Property insurance policies often give policyholder’s the option of insuring to replacement cost value (RCV) or actual cash value (ACV). Which option should you consider?
In short, the difference between ACV and RCV is depreciation, or wear and tear.
ACV says that the property that was lost has probably depreciated by some amount over time, and attempts to inject depreciation into the equation. For example, say the property destroyed was a sofa that would cost $500 to replace. However, the sofa was 10 years old and although it might have been in good shape for a 10-year-old sofa, it was not brand new. Some wear and tear inevitably occurred.
Under ACV, the insurance company determines that $25 of depreciation occurred each year since the purchase so that the old sofa was only worth $250 at the time of the loss. They would then pay you $250 minus any applicable deductible and you would in a sense be paying an increased deductible in the form of the $250 depreciation. More precisely, you would be paying the difference between the replacement cost, the amount the old sofa depreciated by, and any deductible. You would be “co-insuring” that amount. That’s ACV.
RCV is, simply put, the cost of replacement of the lost property with an identical or similar piece of property. In our sofa example, if it costs $500 to replace the sofa, the insurance company will pay you the $500 less any applicable deductible. Case closed. It does not matter the sofa was showing the effects of age and you couldn’t possibly get $500 for it.
The question of which option to take cuts to the heart of what insurance is all about — making the insured whole again. ACV sometimes falls short. RCV, on the other hand, can create a beneficial state for the insured in some cases.
For example, forgetting any sentimental value the original sofa may have, if it is old and worn, but the insurance covers RCV, obviously the insured will benefit by receiving funds for a brand new sofa to replace the old one.
A more dramatic example might involve the loss of an old house in a fire. The house might have only been worth $200,000, because the components of the house, i.e., roof, HVAC, etc., were approaching the end of their life expectancy. Obviously, replacing the house with one containing similar features might result in a higher property value due to the new features.
Some insurers require that, in order to obtain the full replacement cost of the property, repairs must first be completed. They might pay the ACV up front and hinge the remaining payment of the difference between RCV and ACV on the actual repair or replacement being completed. This prevents the insured from pocketing the money and gaining financially from the loss, but the result of replacement at RCV is still beneficial and therefore, seems worth the small additional cost of coverage.
There is at least one caveat regarding the benefits of RCV, however.
David Patterson, CEO of Medici Insurance Services notes:
“Given the irrational real estate market, replacement cost may in many cases be less than actual cash value. Although depreciation has theoretically occurred,” according to David, “the run up in home values in recent years may have created a situation wherein the actual cash value of the existing home may exceed the cost of replacing the home with one that has similar features and qualities. Thus the extra cost of purchasing RCV may be inappropriate.”
As always, consult with your agent to determine which option to go with.