What does replacement cost mean in insurance

Replacement cost is a term referring to the amount of money a business must currently spend to replace an essential asset like a real estate property, an investment security, a lien, or another item, with one of the same or higher value. Sometimes referred to as a "replacement value," a replacement cost may fluctuate, depending on factors such as the market value of components used to reconstruct or repurchase the asset and the expenses involved in preparing assets for use. Insurance companies routinely use replacement costs to determine the value of an insured item. Replacement costs are likewise ritually used by accountants, who rely on depreciation to expense the cost of an asset over its useful life. The practice of calculating a replacement cost is known as "replacement valuation."

Replacing an asset can be an expensive decision, and companies analyze the net present value (NPV) of the future cash inflows and outflows to make purchasing decisions. Once an asset is purchased, the company determines a useful life for the asset and depreciates the asset's cost over the useful life.

Key Takeaways

• The replacement cost is an amount that a company pays to replace an essential asset that is priced at the same or equal value.
• The cost to replace an asset can change, depending on variations in the market value of components used to reconstruct or repurchase the asset and other costs needed to get the asset ready for use.
• Companies look at the net present value and depreciation costs when deciding which assets need to be replaced and whether the cost is worth the expense.

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Replacement Cost

Understanding Replacement Costs

As part of the process of determining what asset is in need of replacement and what the value of the asset is, companies use a process called net present value. To make a decision about an expensive asset purchase, companies first decide on a discount rate, which is an assumption about a minimum rate of return on any company investment.

A business then considers the cash outflow for the purchase and the cash inflows generated based on the increased productivity of using a new and more productive asset. The cash inflows and outflow are adjusted to present value using the discount rate, and if the net total of all present values is a positive amount, the company makes the purchase.

The cost to replace an asset can change, depending on variations in the market value of the asset and other costs needed to get the asset ready for use.

Special Considerations

When calculating the replacement cost of an asset, a company must account for depreciation costs. A business capitalizes an asset purchase by posting the cost of a new asset to an asset account, and the asset account is depreciated over the asset’s useful life. Depreciation matches the revenue earned by using the asset at the expense of using the asset over time. The cost of the asset includes all costs to prepare the asset for use, such as insurance costs and the cost of setup.

Some assets are depreciated on a straight-line basis, meaning the cost of the asset is divided by the useful life to determine the annual depreciation amount. Other assets are depreciated on an accelerated basis so more depreciation is recognized in the early years and less in later years. The total depreciation expense recognized over the asset’s useful life is the same, regardless of which method is used.

Replacement Cost Budgeting

Given the cost of replacing expensive assets, well-managed firms create a capital expenditure budget to plan for both future asset purchases and for how the firm will generate cash inflows to pay for the new assets. Budgeting for asset purchases is critical because replacing assets is required to operate the business. A manufacturer, for example, budgets for equipment and machine replacement, and a retailer budgets to update the look of each store.

If disaster strikes, do you have enough insurance to rebuild your home and replace all of your belongings? Because inflation and natural catastrophes can dramatically increase the cost of home construction, you might need more coverage than you think.

To avoid being underinsured, it’s important to know the replacement cost of your home and how much insurance your policy provides.

What is replacement cost insurance?

Also known as replacement cost coverage, replacement cost insurance pays for you to replace a damaged piece of property with a new one.

A standard homeowners insurance policy generally includes replacement cost insurance for your house and other structures on your property, such as a shed or fence. So if your house burns to the ground, a replacement cost policy would pay to rebuild it exactly as it was.

Replacement cost coverage may also apply to your belongings. With this type of coverage, your insurer would pay for a new laptop if someone steals your old one. However, many insurance policies cover your belongings on an “actual cash value” basis instead.

Replacement cost vs. actual cash value

An actual cash value insurance policy pays what your items are worth minus depreciation, or the loss of value over time. For example, if your sofa is lost in a covered fire, your insurer will pay only what the sofa was worth when it was destroyed, not the amount it would cost to replace it with a new one.

Choosing actual cash value coverage will usually save you money on your insurance premiums. However, it could cost you more in the long run if many belongings are damaged at once and your insurance payout isn’t enough to replace them. Most insurers offer the option to upgrade to replacement cost coverage for your belongings.

