Replacement cost vs. market value: What’s the difference?
Homeowners insurance policies use two ways to determine how much to pay in the event of a covered peril that damages or destroys your home or personal property. They either cover the replacement cost of the covered items or their market value, which is often referred to as actual cash value.
Replacement cost policies pay the full amount needed to replace your damaged items with comparable items, even if the damaged item is worth less than the cost of the replacement.
Say, for example, lightning strikes a tree in your yard, and the tree crashes through your fence as it falls. A replacement cost policy would cover the entire cost of replacing the broken fence with a similar one (minus the deductible), even if the existing fence was old and in poor condition.
Replacement cost works the same way with belongings inside your home. If a covered plumbing emergency saturates your 10-year-old sofa and ruins it, a replacement cost policy will cover the cost of replacing the sofa with a new one.
The dwelling portion of most homeowners insurance policies provides replacement cost coverage for your home’s structure, but there are exceptions. An older home, for example, might have obsolete materials and architectural elements that are prohibitively expensive to duplicate.
In that case, the insurer might limit coverage. Or, if the home would need to be rebuilt differently to comply with modern standards and building codes, you might need to purchase an endorsement to your policy to cover the extra costs.
An item’s market value, or fair market value, is the typical price a buyer would be willing to pay for it on the open market. A number of factors determine market value, such as the item’s age, useful life, condition, style, and use. When these factors reduce the item’s value, they result in depreciation.
Take, for example, a decade-old refrigerator destroyed by a power surge from a lightning strike. Depreciation makes this fridge less valuable than a pristine 2-year-old model with all the bells and whistles. But even the newer refrigerator has depreciated — the very fact that it’s been used for two years means it has a lower market value than the $1,200 identical model on display at the store.
Market value coverage is limited to the depreciated value of your property. Your insurer will determine how much the item depreciates each year, then subtract that amount from the original value of your fridge for each year you’ve owned it. You’ll then receive the depreciated value of your damaged refrigerator, minus your deductible.