Replacement Cost Insurance: What Is Covered?

As you begin your hunt for the perfect home insurance policy, you'll come across the term "replacement cost." Before you make a final decision regarding the amount of coverage you want, it's important to know what replacement cost insurance can do for you. Here, we'll cover what it is, how it works, and whether it's worth the premium you'll pay.

Replacement cost insurance coverage

By some estimates, nearly 64% of U.S. homes are underinsured by at least 27%. That means that 64% of homeowners won't have enough coverage to rebuild if their homes are destroyed. At the very least, they will be on the hook to pay the difference between how much their property is insured for and how much it costs to rebuild. Homeowners with replacement cost insurance have the luxury of knowing that if their home is destroyed it will be rebuilt as good as new, no matter how much it costs. So, as a homeowner asks questions like, "how much home insurance do I need?" they should also ask if replacement cost insurance can further help protect their finances.

What is replacement cost?

Replacement cost refers to having enough coverage to rebuild the home and replace lost items. Homeowners can buy a replacement cost policy that covers their dwelling, personal property (like electronics, furniture, and clothing), or offers both dwelling and personal property coverage.

A quick note about insuring personal property: Most homeowners insurance policies provide some coverage for loss to personal belongings. This coverage is typically for 50% to 70% of the amount of insurance on the dwelling. So, if a house is insured for $300,000, insurance will pay out $150,000 to $210,000 for personal property.

For some people, that's plenty of coverage. For anyone whose personal property is valued at more than their standard homeowners policy provides, it makes sense to buy a replacement cost insurance policy that covers personal possessions. Personal property replacement cost coverage does not apply only to homeowners. Renters insurance replacement cost provides the same level of security for those who lease their homes.

Factors that affect replacement cost

As straightforward as replacement cost sounds, there are a number of factors that go into determining how much a homeowner needs. Here are a few examples:

• What it costs to replace a home (without the land). Let's say a homeowner pays $600,000 for a home because it's near the beach. If that home burns to the ground and needs to be replaced, it may only cost $450,000 to rebuild because $150,000 of what the homeowner initially paid was due to the value of the lot on which it was built. In this case, replacement cost coverage would be for $450,000 rather than $600,000.
• The existing qualities of a home. Imagine a home is full of unique features like intricate molding, a slate roof, antique door handles, or a custom-built storm room. Even if that person spent $400,000 to buy the home, it may require more to rebuild due to the expense of making it "like new."
• Where the home is located. The price of rebuilding a home varies by region.

How to calculate replacement cost for your home

As mentioned, the market value of a home may not represent the true cost of rebuilding. After all, the land on which a home sits will not need to be replaced if the home is destroyed, but unusual features (like extraordinary woodwork or stained glass windows) need to be factored in. Homeowners have three options for coming up with an accurate replacement cost:

1. Break down each and every feature of the home and seek valuations. For example, find out how much it would cost to replace the model of hot water heater currently in the home, then do the same for every other feature that would need to be replaced if the home was destroyed. This is, by far, the most labor intensive way of calculating replacement cost.
2. Count on your insurance agent. An experienced agent has access to a sophisticated home value calculator. This replacement cost estimator takes location, age of the home, and any special features into account as it calculates how much coverage is required.
3. Hire an independent appraiser. Hiring an appraiser from your area offers a couple of advantages. The appraiser is familiar with the construction codes that govern how your home needs to be rebuilt, understands the value of property in your area, and has a clear sense of how much it will cost to track down and install unique features.

Actual cash value insurance coverage

The name says it all. "Actual cash value coverage" pays up to what something was "actually" worth at the time it was damaged.

What is actual cash value (ACV)?

Let's say a home burns to the ground. The roof had a 20-year lifespan but was 17 years old. Rather than pay to replace the entire roof like a replacement cost policy would, the insurer calculates how much a 17-year-old roof is worth and pays that much towards a new roof. The homeowner is responsible for the difference. Let's say the insurance company decides that a 17-year-old roof is worth $2,500 but a new roof will cost $20,000. The insurer will pay $2,500 and the homeowner must pay the remaining $17,500.

