Actual Cash Value or Replacement Cost: Which One Sets Your Building's Insured Value?
Actual cash value and replacement cost are not the same thing. Using the wrong one can leave a large gap between your building’s insured value and what it would actually cost to rebuild.
For example, a building may cost CAD 8 million to rebuild today, but have an actual cash value of only CAD 4.8 million after depreciation.
If CAD 4.8 million is used as the insured value on a policy meant to cover replacement cost, there could be a CAD 3.2 million gap.
So which value should you use?
It depends on the valuation basis in your policy. A replacement cost policy needs a replacement cost value, not a depreciated value.
What is replacement cost?
Replacement cost is the current cost to repair or rebuild a building with materials of like kind and quality, without deducting for age or wear.
A replacement cost valuation may include costs such as:
Demolition
Debris removal
Professional fees
Applicable building code work
Whether the policy covers these costs, and under what limits, depends on the policy wording and endorsements.
The important point is that replacement cost is about what it costs to rebuild today.
What is actual cash value?
Actual cash value (ACV) is commonly based on replacement cost minus depreciation.
Depreciation can reflect the age and condition of the building and other factors, depending on how the policy defines ACV.
For example:
Replacement cost: CAD 8 million
Less depreciation: CAD 3.2 million
Actual cash value: CAD 4.8 million
The cost of new materials and labour does not become cheaper because the old building was 40 years old.
That is why ACV can be much lower than replacement cost.
What about market value?
Market value is different again.
It asks:
What could the property sell for?
Market value includes the value of the land and is affected by the real estate market.
Replacement cost asks a different question:
What would it cost to rebuild the building?
Land is not part of the building replacement cost.
Market value should not be used as a substitute for replacement cost without first checking what the number represents.
What happens after a loss?
This depends on the policy.
A policy that settles on an actual cash value basis generally pays the depreciated value, subject to the policy terms and limits.
A policy that settles on a replacement cost basis can provide for the cost to rebuild, subject to the policy terms, conditions and limits.
Some replacement cost policies first limit payment to actual cash value until the building is repaired or replaced as required by the policy. The additional replacement cost payment may then depend on the actual costs incurred and other policy conditions.
The policy wording controls the claim.
That is why the insured value matters too.
What happens if the insured value is too low?
Suppose a commercial building would cost CAD 8 million to rebuild.
For this example, assume depreciation is 40%.
Figure | Amount |
|---|---|
Replacement cost | CAD 8,000,000 |
Illustrative depreciation | CAD 3,200,000 |
Actual cash value | CAD 4,800,000 |
Now assume the building is covered on a replacement cost basis, but the building limit is only CAD 4.8 million because someone used the depreciated value as the insured value.
If the building is destroyed, there is at least a CAD 3.2 million gap between the limit and the replacement cost, before other policy adjustments.
There could also be a co-insurance issue.
If the policy requires 80% co-insurance based on an CAD 8 million replacement cost, the required amount of insurance would be CAD 6.4 million.
The CAD 4.8 million limit would be below that amount. A partial loss could then be reduced by the co-insurance rule, depending on the policy wording.
See how co-insurance can reduce a claim.
So which value should be used for insurance?
Start with the policy.
If the policy is written on an actual cash value basis, ACV may be the intended basis of settlement.
If the policy provides replacement cost coverage, the insured value should reflect the replacement cost required by the policy.
The two numbers can be very different.
That is why using an old appraisal, market value or depreciated value without checking the policy basis can create a problem.
How does Remit determine replacement cost?
Remit does not value a building based on what it could sell for.
We determine what it may cost to rebuild the actual building today.
We assess the building’s characteristics and apply current construction costs to develop an insurance replacement cost value.
And the work does not have to start over every time construction costs change.
We assess the building once, then update the replacement cost as construction costs move each quarter, provided there has not been a material change to the building.
That means your insured value can keep pace with construction costs without needing a new site assessment every quarter.
The number on your policy should match the question you’re trying to answer
Market value asks what the property could sell for.
Actual cash value accounts for depreciation.
Replacement cost asks what it may cost to rebuild.
If your policy is meant to cover replacement cost, the insured value needs to be based on replacement cost.
Remit RCV prepares independent insurance replacement cost valuations for commercial buildings and keeps those values current as construction costs change.
Send us the property address to discuss a valuation and how to keep it current.
