What is Replacement Value Method in Home Insurance?

Introduction:

Our homes are often the most important and treasured asset we own. It follows from this fact that our homes need to be protected against unforeseen situations and accidents. Whether it is catastrophic damage caused by natural disasters like earthquakes or the impact of wear and tear over time, our homes need protection and insulation against the vagaries of time and nature. Financially speaking, this translates into securing steady home insurance for your home. The emotional and financial costs of rebuilding a house or saving one can be ginormous. While we cannot help with the emotional aspect, the financial situation can be provided for if you get home insurance that will safeguard against the financial setbacks and provide a cushion to fall back on.

Depending upon the particular policy you take, home insurance can encompass protection against liabilities, natural and man-made calamities, personal belongings and valuable assets within the home. Whether it is for your own home or for one that you have rented, it is crucial to know what all dimensions and events are covered. It is also important to know how you will be compensated in case of a mishap.

Replacement Value:

Simply put, the replacement value of any asset is the cost of replacing it with something of similar value and function. Replacement costs are only calculated in the case of fixed assets to ascertain the amount of money it would require to replace it with a new or different asset of the same category. It is the cost that will be incurred to get a substitute.

It is important to note here that the actual cost of the asset is usually very different – the actual cost accounts for depreciation, that is the reduction in the value that happens due to the wear and tear and the vagaries of time. So, this amount is much lower than what a replacement would cost. Imagine if you were selling a 5-year-old car – all other factors remaining constant, it would be sold at a much lower price than what you bought it for and lower than what it could cost you to get a new one.

The replacement value method arrives at a cost that is, in no way, influenced by the actual cost of the asset. In fact, it is a better parameter to use than the actual cost because the actual cost does not bring you in a position to be able to estimate the funds needed for a substitute or replacement. This has critical implications in many estimations and assessments, including while computing the same for insurance purposes. When we do valuations for a property, this changes orientation because property usually appreciates in value rather than depreciate. Let us now extend this concept to property, houses in particular:

Replacement Value Method in Home Insurance:

When we are computing the value of the property for the purpose of finding out how much insurance should suffice to cover it, we have to make a choice between various valuation methods. We could choose to use the actual value. Another alternative would be using the market value which will encompass all costs of rebuilding the house in case of damage. And then there’s the simple replacement cost – what would it cost to replace not just the building but also the household items that it contained.

Let us explain this with an example: suppose Mr. X bought a home insurance policy, three years ago, that provides protection against fire or earthquake. Last month, due to storms, the electric line short-circuited resulting in a fire.

In this case, if he insured the space on the basis of the replacement value method, he will receive an amount in compensation that is equal to the replacement cost of the building. Market rates will have an influence on the price, but the actual price will not. This means that if in the last 3 years the price of the property appreciated, the replacement costs will take that into account. The claim settlement amount depends heavily on the method chosen.

If you are planning to get home insurance, this should help you make a better-informed decision on the amount and kind of cover you want. Head over to Bajaj Markets to get home insurance policy that fits your needs.

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