A prospective client called me last week with a question regarding the home insurance policy I’d proposed for him. He wanted to know whether or not it was a replacement cost policy. It’s an excellent question and one that most people don’t ask. I assured him it was and explained that all the home insurance policies we write are.
Broadly speaking, there are two types of home insurance policies; actual cash value and replacement cost. There are multiple forms with various options and coverage, but they all fit into one of these two “buckets.”
Actual Cash Value Policies: This is a very basic policy both in terms of coverage and how it pays on a claim. Actual cash value or ACV policies typically have these attributes;
- They are usually named peril policies in that they cover only those perils (causes of loss) that are listed in the policy such as fire, smoke damage, theft, vandalism & malicious mischief, and wind and hail
- They can provide coverage for other types of claims such as water leaks, but it has to be added as optional coverage
- Claims are paid on a depreciated basis
o For example of paying a claim in a depreciated basis, let’s assume we have a home with a 20 year composition shingle roof
o The roof’s been there for 8 years and there’s a hail storm that damages the roof and needs to be replaced.
o The cost to replace the roof is $8,000. Since the roof is a 20 year roof, the roof is depreciated by $400 a year ($8,000 / 20 years) or in this case $3,200.
o The remaining “value” of the roof is $4,800 which is further reduced by the amount of the deductible and then the claim is paid.
- While this policy type will save the homeowner money in the short term, it will usually costs the homeowner more out of pocket if there’s a claim
Replacement Cost Policies: Replacement cost policies provide the homeowner a more complete level of protection in the event of a loss or claim.
- A replacement cost policy may cover only named perils or they may cover everything unless it’s excluded such as earth movement, water backup, etc.
- Claims are paid on the basis of what it would cost to replace a specific loss
- In the example of the hail claim above,
o The age of the roof does not matter
o The only thing factored is the cost to replace the roof (materials & labor) less the wind/hail deductible
- Most policies sold today are either replacement cost to begin with or endorsed to make them that way (always check though!)
- Replacement cost coverage should be on the home (dwelling) as well as your contents (some policies come with the home protected at replacement cost but the contents are covered as ACV – make sure both are set up as replacement cost)
- The amount of replacement cost is limited to the amount of coverage on the home and the amount of coverage on the contents or personal property (make sure it’s enough for both)
Some policies originally came as guaranteed replacement cost. With this type of policy, the home would be replaced regardless of the amount of coverage on the home in the event of a total loss. Most insurance carriers have moved away from this type of coverage, however there are a few that still offer this as an option.
Actual cash value and replacement cost policies have their place depending on the coverage that is wanted and needed, as well as the financial ability to withstand a major loss However, if the mortgage company may require the home policy be a replacement cost policy to protect you and themselves. The bottom line is to know what you’re buying and what coverage you need to have. No one wants to find out what’s covered and what’s not when a claim is filed.
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