subject: Difference Between Replacement Cost And Actual Cost [print this page] A question we continually get from both our current clients and any potential clients is what is the difference between replacement cost and actual cost or fair market value. The question usually comes in the form of "why are we insuring my $200,000 home for $340,000" but can also come in when discussing other forms of property including jewelry, commercial property, or equipment such as tools or backhoes.
When buying a home, we as home buyers, typically look at the sales cost of the home (also referred to as fair market value) when determining which home to buy and what we can afford. This price will rise and fall with both the supply of homes and the demand from the market.
Currently, home values are down so we're able to buy more home than we were saying five years ago. To insurance companies, this number is irrelevant. The amount the insurance company is concerned with is what is the maximum amount needed to rebuild and restore our client to before loss condition if the home were to be destroyed by fire or another named covered peril.
Let's put some numbers down as an example:
* I build a new home at the cost of $200,000 (fair market value at the time of building).
* The price to build the home for the builder is $170,000 due to economies of scale, since they are building 10-15 homes at any given time. Materials, labor, etc., is fairly cheap and reasonable for the builder because they're not building just one house, they're building several at a time. The difference of $170,000 and the sales price of $200,000 is the builder's profit.
* I sell this home 5 years later to you at a price of $230,000 for a profit of $30,000. Not bad!
So, what do we insure this home for: $170,000, $200,000, or $230,000? Could you rebuild this home for any of these amounts? The answer is no, and actually these numbers wouldn't get us close to rebuilding this home at all!
First of all, let's assume we have a total loss due to a fire. We have debris to clean up (your old house) to the tune of $12,000-$30,000 dollars, whereas our builder just had an empty lot to build on. We have to hire engineers and architects to look at the existing foundation or structures to make sure it's suitable to build on and redesign the construction plans. We also have to hire a contractor to build the house with today's prices for materials and labor. Furthermore, we have to build the home as of today's building codes which can significantly raise the cost of construction (building codes get much more stringent as time goes on driving up costs). Plus, this is a one off job now for the builder. He's lost all the economies of scale he had when he could order 15 bathtubs at the same time from his suppliers.
All of these added expenses can add 30-50% to the building (or rebuilding) of your home. We sum up all of these costs with the term "replacement cost", or the cost you would need to rebuild the home to the allowable standard that it was before the loss.
