Should You Choose Functional Replacement Cost or Actual Replacement Cost to Rebuild Your Home
In short, the answer is it depends....and we will discuss why below.
What Is The BIG Difference?
Here is a quick synopsis:
The actual replacement cost is an estimate of how much it would cost to replace the structure to its actual state using the same materials that currently exist in the structure. For example, if the walls of the home are plaster, after a covered loss, you want to rebuild the walls with plaster. This process can be very expensive and labor intensive.
The functional replacement cost is an estimate of how much it would cost to replace the structure with a functionally equivalent structure. For example, the walls of the home are plaster, but after a loss, you will replace them with drywall.
How Does An Insurance Agent or Carrier Determine Replacement Cost
The amount of insurance coverage for your home must equal 100% of the replacement Cost value.*
Agents and carriers use proprietary software, such has 360Value or CoreLogic, that provides dependable, component-based estimates that account for almost all material and labor required to rebuild. The estimate is based on square footage of living space, home quality grade, and geographic location of the home.
Most Replacement Cost Estimators (RCE) tools provide two policy type options for older home reconstruction:
a) actual replacement cost and b) functional replacement cost.
Homes built prior to 1940 were built before mass production of common construction materials and methods, such as pre-engineered trusses and drywall. Homes built between 1940 and 1986 also used different materials, such as wood trim/moldings and wood soffit with galvanized gutters rather than today's commonly used MDF (medium density fiberboard) and metal soffit with aluminum gutters. These differences are accounted for in RCEs based on the correlating policy type as described below.
1940 and 1960 were break-through years in the fabrication of construction materials. There were many similar construction milestones throughout the 20th century. RCEs uses these milestones to apply different types of windows, doors, moldings, exterior siding, etc. for replacement cost calculation. RCEs employ appropriate items based upon the year the home was built and whether Actual or Functional Replacement Cost was selected. The calculated value changes if the year built is altered and it will change when another replacement cost method is selected.
Actual Replacement Cost
RCE's default is to calculate Actual Replacement Cost. This means that the cost to rebuild the home is based on using materials and construction techniques that are like kind and quality (as close as possible) to those used when the home was originally built (as long as they are compliant with current building codes). For example, a home built in 1910 will typically have plaster walls. The equivalent using today's building codes is gypsum (drywall) "lath" with a two coat plaster finish, which costs much less than having a specialist use historic home techniques to restore to the original wood lath. However, this is still very expensive compared to just drywall.
Functional Replacement Cost
The second calculation option is Functional Replacement Cost. Functional Replacement Cost is available for homes built prior to 1986, with the most significant differences for homes built prior to 1940. Functional replacement bases the cost to rebuild the home on modern materials and techniques. The modern equivalents give the rebuilt home the same aesthetic value as the original home using current, common construction methods. For example, the same home mentioned above built in 1910 calculated using Functional Replacement Cost, would result in a lower replacement cost estimate and with typical materials and methods used in construction today, such as thin coat plaster finish, MDF trim/moldings, and metal soffit with aluminum gutters. Please note that these materials will vary depending on the Quality Grade selected.
Related Home Values
There are also two other commonly misconstrued terms that can be easily confused with the above. Those terms are Market Value and Actual Cash Value. Ideally, you should not be insuring your home based on either of those if they are not equal to the replacement cost of your home.
Current Market Value - The price a buyer would be willing to pay for the dwelling, minus the value of the land. To the public, current market value generally includes non-insured elements of the property, such as land and foundation, which reflects surrounding real estate market conditions. The current market value for insurance coverage purposes, and consequently for any claim settlement, does not include the non-insured elements.
Actual Cash Value - The cost to repair or replace property with conventional materials of like kind and quality, less allowance for physical deterioration and depreciation, including obsolescence. You should not choose ACV unless you plan on knocking down the building or don't have any intentions of rebuilding the existing structure.
Which Option Should You Choose?
Do you have a Colonial Craftsman, Tudor, Victorian, or other old style home? Did you buy your home because of its charming old world look? If you did, then you may want to choose Replacement Cost. If you want your home to be built back to its original look with plaster walls, built-in cabinets or shelving, time period trim and floors, then this is the way to go. Just note, the replacement cost will come back significantly higher than if you chose Functional Replacement Cost. This also means a higher annual premium.
Hope this helps.
*Some suggest your dwelling limit must be at least 80% of your home's rebuilt value to be fully covered. However, to be eligible for important endorsements such as Guaranteed Replacement Cost or Extended Replacement Cost, you must be insured to 100% of the replacement cost value.
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