Market Value vs. Replacement Cost

There are multiple ways that insurance companies calculate the amount of compensation you are entitled to. From the policy holder’s point of view, the best solution is for the insurance company to reimburse policy holders the full cost of replacing the loss with a new item. Under this methodology, the insurance company will not be able to take into account the actual market value of the insured item, and the amount of compensation may be more or less than the cost of replacing the item in question, depending on current market values.

Naturally, insurance companies prefer coverage based on the actual cash value (ACH), or market value. Under this type of insurance, you would be entitled to compensation equivalent to that you would have received had you sold the item at market rates. In other words, you are entitled to just enough money which will enable you to buy the insured item in exactly the same condition as it was when destroyed. So who determines the current depreciated value of the insured item and how accurate is the figure?

The insurance company has depreciation rates for all categories of insured items, and they use these formulas, along with visual evidence, such as an inspection of the insured item and/or photographs to determine the current state and appropriate compensation required to replace the item with one in approximately the same state of depreciation.

These terms will be specified in your insurance contract, and you are advised to read and enquire about the terms of compensation before you sign the contract. Replacement cost is generally defined as the cost to replace the insured item to be used on the same premises and made of similar (if not the same) material and quality. The insurance will compensate loss only up to the value of the coverage, and the insurance company might also decide to consider repair instead of replacement, if the cost difference is huge.

The actual cash value is a more ambivalent term, and is subject to different interpretations depending on individual and specific circumstances. Generally speaking, the actual cash value would be the cost of replacing with an item of similar quality and make, minus depreciation. Again, this is subject to interpretation, and disputes can and do arise as to the exact market value. Thus the difference between these two methods is whether or not depreciation is taken into account. Logically speaking, depreciation should be taken into account. However, there are situations which warrant replacing the item with a totally new one, and under these conditions, the insurance company should be liable to pay for the full cost, without factoring in depreciation. Insurance companies will generally offer both kinds of coverage, with differing premiums based on your choice of compensation requirements.

Please note that the book value is rather irrelevant when it comes to quantifying compensation, since the depreciated value calculated based on the book value would be vastly below the required amount. Also, there may be even more ways of arriving at a valuation, other than replacement cost or ACH. You are advised to consult with your financial planner and your insurance agent, as also to research and compare insurance plans from multiple companies before arriving at any decision.