What it means
When property is damaged, insurers can settle in two main ways. An actual cash value policy pays the replacement cost minus depreciation, so an eight-year-old roof is paid for at its reduced value.
A replacement cost policy pays the cost of a new roof, aside from the deductible. Replacement cost cover is designed to put the owner back in the position they were in before the loss, which is helpful when old items cannot be replaced for what they are worth on paper.
Without it, owners often face a large gap between the payout and the actual cost of repair. Businesses with machinery, buildings and stock often prefer it for this reason.
There are usually conditions attached. Many insurers pay the actual cash value first and release the withheld depreciation only after the repair or replacement is completed, and some require that the work be done within a stated time.
The policy also has a limit, so if the replacement cost rises above the sum insured, the owner is again underinsured. The premium for a replacement cost policy is higher than for actual cash value cover, because the insurer expects to pay more on a claim.
The business decision is whether the extra premium is worth the protection against a large uncovered gap. For essential, long-life assets the answer is often yes.
The nuance is that the initials RCP can mean different things in different industries, so check the context before relying on the definition. In insurance wording, a replacement cost policy covers the cost to replace, not the market value or the sentimental value, and it excludes losses that the policy specifically lists.
Choosing the sum insured is the key step in making the policy work. It should reflect the current cost to rebuild or replace, including fees and clearance, rather than the purchase price or market value.
A yearly review with a broker or valuer, using current cost indexes, keeps the figure realistic.
In practice
Real-world examples.
Example
A bakery owner insures her ovens under a replacement cost policy. When a fire destroys a five-year-old oven, the insurer first pays the depreciated value and then releases the balance once the new oven is installed. She ends up with a modern oven at no extra cost beyond the deductible.
Example
A homeowner chooses between two quotes and finds the replacement cost policy costs $300 a year more. He estimates that a major claim on his ageing roof could leave him $8,000 short under the cheaper policy. He decides the extra premium is worth it.
Example
A small manufacturer reviews its insurance after buying a new machine. The sum insured has not changed for years while equipment prices have risen. The broker updates the limit so the replacement cost cover is not undermined.
Formula
Calculation
Actual cash value payout = replacement cost - depreciation - deductible
Replacement cost payout = replacement cost - deductible
A roof damaged in a storm would cost $20,000 to replace, and the insurer calculates depreciation of $8,000 because of its age. The deductible is $1,000. Under an actual cash value policy the payout is 20,000 - 8,000 - 1,000 = $11,000. Under a replacement cost policy the payout is 20,000 - 1,000 = $19,000, which is $8,000 more.Case study
Seen in the real world.
Hartwell Print Shop is an illustrative, fictional business that insured its printing equipment on an actual cash value basis to save on premiums. The equipment had a replacement cost of $120,000 but was depreciated to $70,000.
A burst pipe damaged the whole set, and the insurer paid 70,000 less a $2,000 deductible, a total of $68,000. The new equipment cost $120,000, so the company had to find 120,000 - 68,000 = $52,000 from its own funds.
Afterwards the owner switched to a replacement cost policy, paying $1,800 more per year. The illustrative lesson is that a cheaper premium can be costly after a loss, so the difference in cover should be weighed against the size of the possible gap.
Watch out
Common mistakes.
- Assuming replacement cost cover pays the full amount immediately, when many policies pay the depreciated value first and release the balance after the repair.
- Leaving the sum insured unchanged for years, so that it no longer covers the real replacement cost.
- Assuming the policy covers every cause of loss, when the exclusions in the policy still apply.
Questions
People also ask.
What is the difference between replacement cost and actual cash value?
Replacement cost pays the cost of a new item, while actual cash value pays that cost less depreciation for age and wear.
Why is the premium higher?
Because the insurer expects to pay more on a typical claim when it does not deduct for depreciation.
Does replacement cost cover increase the limit?
No, the payout is still capped at the policy limit, so the limit must be set high enough to rebuild or replace.
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