Do you have a general idea of what it would cost to replace your home or business property? What if we asked you if you know what your insurance carrier thinks it’s worth? If you didn’t think these two answers could be different, you’re not alone.
Unfortunately, many property owners assume that their home or business insurance policy will match the price they paid for the property when it was purchased, but that’s not exactly how it works. Instead, carriers determine property value based on how much it would cost to repair or replace it in the event of a major loss.
Understanding how insurance carriers assign residential and business property replacement value is essential to being prepared for realistic reimbursement amounts after a total loss. In this article, we’ll break down the three primary ways properties are valued and how understanding your coverage — and making adjustments if necessary — can provide you some peace of mind.
The Three Main Types of Property Valuation
Insurance carriers typically use one of these three valuation methods when providing a property policy proposal:
- Replacement Cost (RC) —This is the cost to replace or repair the property with comparable materials (quality and aesthetics) without deducting for depreciation.
- Actual Cash Value (ACV) — This is the replacement cost minus depreciation, which accounts for the age and wear of the property to date of the damage.
- Functional Replacement Cost (FRC) — This is used most often for historical or industrial buildings and allows for modern and functionally equivalent material replacement instead of exact original materials.
Common Misconceptions About Property Valuation
A big misconception about property valuation is that the limit of insurance coverage equals the original purchase price of a home or commercial building. In reality, insurance coverage is based on replacement costs — what it would cost to rebuild the property using comparable materials and craftmanship today, which also factors in labor and materials at current rates.
Another common myth is that if a property is insured for market value, the owner is fully protected. Market value includes land, location and other market-driven factors; alternatively, insurance coverage focuses solely on the structure.
Taking a Closer Look at Replacement Cost
In the event of a major loss, replacement cost ensures you can rebuild your property close to its original condition without paying out-of-pocket expenses beyond your deductible. Most carriers prepare a replacement cost estimation, which considers things like:
- The year the property was built
- Construction materials used
- Building height and design
- Property use
- Upgraded features
- For residential properties, bathrooms, attached decks, garages, etc.
For residential properties specifically, carriers may offer an enhanced replacement cost endorsement, which provides additional coverage behind the stated limit. For example, if a home has a replacement cost of $400,000, and the insurance policy includes a 25% extended replacement cost endorsement, the property owner could receive up to $500,000 in coverage if there is a total loss. This can offer valuable peace of mind to the homeowner, especially in a time when construction costs fluctuate.
It’s important to note that replacement cost values are not static. Insurance companies typically adjust these values annually, often increasing them by 5-6% to account for inflation and rising material and labor costs. Given inflation trends, particularly in California where recent wildfires caused widespread devastation, labor and material costs are likely to skyrocket. Property owners — commercial and residential — should verify their replacement cost limits each year to ensure they will offer the needed coverage, if necessary.
When Actual Cash Value Makes Sense
Unlike replacement cost, ACV policies take depreciation into account. While ACV policies generally offer lower premiums, they may not provide enough coverage to fully replace a lost property without out-of-pocket expenses. Take, for example, a property with a 15-year-old roof that’s damaged by a hailstorm. An ACV policy may only reimburse the depreciated value of the roof, leaving the homeowner on the hook for covering the rest of the replacement cost. Ouch. Many carriers apply ACV endorsements to older roofs, limiting payouts based on the roof’s age.
Additionally, some older properties may be required to have ACV coverage if the age or condition of the property makes full replacement impractical. Carriers often set a cut-off age for properties — maybe 60 to 100 years — where properties transition from RC to ACV.
There’s also room for negotiation. Let’s say you own a farm and have an old barn that you used only for storage. If the barn collapses in a storm, and you wouldn’t want to rebuild it, opting for an ACV valuation makes sense, because it saves you money on premiums while still providing some level of protection.
When Functional Replacement Costs Make Sense
FRC is often the best option for high-value properties like historic buildings, municipality buildings and industrial structures. Instead of replacing a structure with identical materials, which may be rare or extremely expensive, FRC allows for modern alternatives that serve the same purpose.
For example, if an historic city building was originally constructed with imported Italian granite, it might be impossible (or wildly expensive) to rebuild the property to the exact specs as the original. Negotiating an FRC policy allows for replacement with locally sourced or functional materials at a more reasonable cost. However, if a property owner wants exact material replacements, there are costly excess and surplus lines for coverage available.
Knowledge Is Power
Understanding how your carrier is valuating your property helps you make more informed coverage decisions. You want to ensure that in the event of a major loss, you will receive adequate compensation to restore the property to your satisfaction.
My goal as an insurance advisor is to educate my clients so they can move forward with peace of mind. I encourage you to ask questions of your carriers or advisors — check on your coverage annually to ensure you have the right protection in place. Because when disaster strikes, the last thing you want to be wondering is, “Do I have enough coverage to rebuild?”
If you’re unsure about your property valuation, now’s the time to ask the questions. Not sure who to ask? I’m always happy to chat!
