What is the difference between market value and replacement cost?

Many traditional homeowner insurance policies are written for replacement cost. Replacement cost insurance will insure a home for the expected cost to rebuild a home from the ground (or sub-ground if there is a basement) to the peak of the home. Replacement cost values usually run higher than you might expect because insurance companies try to estimate what the would be to rebuild a home at a future time.

Costs can vary from day to day because of the cost of goods, labor, supply and demand. When hurricane Katrina destroyed much of the southeast, labor and building material costs went up because of increased demand to build homes and the reduced supply because of business that were destroyed. A home in Michigan would have to pay more even though it wasn’t directly effected by the storm because the cost to rebuild a home during this time would be higher due to the lack of materials and labor.

Market Value insurance for landlords and property owners have become a much more common in recent years. Market Value policies will insure the home for its selling value. That is a hard number to gauge today, but it can be done or at least estimated.

The reason market value policies are becoming more common recently is for two reasons. The first is the moral hazard of insuring a property for more than it can be sold for is risky for the insurance company. Lets say you have a home that is worth $120,000 on the market but the replacement cost is $240,000 to rebuild the home.

A homeowner or landlord would benefit from the house being completely destroyed because they could cash out the insurance for $240,000 on a house they may not be able to sell for $120,000. The insurance company does not want to start owning vacant land at $240,000 a piece. The second reason market value is more popular is because most homeowners and landlords would rather cash out on a home that is a total loss than wait for the contractor to rebuild the home.

Homes can take a year or more to rebuild and that can be inconvenient for anyone. With a market value policy, the property owner can cash out and buy another home just like it for the same amount their home was worth or possibly even less in 30 days or less. This is a much more convenient and cost effective option for the insurance company and the insured.

One important issue to be considered on a market value or replacement cost insurance policy is how a claim is paid for a partial loss. If a home has a fire in the kitchen and the cost to replace the damage would be $20,000, each type of policies would pay differently. A replacement cost policy will replace the kitchen to a like kitchen with new materials.

So you wouldhave a new kitchen to replace the old one. A market value policy will pay on an actual cash value basis. Actual cash value is best understood by thinking of a car.

A new Ford Mustang may be $30,000. A five year old Mustang may be $12,000. A replacment cost policy would give the owner a brand new Mustang even if it was five years old while an actual cash value policy would only pay $12,000 because that is what it would be worth after depreciation.

That means if the owner had an actual cash value policy and wanted to buy a new Mustang they would have to pay the additional $18,000 out of pocket to purchase the vehicle. The same would apply with the kitchen. The insurance company might pay, lets say $10,000, and the owner would have to pay the other 50% out of pocket.

That could be a substantial out of pocket cost. Some market value policies offer a rider which can be called different things but for simplicities sake lets call it a replacement cost rider. A replacement cost rider would give the homeowner or landlord a market value payout in the event of a total loss but would pay for a complete replacement in the event of a partial loss.

This is a great option when looking to save money on insurance but still protecting yourself from a catastrophic expense.