Replacement cost vs. actual cash value (ACV)

When it comes to actual cash value vs. replacement cost, the coverage that works best depends on at least two factors, including:

1. Age of the home. If it's a brand new cookie-cutter home (without special features that make it stand out), ACV may be just fine -- for a time. With each passing month, the value of the components in the home decrease in value. For example, the carpet is no longer new, so the insurer is only on the hook for how much used carpet costs. The only way to be certain that you won't have to come up with thousands of dollars toward rebuilding your home is to opt for replacement cost coverage.
2. Finances of the homeowner. Let's say that someone owns a small home in the mountains and can easily afford to replace it out of pocket if it is destroyed. ACV may be all the coverage that the homeowner wants or needs.

Extended replacement cost insurance coverage

Think of extended replacement cost insurance as a "booster" that's been added to an existing policy. Adding extended replacement cost to a policy helps cover unanticipated overages associated with rebuilding a home.

Let's say a homeowner lives in Oklahoma and a tornado destroys their house (along with all the other houses in their neighborhood). A couple of things happen at once: Everyone in the neighborhood needs their home rebuilt, and the demand for labor and materials increase, driving up prices.

Now, imagine that this homeowner insured their home for $300,000, but with the rising cost in labor and materials, it's going to cost $375,000 to rebuild. As long as the homeowner has extended replacement cost insurance, the extra funds are there to cover the difference between what they initially insured the property for and what it will cost to rebuild. This policy rider allows homeowners to buy coverage that goes above and beyond.

Perhaps this homeowner initially purchased replacement cost coverage of $300,000 because that's what their insurance agent or home appraiser told them it would cost to fully rebuild the home in the event of a catastrophe. Now that the cost of labor and materials is so expensive, the $300,000 no longer covers the entire loss.

Most extended replacement cost riders allow homeowners to extend their coverage by 10% to 50%. For example, if a homeowner extends their coverage by 25% it means they would have an additional $75,000 available to them ($300,000 x 0.25 = $75,000), enough to cover the entire cost of rebuilding their home.

Making a replacement cost insurance claim

Making a replacement cost insurance claim is like making any insurance claim. Here's how it works:

• The homeowner contacts their insurance company to file a claim.
• An appointment is set for a claims adjuster to come to the house.
• The insurance company offers information regarding temporary living expenses.
• The insurance company may also offer advice regarding safety issues (like whether the homeowner should try to retrieve anything from the home).

How is replacement cost calculated?

Insurers have access to a detailed replacement cost calculator. These calculators allow them to factor in the value of a home per square foot, age of the home, any special features, and every other detail of the dwelling -- down to the type of appliances that need to be replaced. Because it's all about rebuilding the property "as good as new," part of their calculation also involves the cost of labor and materials following the claim.

How is replacement cost paid out?

Payout procedures vary by insurer, which underscores the importance of learning how a particular insurer handles claims prior to settling on a policy.

Typically, when a home is destroyed, the homeowner receives separate checks for:

• Dwelling coverage
• Personal possessions
• Additional living expenses (ALE)

ALE funds are intended to cover things like hotels, meals, car rental (if necessary), and clothing while everything is sorted out.

Payments for the rebuilding project can be handled in a couple of different ways. Some contractors will ask the homeowner to sign a "direction to pay" form that allows the insurance company to pay them directly. Otherwise, checks are written to the homeowner and their mortgage company (if they carry a mortgage). That's because the mortgage company holds title to the property and must agree to the payments being made. The mortgage lender signs off on the checks before they are returned to the homeowner and contractors are paid.

If a homeowner took out a replacement cost policy to cover their personal possessions, they may be required to buy replacement items and provide proof of purchase before their insurer compensates them.

There is no one-size-fits-all method for how insurers pay out replacement claims. Not only does it depend on the insurer in question, but also the region of the country in which the claim occurs (different regions have different laws governing insurers).

One thing that applies to all homeowners in this situation is that they are expected to keep extraordinary records. They must provide the insurance company with receipts of purchased replacement items and ensure that each contractor working on the house is paid as agreed.

When it comes time to purchase (or upgrade) homeowners insurance, the cheapest way to get by is to purchase ACV coverage. However, ACV coverage is unlikely to cover the entire loss. Total replacement cost coverage costs more upfront, but can be the difference between rebuilding or walking away.