Replacement Cost

Reviewed by Stefan Tirschler

Noun

re·place·ment cost | rɪˈpleɪsmənt ˈkɔst

Definition: The monetary cost to replace property with new property of similar kind and quality.

Mary was surprised that the replacement cost of her home was so high.

What is replacement cost?

Replacement cost is one of several ways that insurance companies decide how much money to pay when they settle a customer’s claim.

The replacement cost is the cost to replace a piece of lost or damaged property with a similar, new item that is of similar kind and quality to the original article. The “item” can be a bicycle, car, house or anything else, depending on which type of insurance you’re talking about.

When it comes to home insurance, most policies offer coverage on a replacement cost basis. That applies to the big stuff, like the house or garage, plus the small things inside the building, like furniture.

When your home insurance policy offers replacement cost coverage, the insurance company is agreeing to replace lost or damaged property with similar new property. Of course, the cost has to be within the overall coverage limits of your policy. Replacement cost coverage means your insurance company will try to put you in the same place financially that you were in before the loss happened.

There are two essential parts of replacement cost coverage: your lost or damaged stuff will be replaced with (1) new property, which is of (2) similar kind and quality.

New means what it sounds like: you’re insured for the cost of buying new stuff. If your 20-year-old dining room furniture gets destroyed by a fire, your insurance policy won’t pay for 20-year-old furniture, it will pay for a new dining room set. Your insurance company doesn’t expect you to buy replacement property at garage sales.

Similar kind and quality means that your replacement property will be roughly equivalent in quality to your lost or damaged property when it was new. A TV that was top-of-the-line in 2005 should be replaced with a TV of similar quality today.

Aside from moveable property, replacement cost coverage also applies to the insured building.

In the context of a house, replacement cost is the cost of rebuilding the house to similar specifications on the same site.

The replacement cost of a home is not the same as the home’s market value; it’s usually much lower. That’s because when you rebuild your home, you don’t need to re-buy the land it was sitting on.

When you buy a home insurance policy, your home insurer will estimate the rebuild cost of your home. Their estimate is based on the home’s age, construction materials, location, and other factors. If your house has many expensive upgrades, like hardwood floors or a fancy kitchen, you may want an even higher coverage limit than your insurer’s estimate.

What is the difference between replacement cost and actual cash value?

Actual cash value is another way for insurers to determine how much to pay to settle a claim.

Unlike replacement cost, actual cash value does factor in the lost or damaged property’s age. When you have an insurance policy that protects your property on an actual cash value basis, it means your insurer will factor in the age and condition of the property in the settlement. This process is called depreciation.

We have an article on actual cash value that explains it in full, but here’s a summary of the differences.

Under replacement cost coverage, the insurance company pays to replace your lost or stolen property. One of the conditions of this coverage is that you actually replace the property; you can’t choose to receive the settlement in cash.

With actual cash value, however, you would receive the cash instead. Most home insurance policies offer protection on a replacement cost basis only when you choose to replace (or repair) property. Cash settlements, meanwhile, are calculated on an actual cash value basis.

Replacement cost coverage is usually the better of the two. You’ll end up with comparable new stuff when your property is damaged or lost (as long as the cost is within your overall policy limit). Actual cash value settlements are almost always smaller, since they factor in the property’s age and condition.

Example

William recently had a break-in at his home, and his television and stereo were stolen. He bought the electronics 10 years ago, but they were pretty high-end. He paid $8,000 for them originally. William’s policy offers replacement cost coverage. His insurer determines that it will cost $11,000 to replace his TV and stereo with new models that are similar to the stolen models when they were purchased. His insurance company offers to pay $11,000 for replacements (minus William’s $500 deductible).

William asks what he would receive if he chose cash instead of replacement electronics. His insurer calculates that his stolen electronics had depreciated in value by about 50% over the 10 years he’d owned them. They offer an actual cash value settlement of $4,000 (again, minus his $500 deductible). That’s the original $8,000 purchase price, minus 50%. William decides to go for the $11,000 replacement electronics instead of the $4,000 cash settlement.

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What is the difference between replacement cost and guaranteed replacement cost?

Some home insurance policies offer guaranteed replacement cost coverage.

Guaranteed replacement cost coverage isn’t too different than replacement cost coverage. The difference is that with this coverage, the insurance company agrees to pay for replacement or repair even if it costs more than the limit of coverage on the policy.

Guaranteed replacement cost coverage often applies to the house itself. It can be difficult to accurately estimate the cost of rebuilding a house. And, some situations (like large wildfires) create so much demand that the cost of rebuilding can unexpectedly skyrocket. Accordingly, some insurance policies guarantee that they’ll pay for repair or rebuilding even if it gets more expensive than the policy’s coverage limit. This shields the homeowner from unexpected shortfalls in coverage.

The catch is that you still need to insure your home for the full estimated rebuild cost to be eligible for guaranteed replacement cost coverage.

When you buy a homeowner’s insurance policy, the insurance company will estimate the cost of rebuilding your house. Under guaranteed replacement cost coverage, as long as you agree to buy insurance in the amount the insurer estimates, they will cover the cost of rebuilding the house even if it ends up being higher than the insured amount. Most home insurance policies will require you to inform your home insurance provider if you make any changes or improvements to the home, as a condition of receiving guaranteed replacement cost coverage.

If you decide to insure your home for less than their estimated amount, they will only cover the house up to your chosen limit.

Some insurers offer guaranteed replacement cost as an add-on coverage to their homeowner’s insurance policies. Home insurance policies sold by Square One include guaranteed replacement cost coverage by default.

The important points

  • Replacement cost coverage will cover the cost of replacing lost or damaged property with new property of similar kind and quality.

  • Replacement cost is different from actual cash value coverage, which only pays the present value of lost or damaged property.

  • Guaranteed replacement cost coverage means the insurer will repair or replace damaged property even if it exceeds the policy’s limits of coverage.

  • Always notify your home insurance provider before you make any changes or improvements to your home.

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