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Tuesday, March 5, 2024

How to Save Money on Home Insurance: Replacement Cost vs. Actual Cash Value Explained

The cost of home insurance is rising due to rising house prices, rising construction costs, increasing natural disasters and less risk appetite among insurance and reinsurance companies. As a result, more and more homeowners are looking to save by purchasing actual cash value (ACV) home insurance, as opposed to the more common replacement cost value (RCV) home insurance.

I’m going through this dilemma right now as I diligently search for home insurance for a new home I’m planning to purchase. The actual cash value policy I found is about 52% cheaper than the best replacement cost policy I found. With such significant annual savings, I’m leaning toward the actual cash value option.

Let me explain the definitions of each home insurance and discuss why one is better than the other. Ideally, a homeowner needs disaster insurance in case the worst happens, such as a fire that destroys everything.

First, let’s look at what depreciation means. It is essential to understand the difference between replacement cost and actual cash value. Simply put, depreciation is the loss of value of your property over time.

Replacement cost is the amount paid to replace property or personal belongings, without any deduction for depreciation. You may also have the option for replacement cost options for car, motorcycle and boat policies.

Actual Cash Value Home Insurance Policy Definition

The actual cash value is equal to the replacement value minus depreciation. In other words, actual cash value home insurance does not replace what you have lost. Instead, you will be reimbursed for the CURRENT actual value of the item.

For example, your roof may have cost $30,000. However, because it is 15 years old and only lasts 30 years, the current value of your roof may be as little as $15,000. If your roof tears off during a tornado, your actual home insurance policy will only pay $15,000.

How is the current value of your roof determined? To determine an item’s ACV, an insurance adjuster will assume the cost of replacing your damaged or stolen property and reduce the cost of the property based on depreciation, such as age and wear and tear.

The older your home, the less an actual cash value policy will likely cover.

Replacement Cost Value Home Insurance Policy Definition

Replacement cost value (RCV) is what it costs to replace damaged or stolen property without depreciation. It doesn’t matter how old the item is. A replacement cost value policy is required to replace the item at the price it costs today.

Going back to the roof example, if you have an RCV policy, your insurance company will pay the entire cost to replace your roof. Fifteen years ago the roof cost $30,000, but thanks to inflation it can cost $60,000 today. With an RCV policy, you will receive the full $60,000 to replace your roof with one of comparable quality.

An insurance adjuster will likely still come by to assess the damage before approving your claim. But the insurance adjuster will not attempt to calculate the depreciation in value of the damaged or destroyed property. Instead, the adjuster is there to verify the extent of the damage and identify suppliers who can perform the replacement job at a reasonable price.

Why you might prefer replacement cost insurance

Most people get replacement cost insurance for added peace of mind. In the worst-case scenario, an RCV policy will replace your home and belongings in the event of a disaster, without you having to pay more out of pocket.

If you don’t have a lot of savings, a replacement cost policy offers more financial protection. Valuable personal items, such as rare books or ancient Chinese coins, should probably also adopt a replacement cost policy. There’s probably a lot of subjective wiggle room when it comes to valuing collectibles and memorabilia.

Certain rare items gain value over time. These items require special treatment in your insurance policy to ensure they are covered for their full value. You may need to purchase additional insurance and name each item.

If you have a lot of debt, a replacement cost policy can also be reassuring to prevent you from getting into more debt. To qualify for a mortgage, a lender may even require you to purchase replacement cost insurance. Unless you Pay cash for a house you may have no choice but to take out an RCV policy.

In these cases, it’s better to pay the higher premiums every month than face a worst-case scenario and an insurance advisor costing you money. No one wants to lose everything, not be able to replace items and end up homeless.

Why You May Prefer Actual Cash Value Home Insurance

For homeowners who have a lot of savings and strong cash flow, it may make sense to get actual cash value home insurance. ACV premiums are much cheaper.

Most home insurance claims do not apply to complete renovations or replacements. Instead, most home insurance claims are for partial damage that doesn’t come close to providing full coverage for Home A, B, or C.

If a homeowner has weak cash flow and/or not much savings, they may also choose to purchase an ACV policy to save on monthly insurance premiums. This situation is obviously riskier, but can be rewarding if nothing bad happens to the house.

For homeowners who have another home to live in in the event of an accident, purchasing cheaper home insurance with actual cash value may also make sense. Although Coverage D, or loss of use, should be available for both types of home insurance policies. Loss of use is the amount a homeowner is paid to rent a comparable property while their damaged home is being repaired.

Actual Cash Value vs. Replacement Cost Value Price Difference

After hours of talking with various home insurance agents, it becomes clear that an actual cost policy is cheaper than a replacement cost policy. My quoted RCV policy is approximately 100% more expensive than my quoted ACV policy. It’s not quite apples-to-apples, however, as the RCV policy has 60% higher Dwelling A coverage.

