When a person purchases a house, most often they will also purchase insurance for their house and the items contained inside the house. This is called homeowners insurance. The way most home insurance policies work is that the homeowner pays a monthly fee to the home insurance agency and in exchange, if there is an accident or disaster such as a fire, and the house or items contained within the house are destroyed, the insurance will pay to have the house or items replaced. While the concept is simple, insurance policies are more complicated than they may seem.
Depreciation
One of the most important aspects of a home insurance policy is that potential policyholders must be aware of is depreciation or the gradual reduction of the value of an item over time. The way it works is when a homeowner purchases a home insurance policy, the insurance agency will do an initial audit of the value of the home and the items stored within the home, such as furniture and appliances. This is the initial value. However, like most physical things, houses depreciate in value over time, particularly when they are not properly maintained. Therefore, insurance agencies not only calculate how much the house and other items are worth at the time the insurance was purchased but also how much they will depreciate.
For example, a deck might be initially valued at $10,000, but without proper maintenance, the deck will depreciate to no-value in twenty years. So, the deck will depreciate $500 per year. If an accident were to occur five years into the insurance policy, the insurance agency would only be liable to pay $7,500 to compensate the insurance policyholder.
ACR vs. RCV
There are two main ways that insurance agencies will pay back home insurance policyholders in the event of an accident or disaster: either in cash for the agreed value of the home and items or in replacement costs. When policies state that the homeowner will be compensated in cash, called Actual Cash Replacement, or ACR, the depreciated value of the destroyed items and home are paid. When the insurance policy states the cost of replacement will be paid to the homeowner, the compensation gets a bit trickier. This second form of compensation is often referred to as Replacement Cost Value or RCV. In a RCV insurance contract, newer items will be replaced while older items will only be replaced according to their depreciated value. This is unless the home insurance policyholder can prove that they maintained the item through repairs or maintenance, thus maintaining the originally audited value of the item.
An example of ACR, a piece of furniture, such as a chest of drawers might be originally valued at $3,000 by the insurance agency. The insurance agency might put the estimated lifespan of the value of the chest of drawers at ten years. Therefore, the chest of drawers will depreciate $300 per year. On a piece of furniture, it can be more difficult for a homeowner to demonstrate proper maintenance and repair of the item, and when an insurance claim is made, it is likely the homeowner will simply be paid the depreciated value of the furniture.
An example of RCV, an addition to the home that requires upkeep, such as our deck example from earlier. A deck valued at $10,000 might depreciate $500 per year. If an accident occurs five years into an established homeowners insurance policy, the deck will be valued at $7,500 and the insurance agency will replace the deck up to $7,500. However, if the homeowner can clearly demonstrate to their insurance agency that they maintained the value of the deck through repairs and general maintenance, then the home insurance policyholder can make a second claim for the recoverable depreciation.
Recoverable depreciation is the depreciated value of a home or item that can be claimed by the home insurance policyholder. Generally, home insurance policyholders must keep documentation that they made any necessary repairs to the item they are claiming recoverable depreciation for, or that they claim they have maintained. Like in our deck example, a homeowner might put new sealant on the deck or repaint, maintaining the original value of the deck. Moreover, maintenance and repairs may need to be conducted within a certain time frame, which should be outlined in the insurance policy. When insurance agencies are presented with documentation that an item’s value was maintained, a second payout will occur for the depreciated amount.
For example, if a deck was originally valued at $10,000 and depreciated $500 per year, and after five years a disaster wrecks the deck, the value of the deck is now $7,500, that is what the insurance agency expects to pay. However, if documentation can be provided that the deck was up-kept, then the homeowner will be entitled to a second payout up to the $2,500 in depreciated value.
While this above explanation may seem reasonable, it does not however explain why homeowner insurance premiums continue to rise as the assessed value of the house also rises. Most houses appreciate over time. Most houses cost more, not less over time. The average house purchased 20 years ago will cost more today. Accordingly the local taxes and the insurance values of the average house will rise. So why does the damaged deck cited above depreciate?
Please consider this: If you have a deck on your house that originally cost $10K, and the insurance company calculates that your deck depreciates by $500 a year after it’s damaged, does the insurance company factor the depreciation into their premiums? Does any homeowner premium ever drop for the same house under the same contract due to recognized depreciation?
No. Never.
The insurance company assumes that almost every house is appreciating, They assume that the replacement cost of the house has risen, and thus their rationale for always rising your premiums. Yet when you have a tree fall on your deck and that deck is smashed to bits, the insurance company will return to the original $10K cost and then start deducting from that dollar amount. They entirely overlooked the fact that the house, and thus the deck has appreciated!
Why do the insurers not state that the $10K deck is now worth $15K due to appreciation? Not less than $10K due to depreciation? After all, the entire house has appreciated, so why does one part of it depreciate? How can the entire value of the house go up, while the value of the deck goes down?
Let’s face it, the insurance companies want it both way.
They want to charge you more money when they assume there’s an appreciation, and then they’ll nickle and dime you when it’s in their best interest to argue for a depreciation.