When an insurance company issues a replacement value policy, the policy covers the full replacement cost of the item. For example, if a homeowner purchases replacement value coverage and his house burns down, the insurance company will pay to build a new house that is the same size and is constructed from the same materials.
Replacement value coverage is an alternative to cash value coverage. With cash value coverage, an insurance company pays the current market value of the item, not the cost of a new item. If the item is worn down from frequent use, cash value coverage will not pay for the full replacement cost. Because of depreciation, a replacement policy may pay out nothing. If a machine has a useful life of 10 years, and it breaks after 11 years, it has no value after subtracting depreciation.
Replacement value coverage is more expensive than cash value coverage. With a cash value policy, the insurance buyer only needs to purchase coverage for the current value of the item. A house that cost $100,000 to build may only be worth $20,000 now. To obtain full replacement value coverage, the homeowner must purchase a policy that covers 80 percent of the cost of building a new home.
When a homeowner has insufficient replacement value coverage, the insurance company does not reimburse the full value of a damaged item on a partial claim. For example, if a homeowner buys $200,000 of coverage, but the cost to replace her house is $400,000, 80 percent of the home's value is $320,000. Dividing $200,000 by $320,000 equals 62.5 percent of the full coverage requirement. If the house sustains $50,000 worth of damage, the insurance company reimburses $31,250, minus the deductible.
An insurance company may refuse to sell a replacement value policy when an asset is worth much less than its replacement cost. According to the Michigan Office of Financial and Insurance Services, a homeowner's insurance company has to offer a repair policy as an alternative. A repair policy pays for a replacement item with similar performance to the damaged item. Construction materials in an older house may have a small market value but cost a lot to replace because modern builders no longer use these materials.
A homeowner who wants replacement value coverage should make sure that each policy she purchases provides this coverage. According to Fort Valley State University, a replacement value homeowners policy may only cover the building structure. The homeowner can purchase a separate replacement value policy for her furniture, appliances and other personal items.