value
  • How Replacement Value is Calculated
  • Actual Cash Value Concerns & Considerations

Actual Cash Value & Replacement Cost: An Example

As an example, let’s consider Bob Johnson, a fictional character who purchased a Condominium for $250,000 brand new in 2010 that is now only worth $225,000 in 2020 due to wear and outstanding projects.  In 2020 Bob’s home is involved in a flood that leaves his 10-year-old condo with plenty of life remaining completely destroyed!   

If Bob’s homeowner’s insurance policy states that his replacement coverage is based on Actual Cash Value, Bob would get a check for $225,000 to replace his condominium.  While $225,000 is an accurate representation of what Mr. Johnson’s condo was worth when it was flooded, the check will not allow him to purchase new home of equal quality to the one he bought in 2010.

In contrast, if Bob’s homeowner’s insurance policy stated that his coverage was Replacement Cost based, he would get a check closer to $250,000 allowing him to purchase a new home of similar size and build quality to the one that had been flooded. 

After considering this example you may be asking: “Why would anyone choose Actual Cash Value over Replacement Cost?” The answer always comes down to recurring monthly costs, budget and value of the insured property. Typically, a policy that is based on Replacement Cost will have steeper premiums which can turn a lot of buyers away that don’t fully understand the repercussions in the case of an expensive loss. 

Actual Cash Value and How It’s Calculated

Actual Cash Value (ACV) of a lost item is typically calculated by subtracting depreciation due to wear and tear combined with age from that item’s full original value.  Therefore, the Actual Cash Value of any personal item by definition will be less than the initial cost of purchase.

To understand ACV it helps to understand depreciation.

Actual Cash Value of your item can also be thought of as Depreciated Value at the Time of Loss.

It’s easy to understand depreciation on a yearly or monthly basis once you have established a house or personal item’s salvaged value. 

For example, if you purchase a hot tub for $5,000 brand new that is expected to be worth $1,000 after 10 years of wear and tear you can calculate the monthly or yearly depreciation by diving the difference in value by time.  In this example, you would divide $4,000 (the loss in value over time) by 10 years or 120 months which would give you an approximate depreciation rate of $400/year or $33.33/month. 

In this example, if your personal property insurance policy states that replacement is calculated off of Actual Cash Value, each year that you have owned the hot tub prior to the loss would subtract $400 from the final check that you could receive. 

Because of the impactful depreciation element, Actual Cash Value will often leave an owner short on cash to purchase a similar product brand new.  If you don’t mind putting up a bit of your own cash to purchase a replacement product this may not be the end of the world, but for daily essentials such as functional plumbing or kitchen appliances this may not be a risk worth taking.

Replacement Cost and How It’s Calculated

In contrast with Actual Cash Value, Replacement Cost (RC) is a very simple calculation.  Replacement Cost is defined as the payment you would be required to make in order to replace the item that was lost with a similar make or model brand new, whether that be a hot tub, piece of furniture, bathroom or structure.

In the example that I used above Replacement Cost insurance would cover the purchasing of a brand new $5,000 hot tub similar to the one that you had lost.  Replacement Cost takes the element of depreciation completely off of the table!

While Replacement Cost is considered superior in almost all insurance applications, the premiums can be a bit higher as previously discussed depending on the value of the items you are looking to insure.  If ever the value of the item insured is surpassed by the combination of premium related expenses, you’ll know that the personal belonging is over protected.

Actual Cash Value Concerns & Considerations

In most cases, a general homeowners insurance policy will contain language that covers personal property such as furniture, light fixtures, appliances and electronics inside your home under Actual Cash Value settlement terms.  Depending on the value of the electronics and furniture in your home, it may be worth asking your insurance agent about the cost of upgrade from Actual Cash Value to Replacement Cost settlement terms. In some cases, especially with renter’s insurance the difference in price can be a few hundred dollars a year which may be worth considering if you’re in natural disaster territory.

Consider this one final example of a larger loss:

Bob Johnson owns a house with an older shingled roof, originally purchased 25 years ago for $15,000.  If a large windstorm comes through Bob’s small town and destroys his roof which has been deteriorated by 25 years of wear and tear Bob will be relying on his homeowner’s insurance for replacement.  Under an Actual Cash Value insurance policy, Bob may not get any insurance payouts for his roof due to the exorbitant depreciation and would therefore be responsible for the entire replacement cost.

Below you can find a few important questions to ask yourself prior to making your final decision on Actual Cash Value vs. Replacement Cost:

  • Are there are elements of your home that are outside of their “useful life” as defined by your insurance policy? (Ex. Bob Johnson’s Roof)
  • Do you have a lot of expensive to replacement, depreciated electronics?
  • Are you in possession of collectible items that would be difficult to replace or not properly valued in an ACV scenario?
  • Do you have funds to supplement the difference in replacement value?

In Conclusion

In conclusion, understanding Actual Cash Value (ACV) and Replacement Cost (RC) is an essential function of reading through any Property or Homeowners Insurance Policy.  But understanding these terms and making the right decision for your unique application is where the difficult decisions really begin.  Consider the examples we have discussed above and try to imagine yourself in a position of loss in order to establish your precise insurance needs. 

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