While actual cash value coverage is most common in your policy’s personal property section, it may also apply to your roof. That means if a hailstorm damages your roof halfway through its expected lifespan, your insurance company might pay only half the amount you’d need to replace it.

How does replacement cost insurance work?

When you file a claim, your insurer may not pay out the full replacement cost of your home or belongings right away. Instead, you may get an actual cash value payment first. Then you’ll receive the balance of the payout once you’ve replaced the item and submitted your receipt to your insurer as proof.

Dwelling, other structures and personal property coverage are generally subject to a deductible. A deductible is the amount of your claim an insurer expects you to cover yourself, so it will be subtracted from your payout.

Here’s an example: A tree falls on your home, damaging your 5-year-old roof. You file a claim to replace it. The insurance company estimates that your existing roof is worth about $8,000 and that it’ll cost $12,000 to buy a new one. The deductible on your policy is $1,000. 

The insurer mails you an initial check for $7,000 — the actual cash value of your roof ($8,000) minus your $1,000 deductible. Once you’ve replaced the roof, you send the receipt from the contractor to your insurance company, which mails you a check for the remaining $4,000.

Know your home’s replacement cost

While replacement cost insurance offers more financial protection than actual cash value coverage, you could still end up underinsured if you don’t set your coverage limits high enough.

Insurers use replacement cost calculators to determine how much dwelling coverage you’ll need to rebuild your home. The estimate will incorporate various information about your home, like its square footage, construction materials and the year it was built.

You can also determine your home’s replacement cost on your own. One method involves multiplying your home’s square footage by the current cost of construction per square foot in your area, Alan Himmel, a public insurance adjuster in Florida, said by email. “You can get an idea of per square foot building costs by calling the builders association in your area, an insurance agent, or even … contractors.” 

The average cost to build a house is about $150 per square foot, according to HomeAdvisor.

You can also hire a contractor to provide a construction estimate or have an independent insurance agency pull multiple homeowners insurance quotes to get a sense of what each insurer estimates it will cost to rebuild your home.

Consider extended or guaranteed replacement cost coverage

While you may be able to determine how much it would cost to rebuild your home today, it’s difficult to predict construction costs in the future. Even a catastrophic storm could greatly increase the cost to rebuild in your area overnight.

To offset such uncertainties, consider adding extended replacement cost coverage to your home insurance policy. This coverage will pay a percentage over your dwelling coverage limit if that amount isn’t enough to completely rebuild.

For example, if your policy’s dwelling coverage is $100,000 and you have 25% extended replacement cost coverage, your insurer will pay up to $125,000 to rebuild your home.

If you want full assurance that your insurer will cover the entire cost to rebuild your home, regardless of how much construction costs increase, consider guaranteed replacement cost.

“The most confident I ever am when I sell a policy is when the client has a guaranteed replacement cost endorsement,” says Peter Conte, an independent insurance agent in New York City. “They can sleep better because, come time for a claim, they know they’re getting their house back.”

Guaranteed replacement coverage typically comes with a higher premium. It may not be available from all insurance companies, and it may not cover older homes.

Check for other coverage options

Many home insurance policies come with an inflation guard, which can offset the possibility of being underinsured because of expected inflation increases. An inflation guard will automatically raise your coverage limits to account for inflation when you renew your policy.

Your premium may rise because of the inflation guard, but don’t lower your coverage limits just to save on home insurance. “The inflation guard is actually there to help you stay in line with the inflation rate of the U.S. dollar,” Conte says.

If you live in an older home, check your policy for ordinance or law coverage. In the event of a covered claim, this coverage will pay the cost to meet current building codes when rebuilding. Without it, you’ll likely need to pay out of pocket for any work done to abide by building codes, even if you have guaranteed replacement cost coverage.

If you’re still worried about being underinsured, talk to your insurance company or agent. They’re best equipped to break down your policy, including what’s covered and what’s not. Keep them informed of changes you make to your home, such as upgrades or renovations, so they can increase your coverage limits accordingly.

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