Replacement Cost Value or Actual Cash Value – Which Option Suits Your Needs?

Homeowner’s insurance policyholders usually have the option to insure to actual cash value (ACV) or replacement cost value (RCV).  To make the best decision, the individual first needs to gain a clear understanding of the difference between the two policy options.

In a nutshell, the difference between RCV and ACV is wear and tear; otherwise known as depreciation.  ACV considers that the lost property has most likely depreciated over time, and endeavors to insert depreciation into the equation.  For instance, suppose the ruined property was a sofa that would cost $700 to replace.  Even though the sofa was in good shape for a 10-year-old piece of furniture, it was definitely not brand new.  In ten years time, some wear and tear inevitably occurred.  With ACV, the insurance company may determine that $30 of depreciation occurred each year since the sofa was purchased. In this case, the sofa would only be valued at $400 at the time of the loss.  The company would pay you $400 minus any applicable deductible. In a sense, you would be paying an increased deductible in the form of the $300 of depreciation.  To summarize ACV, the insured would pay the difference between the replacement cost, the amount the old sofa depreciated by, and any deductible. In essence, the policyholder is “co-insuring” that amount. 

On the other hand, RCV is simply the cost of replacing the lost property with either an identical or similar piece of property.  Using our sofa example, if it costs $700 to replace the sofa, the insurance company will pay you the $700 minus any applicable deductible.  Even though the ruined sofa was showing its age, and could never be sold for $700, RCV allows the policyholder to recoup the value of a brand new replacement sofa.

Which option is best?  This question cuts to the core of what insurance is all about – making the insured whole again. In some cases, ACV falls short.  Conversely, RCV can create an overly beneficial situation for the insured. Not including sentimental value, if the sofa is old and dilapidated, but the insurance covers RCV, it is obvious that the policyholder will benefit greatly by receiving enough funds to purchase a brand new sofa to replace the old one.

An old house that has been severely damaged by a fire may provide a more dramatic example of RCV.  At the time of the fire, the house may have only been worth $200,000, because the components of the house (such as roof, flooring, HVAC etc.) were approaching the end of their life span.  In this case, the house would increase in value as the old worn-out components were replaced with brand new ones.   So the homeowner would be better off in terms of the value of their home, than if the fire had never occurred at all.

Some insurers stipulate that all repairs must be completed, in order to obtain the full replacement cost of the property.  They may decide to pay the ACV up front, and have the rest of the payment (the difference between RCV and ACV) contingent upon all repair work being completed.  This keeps the insured from pocketing the money and gaining financially from the loss. 

There is at least one caveat regarding the benefits of RCV, however. Since the real estate market can fluctuate quite a bit, sometimes replacement cost value turns out to be less than ACVWhen the housing market is strong, and home prices are high, the actual cash value can be higher than the cost of replacing a home with one that has similar features and qualities.  Therefore, the additional cost of purchasing RCV may be a bad decision.  As always, consult with an agent to see which option is right for you.

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