Homeowner’s insurance companies use different methods to calculate the payable amount in the event of a loss. It is advisable to have a clear understanding of some important concepts related to homeowner’s insurance. “Replacement cost coverage” and “Actual cash value (ACV)” are two important terms which are frequently used by homeowner’s insurance companies. These terms refer to the type of replacement that the insurance policy offers for the home and its contents.
Replacement cost is defined as the price that has to be paid to replace an existing asset with a similar asset. For example, if your camcorder is stolen, a replacement cost policy will reimburse you the full cost of replacing it with a similar camcorder. The insurance company does not bother to calculate the depreciation.
Replacement cost may not be same as fair market value or net realizable value. The term replacement cost is usually explained in the policy. It is advisable to go through this explanation before purchasing the policy. Insurance companies usually require homeowners to insure their homes for at least 80% of the replacement cost. A replacement cost policyholder may have to produce a proof of value for the item insured (like receipt) in the event of a claim.
Investopedia defines actual cash value as, “The amount equal to the replacement cost minus depreciation of a damaged or stolen property at the time of the loss”. Depreciation is the decrease in value since the time it was purchased or built due to wear and tear. For some unknown reason, most of the homeowner’s insurance companies do not clearly define the term “actual cash value” in the policy document. Actual cash value policy is also known as HO8 policy in the US. Actual cash value policy is ideal for owners of new homes.
The difference between replacement cost and actual cash value can be clearly understood with the help of the equation, ACV = (replacement cost – depreciation). Replacement cost policy does not take depreciation into consideration. Actual cash value policy takes depreciation into consideration. This is the main difference between the two. Some courts have interpreted the term “actual cash value” to mean fair market value. Replacement cost policy is usually more expensive than actual cash value policy.
From the homeowner’s point of view, it is advisable to purchase a replacement cost policy. Replacement cost policies are more popular among homeowners.