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Understanding The Difference Between Cash Value and Replacement Cost of Insurance

By Hank Coleman

replacement cost vs cash value insuranceAs you’ll see in any insurance guide, there are many choices when it comes to choosing the best insurance policy and the features associated with those policies. When you are insuring something like property or real estate, one of the biggest decisions that you have to make is whether you want the insurance company to reimburse you for your potential loss based on its current cash value (Cash Value Insurance) or the amount it would cost to replace the asset (Replacement Cost Insurance). The replacement cost option may be more expensive, but sometimes it can be well worth the added expense.

Cash Value Insurance Can Cost You

When you buy a home, for example, and insure it for cash value only, the insurance company will only reimburse you for a loss up to the value of your home. So, if you bought a $150,000 home and it was destroyed in a fire, the insurance company will only pay you the $150,000 original minus your deductible and depreciation as well. On this depreciation aspect, the insurance company will deduct an amount for the wear and tear you have caused on an asset before they pay out the claim. This can significantly reduce your payment and potentially leave you in debt.

With cash value, you may end up receiving a significantly less amount of money than your house was worth and insured for, especially if you’ve lived in it for a long time. With cash value insurance, the insurance company will pay whatever it believes your property was worth at the time of the loss.

Replacement Cost Clause Insurance Is Worth The Price

Replacement cost insurance is a great clause to have as part of your homeowner’s insurance coverage to ensure that you are completely covered for the entire cost of rebuilding should you have an insurance claim. With a replacement cost term in your insurance contract, depreciation is not deducted from your claim payout. The only thing you are responsible for is your deductible. So, for example, if you have a sixty inch plasma television that you have had for over five years that was stolen from you home, your insurance company would have to pay your claim in the amount of what it costs to replace your television with another comparable sixty inch television minus your deductible.

Replacement Cost Insurance: Better Off Than When You Started?

One of the best features of having a replacement cost insurance policy is that you could potentially make a profit on a total loss. Let’s take your home for an example. If you bought your home ten years ago for $150,000 and it appreciated to a value of $250,000 when it burned down, you would receive the current amount it would cost you to rebuild the exact same house in today’s dollars, which could very well be that $250,000 amount because you had the total replacement cost clause in your insurance policy. Some insurers are now requiring policyholders to rebuild their homes with this money instead of pocketing the cash, which used to be an option. The reason for this is that insurers are trying to prevent things like fraud or excessive profiting on this type of insurance. If you still choose not to rebuild you home, many insurance policies may only pay you an amount equal to your home’s original home value. Figure this stuff out ahead of time before you sign up for a replacement cost insurance clause.

If you have cash value insurance, you will not receive the total amount of money your asset is insured for. You will be charged for depreciation and the wear and tear you created on the asset, such as your home. This can be a significant amount if you lived there for a long time. Opting for total replacement cost insurance can save you thousands of dollars and ensures that you are completely covered through rising inflation and other costs should you have a total loss. The most important thing is to understand the choices that you have when you establish your insurance policy. It’s not the right solution for everyone, but it’s something that each person should consider when evaluating insurance options.

What kind of insurance do you prefer?

(photo credit: Shutterstock)

Hank Coleman
Hank is a freelance writer, entrepreneur, and professional in the government sector. He is also a personal finance writer who is currently studying for his Certified Financial Planning (CFP) credentials. He has a Bachelor's Degree in Business Administration and a Master's in Finance.

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  • Mike Z

    I have an interesting situation right now. I bought my house for $111k a year ago, but I have replacement cost insurance on it of $200k. Homes are significantly cheaper to buy used than to build new because there is such a large inventory and the value of the dollar is declining, so buying the materials to build a new home requires more of these devalued dollars.

    So, if my house burned down (or whatever happened to it) – would the insurance company force me to rebuild even if I was more interested in just buying another house down the street ready to go (and avoid having to move twice in one year)? If they did force me to do that, wouldn’t they be taking a larger loss than necessary? Replacing my house by rebuilding it is significantly more expensive than replacing it with another “already built” house.

    Assuming they would not force me to rebuild and actually would like the idea of me buying another used house, couldn’t I then force them to rebuild it anyway?

    The point I’m getting at is – how about they give me $200k, I go buy another house for $111k, and the pocket the difference…and if not that…then perhaps they would be willing to settle on something else that is similar to that arrangement, but for less money.

    • http://www.moneycrashers.com/author/hankcoleman/ Hank

      Mike,

      You should check the fine print of your insurance policy. Insurance companies are getting smart to the exact type of scenario you were describing. You may receive the full amount of your replacement cost coverage if you decide to rebuild, but you may only receive the cost of a comparable replacement house if you choose to buy a house down the street. Try to circumvent your policy’s fine print, you could possibly find yourself in court, dropped from your insurance, or both.

      • Mike Z

        Hank,

        I am not saying anybody should circumvent the policy…and in fact, I think it would be nearly impossible because the insurance company writing the check is going to have to agree with you first before they write the check. I am simply saying that by a person choosing to not rebuild (assuming they have the option to do so) may save the insurance company money, and therefore, would be in the interest of both parties to work out an arrangement where the insured gets paid more than the fair market value of the destroyed home.

  • Jennifer Rensing

    Hi Hank,

    I recently switched homeowners insurance to a different carrier. One of the sales points the agent used to sell the insurance to me was that “No matter what we have down as the value of your home if your home ends up costing more to rebuild it back to exactly what it was before, we will pay that extra cost and there is no limit to it”. I know she was talking about replacement cost. However, when I received my policy fine print, I feel like it reads differently. It says”If you repair or replace the damaged property. Payment will be made for the smallest of the following: 1. Replacement cost of the damaged property at the time of the loss, or 2. the applicable limit of liability shown in the declarations. The key word that concerns me is the smallest of the following. My understanding is which ever comes up to the smallest amount will be paid, so if replacement cost is less than your limit of liability that will be the amt paid, if not it will be what your limit is. And that limit is the value limit assesed by the company on our policy right? So this is my concern, this new company assessed our house to be less than our prior company, by about 30,000$. I feel our house is really worth what the other company assessed it at and am concerned that if we had a fire if I read the current companies replacement clause info right, we would not get anything over what their current assessment is, which is 30,000$ less than what we feel the house is worth. I called the agent she just kept saying if they have the value of the home at a certain amt and it costs more to rebuild back to its orig state, they would pay it, and again their is no limit over what they would pay extra. I am not sure what to think of all this. I need to figure it out before our policy starts with them feb 2. Thanks much for your professional opinion. Jen Rensing

    • Hank Coleman

      Jennifer,

      Thank you for leaving the comment and your question. While I am not an insurance
      expert or agent and your case seems tricky and unique to you, here are my
      initial thoughts.

      You said, “if replacement cost is less than your limit of liability that will be
      the amt paid, if not it will be what your limit is. And that limit is the value
      limit assessed by the company on our policy right?” My question is can you not
      insure your house for $30k over the insurer’s assessed value, of course with a
      higher premium? You “feel” that it is worth $30k more, but is it really worth
      that much in today’s current market in your location? You may need to have an
      appraisal done to confirm your valuation.

      I would also suggest that you talk to your agents supervisor, expressing your
      concerns. You should also be keeping written records of (hopefully) email
      traffic with these promises from your insurance agent. You made need this proof
      to settle a lawsuit you may have to bring against your insurer if they did not
      pay the true replacement cost.

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