My Property Isn’t Worth That Much!
If you are a homeowner or own a building for your business, you may have asked yourself this question. My house/building is only worth X, why in the world is my coverage so high?
This is one of the most frequent question I get asked by both homeowners and business property owners. It often leads to frustration and the thought that insurance company is simply trying to get more money.
The problem is that most people confuse market value or appraisal value and replacement cost. The two are very different indeed and this is very important when understanding your dwelling/building insurance amount.
Let’s take a 1500 square-feet, frame, 2-story home. The market value or appraisal value could be $125,000. Of course this depends on the area, market conditions, etc. Most people then think that they should insure this home for $125,000. Makes sense right? Wrong.
Since almost all homeowner’s policies pay at replacement cost, the market value or appraisal value had no bearing on how much the home should be insured for. Replacement cost depends on how much the insurance company thinks it would cost to rebuild.
In the example I gave above, the insurance company may feel that the home should be insured at $180,000 ($120/square foot). Unless you understand that the insurance company is using replacement cost vs. market value or appraisal you may feel that they are insuring your home for too much.
Insurance companies use replacement cost estimators to try to determine how much would be needed to replace the home or building in the event of a loss. Although these estimators are not always perfect, they do give guidance on what amount is needed to property insurance your home or commercial building.
The bottom line is that once you understand this fundamental difference you can better understand the reasoning on how and why the replacement cost on your home or commercial property is often times much higher than what the market or appraisal value would suggest.
Replacement Cost vs. Actual Cash Value
Imagine you are heading home from work and notice smoke coming from the distance. As you get closer you see fire trucks and realize that the smoke is coming very close to where you house is located. You start to panic and 
pull closer. You realize that your worst fears are confirmed. Your house has caught on fire.
Fortunately, the damage was limited to your attic and no major damage was done. You are relieved and realize you need to contact your insurance company to file a claim.
After receiving some bids to repair the damage and replace some personal items that were damaged, you are told that the insurance is only going to pay for about 75% of the bid received from the contractor. How can that be?
You were told that you were insured on an actual cash value basis.
Most people assume that when they have insurance and suffer a loss (claim) that they will just get new things to replace the old things that were lost.
To some degree that is correct, but you may be surprised when you understand the true meaning of replacement cost and actual cash value.
Most property insurance policies today are written on replacement cost. Simply stated, it means the cost to replace the property on the same premises with replacement property of comparable material and quality used for the same purpose. This applies unless the limit of insurance or the cost actually spent to repair or replace the damaged property is less.
Like in my example given above, sometimes property policies are written on an actual cash value basis. The term “actual cash value” is not as easily defined.
Some courts have interpreted the term to mean “fair market value,” which is the amount a buyer would pay a seller if neither were under undue time constraints. Most courts, however, have upheld the insurance industry’s traditional definition: the cost to replace with new property of like kind and quality, less depreciation.
How would this play out in my example above regarding the damage roof. A replacement cost policy would pay for a new roof of like kind and quality whereas an actual cash value policy would pay for a new roof minus depreciation.
Let’s say this homeowner had a 10 year old roof. The bid to replace the damage roof was $20,000. The insurance adjuster would calculate a figure of how much depreciation has occurred and pay accordingly. Instead of paying $20,000 to replace the roof, they may give you $15,000. Do you really want to be stuck paying $5,000 out of your pocket?
I don’t know about you, but this doesn’t sound like a good plan to me. There are a few times where actual cash value makes sense or instances where insurance companies will not offer replacement cost. There are also cases where the building or structure is insured for replacement cost, but the contents are insured for actual cash value.
There are also some other options such as functional replacement cost. However, in most cases, replacement cost should be the preferred method.
The bottom line is that you need to be aware of how you are protecting one of your largest assets. Are you 100% sure you have the proper coverage? Speak with your agent to ensure you are being protected correctly.
The Insurance Coach 