The next time you find yourself examining the declarations page of an auto insurance policy be sure to read the fine print to learn about how you would be reimbursed in the future for property loss. Generally, on the declarations page of an insurance policy, it will explain whether your specific policy covers the Replacement Cost of your car or simply it’s Actual Cash Value. This minor distinction may not seem like a big deal now but the disparity in cash reimbursement may be the difference between being able to replace your vehicle or not!
If you’re not cautious it’s easy to end up with an insurance policy that won’t replace your car, truck or SUV at the cost that you would have personally valued it at.
After reading this article you’ll have learned about:
- How Actual Cash Value is Calculated
- Depreciation and its Relationship to Actual Cash Value
- How Replacement Value is Calculated
- Actual Cash Value Concerns & Considerations
Actual Cash Value & Replacement Cost: An Example
As an example, let’s consider Bob Johnson, a fictional character who purchased a car for $25,000 brand new in 2015 that is now worth $16,000 in 2020 due to depreciation, age, and mileage. In 2020 Bob is involved in a car accident that leaves his 5-year-old car with plenty of life remaining completely totaled!
If Bob’s auto-insurance policy states that his auto replacement coverage is based on Actual Cash Value, Bob would get a check for $16,000 to replace his car. While $16,000 is an accurate representation of what Mr. Johnson’s car was worth when it was crashed, the check will not allow him to purchase a car of equal quality brand new like he did in 2015.
In contrast, if Bob’s auto-insurance policy stated that his auto replacement coverage was Replacement Cost based he would get a check closer to $25,000 allowing him to purchase a new replacement vehicle of similar make and model to the one that had been crashed.
After considering this example you may be asking: “Why would anyone choose Actual Cash Value over Replacement Cost?” The answer always comes down to recurring monthly costs, budget and value of the insured property. Typically, a policy that is based on Replacement Cost will have steeper premiums which can turn a lot of buyers away that don’t fully understand the repercussions in the case of an expensive loss.
Actual Cash Value and How It’s Calculated
Actual Cash Value (ACV) of a lost item is typically calculated by subtracting depreciation due to wear and tear combined with age from that item’s full original value. Therefore, the Actual Cash Value of any personal item by definition will be less than the initial cost of purchase.
Does that mean that in order to understand ACV you have to comprehend depreciation? Yes!
Actual Cash Value can also be thought of as Depreciated Value at the Time of Loss.
It’s easy to understand depreciation on a yearly or monthly basis once you have established a vehicle’s salvaged value.
For example, if you purchase a used Honda Civic for $5,000 that is expected to be worth $1,000 after 10 years of wear and tear you can calculate the monthly or yearly depreciation by diving the difference in value by time. In this example you would divide $4,000 (the loss in value over time) by 10 years or 120 months which would give you an approximate depreciation rate of $400/year or $33.33/month.
In this example if your auto insurance policy states that replacement is calculated off of Actual Cash Value, each year that you have owned the hot tub prior to the loss would subtract $400 from the final check that you could receive.
Because of the impactful depreciation element, Actual Cash Value will often leave a vehicle owner short on cash to purchase a similar product brand new. If you don’t mind putting up a bit of your own cash to purchase a replacement car this may not be the end of the world, but for daily essentials such as vehicles or kitchen appliances this may not be a risk worth taking.
Replacement Cost and How It’s Calculated
In contrast with Actual Cash Value, Replacement Cost (RC) is a very simple calculation. Replacement Cost is defined as the payment you would be required to make in order to replace the item that was lost with a similar make or model brand new, whether that be a hot tub, piece of furniture, vehicle or structure.
In the example that I used above Replacement Cost insurance would cover the purchasing of a $5,000 used car similar to the one that you had lost. Replacement Cost takes the element of depreciation completely off of the table!
While Replacement Cost is considered superior in almost all insurance applications, the premiums can be a bit higher as previously discussed depending on the value of the items you are looking to insure. If ever the value of the item insured is surpassed by the combination of premium related expenses, you’ll know that the personal belonging is over protected.
Actual Cash Value Concerns & Considerations
In most cases, a general auto insurance policy will contain language that covers personal property contained within the vehicle such as aftermarket speakers, electronics, golf clubs and more under Actual Cash Value settlement terms. Depending on the value of the electronics and other aftermarket parts, it may be worth asking your insurance agent about the cost of upgrade from Actual Cash Value to Replacement Cost settlement terms. In some cases, especially with cheaper auto insurance policies the difference in price can be a merely a hundred dollars a year which may be worth considering depending on your situation.
Consider this one final example of a larger loss:
Bob Johnson owns an old collectible car originally purchased 25 years ago for $15,000. If a large windstorm comes through Bob’s small town and destroys his garage containing the car which has been deteriorated by 25 years of wear and tear Bob will be relying on his auto insurance for replacement. Under an Actual Cash Value insurance policy, Bob may not get any insurance payouts for rare, aged vehicle due to the exorbitant depreciation and would therefore be responsible for the entire replacement cost.
Below you can find a few important questions to ask yourself prior to making your final decision on Actual Cash Value vs. Replacement Cost:
- Are there elements of your vehicle that are outside of their “useful life” as defined by your insurance policy? (Ex. Bob Johnson’s Collectible Car)
- Do you have a lot of expensive to replacement, depreciated electronics or speakers?
- Are you in possession of a collectible vehicle that would be difficult to replace or not properly valued in an ACV scenario?
- Do you have funds to supplement the difference in replacement value?
In conclusion, understanding Actual Cash Value (ACV) and Replacement Cost (RC) is an essential function of reading through any Auto Insurance Policy. But understanding these terms and making the right decision for your unique application is where the difficult decisions really begin. Consider the examples we have discussed above and try to imagine yourself in a position of loss in order to establish your precise insurance needs.