Replacement Cost Policies versus Actual Cash Value Policies

All property policies include settlement guidelines.  This is a standard policy condition that outlines the method in which payment will be determined in the event of a total loss.

Replacement Cost and Actual Cash Value are two common methods in which insurance companies will calculate the amounts they will pay the insured for property losses. While both insurance settlements are based on the cost to repair, replace or rebuild the lost or damaged property, they differ in that Actual Cash Value deducts depreciation from the insurance settlement.

“Actual Cash Value deducts for depreciation, whereas Replacement Cost does not.”

Replacement Costs versus Actual Cash Value explained
For Replacement Cost policies, reimbursements are based on the cost to replace the damaged or lost property. Depending on the year of initial construction or development, an appraisal is required to determine the appropriate value to repair, replace or rebuild the property with new material. The values, as determined by the appraisal, are filed with the underwriters and become the basis of the policy limits.

In contrast, Actual Cash Value is equal to the replacement cost less any depreciation. There are 5 different approaches to determining the Actual Cash Value.  Most commonly used is the Market Value approach which takes into consideration an appraisal, the value of the property immediately prior to the loss and the value to the property after the loss and the value of similar properties. Another approach available to underwriters is a “broad approach” which includes a review or evaluation of all or some of the following factors:

• Market Value
• Rental value
• Use of the building
• Location
• Appraised or assessed valuation
• Resale success
• Predicted lifespan of such property (can include wear & tear)

Both settlement approaches are subject to the policy limits, terms and conditions so the best practice is to have policy limits equal to or greater than the total value of the property.

Claims Scenario
A camera is damaged on a construction site. How would your policy respond?

A Replacement Cost policy would reimburse for the full cost of replacing the camera with a new camera of comparable value.

An Actual Cash Value policy would pay the value of the camera immediately prior to the loss. The payment would be determined by reviewing its value when new then deducting for age and all the wear and tear incurred prior to the damage.

Why Owners prefer Replacement Costs over Actual Cash Value
In many cases this can be looked at as “old for new” when older property is replaced with new property of like kind and quality.

Why Lenders prefer Replacement Cost over Actual Cash Value
Lenders stand to lose significant money if property can’t be rebuilt, repaired or replaced thus require Replacement Cost as they lend against the market value of the property and the income generated from it.  Following a total loss, if the same structure or a reasonably close imitation cannot be rebuilt, the market value and income-producing potential of the property may be negatively impacted, which creates a risk of the borrower defaulting on their debt.

JAMIE BENNETT
Risk Analyst, BA, RIBO
Tel: +1-416-583-3778
Email: jbennett@intechrisk.com