6/1/2018 By Agent Ken CobbBy Agent Ken Cobb
In the insurance industry today, there are three basic levels of coverage that you can choose from to insure your home. In this post, I’ll explain each option and some variations that you might see. Having a basic understanding of these concepts may help you to feel more comfortable knowing how well your home is insured.
Actual Cash Value
The basic traditional way to insure a home is on an Actual Cash Value basis. Actual Cash Value is defined as the cost to repair or replace, minus depreciation. For example, if you have thirty-year shingles that are fifteen years old, the Actual Cash Value of your shingles might be half of what it would cost to replace them.
When you insure your home on an Actual Cash Value basis, the coverage limit for your dwelling will typically be set one of two ways: either a) based on the market value of your home, not including the land value, or b) by estimating the cost to replace the home and then subtracting for estimated depreciation. (This second method can be somewhat subjective, since it requires someone to decide how much depreciation should be deducted.)
When there is repairable damage covered by an Actual Cash Value policy, the claim adjuster will calculate the cost to repair the damage and then subtract for depreciation, as in the roof example I cited above. (More about how this would work on a roof claim.) Certainly, most construction materials don’t depreciate as rapidly as shingles, but on an older home, there can definitely be a significant deduction for depreciation in many damage scenarios. It is quite likely that you will be less than satisfied with the claim payment on an Actual Cash Value policy for a repairable loss, as you will have to dip into your own pocket to cover the depreciation (in addition to paying your deductible as well).
Repair Cost is a hybrid between Actual Cash Value (above) and Replacement Cost (below). Like Actual Cash Value coverage, a Repair Cost policy will insure a home for its current value rather than the cost to rebuild it. However, like Replacement Cost, it will pay the full cost to repair or replace damage that doesn’t result in a total loss (once that the damage is actually repaired or replaced, minus the deductible).
Because it’s far, far more likely that you’ll have a claim for a repairable loss than for a total loss, you may find Repair Cost coverage far more appealing than Actual Cash Value if you’re not afraid of “cashing out” after a total loss but don’t want to dip into your own savings to repair damage after a windstorm, broken pipe, lightning strike, etc.
I should note that Repair Cost coverage is not as widely offered as Actual Cash Value or Replacement Cost. Among the dozen or so property carriers that I represent, only two of them offer this option.
The gold standard for insuring a home is Replacement Cost. Most preferred Homeowners policies are written with this option.
With a Replacement Cost policy, the home is normally insured for its estimated cost to rebuild, not for its current market value. (In many cases, there can be a sizable difference between these two values, which often leads to confusion.) The amount of coverage is usually based on a replacement cost estimate completed by the agent or carrier, but it is important for you, the owner of the home, to review this estimate and make sure you agree and feel comfortable with it.
When there is repairable damage, a Replacement Cost policy will pay the full cost to repair or replace the damage, minus your deductible, but only if you actually repair or replace this damage. For this reason, there are usually two payments made. The first payment is made up front and pays for the Actual Cash Value of the loss (subtracting for depreciation), and the second payment comes after the damage is repaired or replaced and pays the additional cost incurred.
One important note is that Replacement Cost policies come with a provision known as a coinsurance penalty. Basically, this provision says that you are responsible to insure your structure for its full replacement cost, and, if you fail to insure for at least 80 percent of replacement cost, you will share in paying for covered repairs. For this reason, it is important to make sure that you are insuring your home for what it would actually cost to rebuild.
Variations of Replacement Cost
Depending on your insurance carrier, there are several variations of Replacement Cost coverage which might be either offered or automatically included in your policy:
Extended Replacement Cost is a provision that is found in a large percentage of Homeowners policies. It promises that as long as you agree to insure your home for its replacement cost and to notify the carrier of any changes or improvements, your policy will pay more than its limit if necessary to rebuild the home. This provides margin for error, protecting you in case either your replacement cost estimate was off or there has been an increase in construction costs since the estimate was completed. (This can often happen after a natural disaster, for example.) The amount that your policy will pay over and above your Dwelling limit is normally capped as an additional percentage of that limit. Many of our carriers offer this option; a Specified Additional Amount of 25 percent is most common.
Guaranteed Replacement Cost is similar to Extended Replacement Cost, except that there is no cap on how much could be paid to rebuild the home. As long as you have complied with the terms of the policy, your carrier will have to pay to rebuild your home after a total loss, even if this costs two or three times the amount of insurance you carried. Today, this option is not widely offered and is more common to find on a higher-end policy than for coverage on middle class homes.
Functional Replacement Cost is an option often selected when insuring an older home (usually one built prior to 1930 or so). A true Replacement Cost policy is required to pay the cost to repair or rebuild a home using the same materials as it previously had. For an older home, many of these construction materials are now obsolete, which can significantly increase repair or replacement costs. Rather than pay the extra premium to insure the home for what it would cost to rebuild using obsolete vintage materials, homeowners may opt to insure their home on a functional replacement cost basis instead, which will pay for repair or replacement with functionally equivalent materials which are currently beins used for modern construction. Most carriers won’t offer their Extended Replacement Cost option if Functional Replacement Cost is selected.
Modified Replacement Cost is somewhat similar to the Repair Cost coverage described above, in that it allows the owner of the home to insure their home for less than its estimated replacement cost. This is usually expressed as a percentage of the Dwelling limit, and the coinsurance penalty described above is modified to allow this lower percentage. However, keep in mind that most losses are not total losses and the insurance company knows they will have to pay the same amount on your partial-loss claim whether you are insuring for 60% of replacement cost or 100% of replacement cost, when this provision applies. For this reason, the lower the percentage of replacement cost you insure for, the higher the rate you’ll pay for the amount of coverage you do buy. Because of this, underinsuring your home may not save as much premium as you would think.
Based on the differences in coverage I’ve described in this post, you might assume that Replacement Cost coverage is considerably more expensive than Actual Cash Value coverage. However, this not usually the case. Because the industry standard is to sell Replacement Cost coverage as the default for owner occupied, stick-built homes in good condition, standard Homeowners policies usually don’t even offer Actual Cash Value as an option. To get Actual Cash Value coverage, you normally have to go to a different type of policy which is usually written for homes that are less desirable to insure. For this reason, you could end up paying more for an Actual Cash Value policy than for a Replacement Cost policy on your primary residence. (Note that this may be different for manufactured homes, some secondary residences and rental properties.)
By and large, a Replacement Cost policy is the way to go to insure your home. Rates are favorable and coverage is much more desirable, should you ever need to use it.
This post provides general information regarding coverage frequently offered in the insurance industry. Every policy has terms and conditions, which cannot be fully explained here. Some policies may also have terms which vary from the descriptions provided. For these reasons, please read your insurance policy carefully.
About the Author
Agent Ken Cobb
Ken is the owner and principal agent at Pine Country Insurance in Bemidji. Active in the insurance industry since 2000,Ken uses his years of personal insurance knowledge and experience to assist clients in customizing insurance coverage to fit their needs. Ken considers himself a "farmer" rather than a "hunter"; rather than focusing on writing a lot of new policies as quickly as possible, he works on cultivating long term relationships based on trust with his clients. When writing new policies and meeting for annual reviews, Ken spends time with his clients explaining and helping them understand their insurance, and he is also pleased to share his knowledge with his blogging audience as well.
Ken Cobb is owner of Pine Country Insurance and has been active in the insurance industry for over 15 years. Meet Ken.
Coverage descriptions found in this blog are summaries provided for general educational purposes and cannot fully detail the terms, conditions, limitations or exclusions of a specific insurance policy. Please read your policy carefully.