Therefore, I estimate that the cost of an actual cash value policy for most homes is approximately 30% cheaper than the costs of a comparable replacement value policy.

There’s a reason why some of the largest companies in the world are insurance companies. Insurance is a very profitable business. The insurance premiums collected are usually higher than what insurance companies have to pay out in claims. In addition, a robust reinsurance market exists that helps reduce risks for primary insurance companies.

In summary: ACV = Lower price, RCV = More coverage.

The Basics of Home Insurance Coverage

Below is an example of a home insurance policy with different coverage. The main focus for ACV and RCV policies is Coverage A: Dwelling, Coverage B: Other Buildings, Coverage C:

Coverage A: Dwelling, also called a physical structure

Your home is covered by your home coverage (also called “Coverage A”). The amount of home coverage is usually based on the cost to rebuild your home. The costs of rebuilding your home are usually calculated on a price per square meter basis. Most standard home insurance policies cover your home at its replacement cost.

Home coverage is what most people think of when purchasing home insurance. The tricky part when it comes to having an actual cost value for a home is how much depreciation goes into physical structures, such as walls, plumbing, electrical wiring, etc.

Ask the home insurance agent to clarify the depreciation of a home’s physical structure. And let them think of different scenarios.

For example, suppose your house burns down and you have an ACV policy for €1 million in Property A. If your house was renovated 10 years ago and cost €1.4 million to rebuild, how much of the ACV policy will cover for reconstruction? Hopefully the full $1 million plus $400,000 out of your pocket.

Coverage B: Other structures

Another reason why the price of Coverage A is important is because all other Coverage limits are determined by the Coverage A limit.

Coverage for Other Structures can be up to 10% of your Coverage A. For example, if you have a limit of $1,000,000 for Coverage A, you will get $100,000 for Other Structures.

Other structures include patios, external fireplaces, fences and the outdoor kitchen. With other structures, it is less risky to have an actual cash value policy because the items are cheaper.

Coverage C: Personal property

Anything that could fall out of your home if it is turned upside down is covered by Coverage C.

When insuring your belongings you can choose between ACV and RCV. Most insurance policies provide coverage based on actual cash value. But you can often purchase replacement cost coverage for an additional cost.

For example, if you paid $3,000 for a new recliner ten years ago and it was destroyed in a fire, the RCV option typically pays what it costs to replace your recliner, which today is likely more than $3,000, minus your deductible .

If you have personal property that is increasing in value, you may want to purchase additional personal property insurance. Tell your independent insurance broker if you own any of these:

  • Valuable art such as sculptures or paintings
  • Precious metals and gemstones
  • Rare signed books
  • Firearms
  • Fine jewelry
  • Antiques or heirlooms that you think might be valuable

Extended Replacement Costs for Home Insurance

Again, most homeowners think of Coverage A: Dwelling when it comes to insuring their home. Many insurance companies offer an “enhanced replacement coverage” option that increases Property A coverage by 25% to 50%.

For example, if your home’s dwelling coverage is $1,000,000 and you purchased 25% additional replacement cost coverage, you would have up to $1,250,000 in dwelling coverage. Calculate the additional costs and see if it is worth it for you.

Please note that the higher replacement costs are intended to cover increases in the price of construction and not upgrades. For example, if a wildfire destroys your town and your home, the costs of materials and labor will likely increase. As a result, there is increased replacement coverage to protect you from the higher costs of rebuilding your home.

Guaranteed replacement costs for home insurance

Let’s say for some reason the cost of rebuilding your home exceeds the comprehensive, higher replacement cost coverage. Your home insurance company may offer a guaranteed replacement cost option, which covers the entire cost of replacing your home/property.

Unlike higher replacement costs, there is no specific limit for additional coverage. However, insurers typically limit guaranteed replacement costs to 20% above the amount of your home’s insured value.

Why I lean toward an actual cash value policy

I lean toward actual cash value home insurance because mine is 50% cheaper than replacement value home insurance. Over ten years I will save approximately €28,000!

I have owned real estate for over 20 years and have never had to make a home insurance claim. It’s not so much that I was lucky. It’s more that the home insurance deductible was so high that filing a claim wasn’t worth it. And if you make a successful claim, your home insurance premium may increase.

Examples of property damage where I have not filed an insurance claim

For example, when I was a renter, my laptop was damaged because water was leaking from the upstairs unit all night. The deductible was $1,000 and the computer was worth maybe $1,200. So I decided it wasn’t worth filing a claim because of the hassle.

When I was a homeowner, I used a bathtub deepener so I could soak deeper. Bad idea! The water overflowed and leaked through my dining room ceiling below. Instead of filing a home insurance claim and paying the $5,000 deductible, I hired guys for $3,000 to open the ceiling, identify the source of the leak, and fix everything.

