Original Article Date: 02/06/2022
Last Updated: 02/07/2022
In this article, we will be reviewing the types of replacement options that property insurance can be written with. These valuations can apply for both residential homes, as well as commercial buildings. Understanding the differences can determine if your property has adequate coverage in the event of a loss.
Replacement Cost is King 🥇
When it comes to property valuations, nothing can top a solid replacement cost (RC) policy. Imagine a home that was built in 2005. Back in January of 2005, the cost of lumber on the futures market was $418 per 1,000 board feet. As of February 1, 2022, the current pricing of lumber is over $1,000 per 1,000 board feet. This is a 300% increase in the cost of lumber in that time span. (Source: https://tradingeconomics.com/commodity/lumber)
When we consider the cost to replace an entire home, perhaps one that was damaged due to a major fire, there is almost no scenario that would ever play out where the cost to rebuild would be less than the cost to originally build keeping a similar design plan.
Thanks to the Replacement Cost valuation method, you're in good hands. The Replacement Cost provision of a policy states that the policy will pay, up to the limit of insurance, to replace your property with similar type and quality materials that were used in the original build.
The good news is that depreciation is not factored into replacement cost. Typically, these policies insure over the market value of the home, and may in-fact be much higher value than what you paid for the property (Although, this is not always the case).
Actual Cash Value: The Runner Up 🥈
Sometimes Replacement Cost is not an option on a home or commercial building. Why? Perhaps the building is in disrepair, or as we call it in insurance terms "Distressed". Another reason is that the Replacement Cost of the building far exceeds its actual value. While Actual Cash Value (ACV) is more commonplace on larger commercial properties, it can be used on homeowners' insurance in certain situations. It is important to remember that depreciation is factored into ACV.
The formula for calculating ACV is:
The Replacement Cost - Depreciated Value = ACV.
Example: John's roof is 10 years into its 20-year life. He paid $10,000 for the roof originally. Should a claim occur on the roof today and John has an ACV coverage on his policy, the maximum that John will receive for his damaged roof is $5,000 ($10,000 - 50% depreciation).
Flat Value/Agreed Value: A comfy medium 🥉
In certain situations, property owners can opt for something sort of in-between ACV and RC, Flat Value (Also called agreed value or stated value). Flat policies tend to work best where the market value of a property is lower than the Replacement Cost, but in good enough condition that the insured does not want to insure strictly to ACV, or perhaps when a building has a certain uniqueness that cannot be accurately calculated.
As an agent, I usually reserve this for three scenarios; when a landlord purchases a property and wants only their purchase price covered, when I get a very unique home or when a bank requires a waiver of co-insurance on a commercial property.
Example: A home designed by Frank Lloyd Wright is one-of-a-kind and the cost to replace it cannot truly be accurately valued. The owner of the house wants to insure to X amount, and the insurance company agrees to that amount - regardless of the replacement cost or depreciated value.
Choosing the correct property valuation method for your property, commercial or residential, is extremely important towards meeting your insurance goals. No matter what route you feel is best for you, talk it over with your agent to make sure your property is covered just the way you need it to be.
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About the Author
My name is Taylor Haines, and I am the CEO & Principal of Encompass Agency, Inc. (Buffalo) and Jordan First Insurance (Jordan, NY). I grew up in rural Skaneateles, NY and have over a decade of experience in the insurance industry after my first job in 2012 at GEICO as a direct writer. I am passionate about insurance and its relationship to law, and frequently research the latest industry trends regarding the legal implications of insurance. I earned a Bachelor from the University at Buffalo in History and hold a Master of Science from Buffalo State College in Human Resources.