Actual Cash Value
What is actual cash value, and how is it used in property insurance?
Actual cash value is a term used in property insurance to describe the valuation of property should there be a loss. It is also known as a depreciated value and is defined as replacement cost minus depreciation. The definition of actual cash value is a guaranteed test question!
What is replacement cost coverage and how is it better than actual cash value?
Using a home as an example, replacement cost is the cost to rebuild the home at today’s construction cost. For example, say the cost of construction is currently $160 per square foot and a structure is 2,500 square feet. Its replacement cost would be $400,000. Keep in mind though, replacement cost and market value are two completely different things.
The owners of this house may be able to sell it to someone else for $800,000. With fire insurance, you are purchasing coverage to repair or rebuild a structure, not sell it. So, if you were to purchase a fire insurance policy with replacement cost coverage, you would want a coverage limit of $400,000, not $800,000.
As you can see the replacement cost of a structure is constantly changing since the cost of construction is constantly changing. Replacement cost is better than actual cash value coverage because it does not take into consideration depreciation.
Click here to learn more about replacement cost.
So, how would you figure out the actual cash value of a structure?
Usually, insurers (insurance companies) will depreciate a structure at a rate of 1% per year of the current replacement cost up to a maximum of 40%. This leads us to an interesting concept. On day one, when a home is brand new, its replacement cost and actual cash value are one and the same. A brand new structure has not depreciated.
However, over time, the actual cash value of a structure will go down. Using the example we did above, say the current replacement cost of the structure is $400,000. It is 10 years old. What is the replacement cost of the structure? $400,000!!
This is a common trick the testing companies play on those taking the insurance licensing exam. The replacement cost is what it is. However, if they ask what the structure’s actual cash value is, this is where you would take depreciation into account. This building has depreciated by 10% (1% every year for 10 years). The actual cash value would be $360,000 ($400,000 X .01 = $4,000 X 10 years = $40,000).
In this example, if the owner of the property had a fire insurance policy that valued a property loss based on its replacement cost, they could carry a policy limit of $400,000. However, if the policy valued a loss based on the actual cash value of the property, the owner could only carry a policy limit of $360,000. How much would it cost to rebuild the home if there was a total loss? $400,000. If the owner had actual cash value coverage they would have to pay the additional $40,000 out of pocket to rebuild the home.
This illustrates how much better replacement cost coverage is. Obviously, a policy that provided replacement cost coverage would have a higher premium than one that provided actual cash value coverage.
What types of property are usually valued based on their actual cash value?
For your exam, personal property (contents) are usually always valued based on their actual cash value. The same holds true regarding damage to an auto. Some insurers may offer endorsements to provide replacement cost coverage, however, don’t assume that is the case on the test.
What else can help me prepare to pass my insurance licensing exam on my first attempt?
Other tips to help you pass your insurance licensing exam on your first attempt:
Insurance Exam Test Taking Tips
Also, check out our definition and question of the day videos on our YouTube channel: