Understanding the Difference Between Cash Value, Fair Market Value and Replacement Cost Insurance

There’s no lack of insurance out there, but how do you know if you’re buying the right policy to insure your valuables? Three of the most popular types of insurance include cash value, fair market value and replacement cost. If you’re not sure of the difference, you’re not alone. Here’s what you should know to prevent a headache–and heartache–should you need to file a claim.

What Is Cash Value Insurance?

A cash value insurance policy insures an item such as a house based on the item’s actual cash value at the time of loss. An item’s cash value can be calculated in several different ways; an insurer can factor in the item’s replacement cost after subtracting depreciation, considering current fair market value or using a broad evidence rule. A broad evidence rule considers factors such as future income loss from a damaged or destroyed property to determine value.

What Is Fair Market Value Insurance?

Several insurance policies pay for a claim based on what is considered fair market value. Fair market value insurance coverage is the price a willing buyer would have paid the seller in a free market.

One thing to note about fair market value is that the value of a property may be below its actual cash value. This has been a problem in the current real estate market, which has seen a decline in the market value of homes. A catastrophic loss of a home with only fair market value insurance coverage could see a payout of less than the amount of a mortgage if the lender did not have a mortgage clause protecting its investment.

What Is Replacement Cost Insurance?

Other insurance policies pay for a claim based on the cost to replace the insured item. Replacement cost insurance means that there is no deduction for the physical depreciation of an item when determining the amount of payout from the insurance claim.

Under a replacement cost insurance policy, the full claim would be paid out to the home or car owner for any loss after subtracting the deductible. Many people do not consider depreciation when they select their insurance coverage. Therefore, replacement cost insurance is an excellent option to insure real property and recoup the entire loss.

It is important for someone to know exactly what type of insurance coverage he or she is purchasing. How will you be reimbursed for your losses? Will it cover enough of the cost to rebuild a home or buy a car of the same caliber? These are considerations that you should make when deciding whether to purchase a cash value, fair market value or replacement cost insurance policy.

Hank Coleman is the founder of Own The Dollar and several other financial websites. He is a freelance writer, entrepreneur, and professional in the government sector. Hank holds a Bachelor’s Degree in Business Administration, a Master’s in Finance, and is currently studying for his Certified Financial Planning (CFP) credentials. You can see more of his writing on his website and be sure to follow him on Twitter.