Hole in Ceiling Water Leakage – Why I Lean towards an Actual Cash Value Policy

Based on my 20+ years of experience owning multiple properties, home insurance has been a waste of money. However, home insurance gave me peace of mind. It was also required on most of my properties as I had taken out mortgages.

Of course, home insurance would have been extremely valuable if my house burned down. Luckily I haven’t experienced any disasters yet.

As a landlord, building insurance is important to me rental properties because I have no control over what my tenants do inside. As far as I know, they can leave the heater on all week while they go on vacation.

That’s why I feel like home insurance is more worthwhile for rental property owners. In fact, I require all my tenants to get this renters insurance before entering.

What bothers me most about the actual cash value policy

If something bad ever happens to your home, you will feel stressed. Then when you have to deal with an insurance adjuster calculating the depreciation of your damaged property, you become even more stressed.

No matter what the commercials say about how nice insurance agents are, the insurance adjuster’s goal is to save the insurance company as much money as possible. The more the insurance company saves, the more profit it will make.

Whereas with a replacement cost value policy, theoretically there should be less discussion after filing a claim. If the item is destroyed, it must be replaced at whatever cost it costs today. This kind of peace of mind is valuable, especially if you don’t have… huge amount of savings or tapable liquidity to cover non-covered damage under an ACV policy.

If I knew the ACV policy insurance adjuster was a good guy, I would be more inclined to go for an ACV policy. But we all probably have no idea who our future insurance advisor will be.

If the cost spread between my quoted ACV policy and RCV policy was 30% or less, I would lean toward the more expensive RCV policy instead.

New construction or recently renovated homes may want an actual cash value policy

There is less depreciation to reduce the actual home insurance payout for new construction or recent renovated homes. Therefore, people with newer homes should get more value from a cheaper ACV policy if something were to happen to their home.

So a money-saving strategy is to purchase an actual cash value home insurance policy for the first 15-20 years of a new or renovated home’s life. Then switch to replacement home insurance after 15-20 years. This way, if anything were to ever happen to your now much older home, you can replace all your old items at today’s much higher values.

This strategy is safer than going without home insurance for 15 to 20 years and then buying insurance. This strategy also reminds me of the strategy of getting married after decades of being together. This way, if one spouse dies, the other spouse can collect the money social security benefits for survivors. Before getting married, the couple may have saved tens of thousands in marriage fines.

Coverage against poor or expensive home insurance

Finally, one way to overcome the feeling of badness about paying a lot for home insurance or getting bad home insurance is to buy stock in the insurance company.

I’ve been using this strategy with health insurers since 2012, when I had to pay 100% of my health insurance premiums after leaving my job. UnitedHealth Group (UNH) has been a juggernaut since 2012. Hooray for gutting my family and others!

The next time you have to pay your home insurance premium, you will feel better as an investor knowing that some of the money is going towards the insurance company’s profits. That is what you want as a shareholder, because it increases the chance that the share will increase in value.

like you Can’t beat them, join them!

Whatever you choose between a cheaper actual cash value policy or a more comprehensive replacement cost value policy, make sure you fully understand what each policy entails. Ask questions to the insurance agent and offer scenarios in which you should file a claim.

It is more than likely that you will not need to make a home insurance claim for the duration of your home ownership. But for the one time you do this, you’ll be grateful that you have the right home insurance coverage.

Questions and suggestions from readers

Does someone choose actual cash value home insurance instead of the more common replacement value home insurance? If so, why? Have you ever encountered any difficulties in applying for home insurance? If so, what was the problem? What do you think is better home insurance: ACV or RCV?

If you’re looking for affordable home insurance, take a look Policy genius. You can get multiple customized home insurance quotes in one place and choose the policy that suits you best.

Listen and subscribe to The Financial Samurai podcast at Apple or Spotify. I interview experts in their respective fields and discuss some of the most interesting topics on this site. Share, rate and review!

Frequently Asked Questions – FAQs

Why choose Actual Cash Value over Replacement Cost for home insurance?

Actual Cash Value may appeal to those seeking lower premiums, especially with strong cash flow.

How does depreciation affect home insurance claims?

Depreciation reduces the payout in Actual Cash Value policies, impacting coverage for older properties.

Are there scenarios where Replacement Cost is more beneficial?

Replacement Cost offers peace of mind, especially for valuable items, and may be required by lenders for mortgages.

What considerations are crucial when insuring personal property with Actual Cash Value?

Consider additional coverage for items increasing in value, such as art, jewelry, or antiques.

Is there a recommended strategy for transitioning from Actual Cash Value to Replacement Cost?

Consider starting with Actual Cash Value for newer homes, transitioning to Replacement Cost after 15-20 years.

How can investors benefit from paying home insurance premiums?

Consider investing in insurance company stocks to potentially offset the cost of home insurance.

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