Key Difference – Actual Cash Value vs Replacement Cost
Individuals and companies purchase insurance policies to claim benefits in a situation of damage to property or assets due to unforeseen circumstances. Actual cash value and replacement cost coverage are two methods offered by insurance companies to replace the damaged, destroyed or stolen assets. The funds received to replace the assets depends on the type of insurance coverage. The key difference between actual cash value and replacement cost is that actual cash value is a coverage policy that pays the cost less depreciation to purchase a new asset whereas replacement cost policy pays an amount of funds to purchase a new asset at the current market value.
CONTENTS
1. Overview and Key Difference
2. What is Actual Cash Value
3. What is Replacement Cost
4. Side by Side Comparison – Actual Cash Value vs Replacement Cost
5. Summary
What is Actual Cash Value
Actual cash value is the initial cost to purchase an asset after deducting the depreciation. In simple terms, the insured party will receive a claim to buy a similar asset to the damaged or stolen one at present cost after allowing for depreciation. Depreciation is a charge to account for the reduction in economic life due to wear and tear of an asset.
E.g. BSC Ltd was affected by a recent fire and some of its machinery in the production flow were destroyed. Total purchase cost of the machines were $55,000. Depreciation for the machinery amounted to $4,750. If the company has an actual cash value coverage, the funds received will be $50,250 ($55,000-$4,750)
Actual cash value coverage is less costly to purchase since depreciation is considered and the insurance payments are lower than in replacement cost policy. Insurance companies may calculate depreciation in a different method to the company, and the depreciation amount for the purpose of the claim will be based on the insurance company’s calculation.
What is Replacement Cost?
Replacement cost coverage policy pays an amount of funds to purchase a similar asset (similar brand or quality) at today’s cost (present market value). What actually happens here is that the insurance company will pay the actual cash value of the asset and the insured party have to submit the receipt of the payment for the new asset prior to paying the remainder. Thus, the insured party has to purchase the new asset first before claiming the balance funds from the insurance company. Insurance payments under this policy are more expensive compared to actual cash value policy. Continuing from the above example,
E.g. Assume that BSC Ltd has taken out a Replacement Cost coverage policy and the present market value of the machinery is $61,000. At first, the insurance company will pay $50,250; which is the actual cost of the machinery less depreciation. BSC has to purchase the machinery worth of $61,000 using the insurance money of $50,250 and its own business funds of $10,750. BCS Ltd. can claim the additional $10,750 from the insurance company by submitting the purchase receipt of the machinery
Guaranteed or extended replacement cost is an extended version of replacement cost coverage where the insurance company pays to purchase the exact replacement for the damaged or lost asset (same brand or quality). This option is more costly than the general replacement cost policy.
Figure 1: Fire, theft and natural disasters are common ways that assets are destroyed and require replacement
What is the difference between Actual Cash Value and Replacement Cost?
Actual Cash Value vs Replacement Cost |
|
| Actual cash value is a coverage policy that pays the cost less depreciation to buy a new asset. | Under replacement cost policy, the insured party receives funds to purchase a new asset at the current market value. |
| Cost | |
| Actual cash value policy is less costly and incurs relatively low insurance payments. | Replacement cost is costly compared to actual cash value since replacement are done at current market price. |
| Depreciation | |
| Depreciation is considered in accounting for the claim under actual cash value. | No allowance for depreciation is applicable for replacement cost. |
Summary – Actual Cash Value vs Replacement Cost
Certain assets may be subjected to a special valuation basis other than replacement cost or actual cash value. Thus, companies should consult the insurance company when deciding which type of policy may be applicable for various type of assets. Further, the difference between actual cash value and replacement cost depends on the cost of insurance payments; replacement Cost policy is more expensive. However, it is also more beneficial compared to the actual cash value policy since asset values are generally increasing.
Reference:
1.”Actual Cash Value vs. Replacement Cost in Homeowners Insurance.” ValuePenguin. N.p., n.d. Web. 08 Mar. 2017.
2.”What’s the difference between replacement cost and actual cash value?” Replacement cost vs. Actual Cash Value. N.p., n.d. Web. 08 Mar. 2017.
3.”What is the difference between actual cash value and replacement cost coverage?” Foundation Insurance Group. N.p., n.d. Web. 09 Mar. 2017.
4.”What is the difference between actual cash value and replacement cost coverage?” Foundation Insurance Group. N.p., n.d. Web. 09 Mar. 2017.
Image Courtesy:
1. “FirePhotography” By Sylvain Pedneault – Own work (CC BY-SA 3.0) via Commons Wikimedia