Extended Replacement Cost – Do You Need It?

Extended replacement cost coverage is an option available on most homeowner’s insurance policies. If you are a first-time homebuyer, you might not understand what this coverage can do, or understand its limits. So today, we’re taking a close look at extended replacement cost. We’ll answer questions like:

• What is extended replacement cost (ERC) on a homeowner’s insurance policy?
• What are the limitations of ERC?
• Do I need extended replacement cost coverage?
• How can I be sure I have extended replacement cost on my policy?

Let’s start with a definition of replacement cost, then we’ll move on to extended replacement cost.

Replacement Cost Defined

Per the International Risk Management Institute (IRMI), replacement cost coverage refers to: one of the primary valuation methods for establishing the value of insured property for the purpose of determining the amount the insurer will pay in the event of a loss… It is usually defined on the policy as the cost to replace the damaged property without any deduction for depreciation.

In plain language, replacement cost coverage will help a homeowner pay for brand new materials or belongings after a covered loss.

Imagine a Covered Loss at Your Home

Imagine you’re one of the 172,000 US residents who accidentally start a fire in your kitchen while making a meal this year.

The fire destroys your oven, the cabinetry, your dishwasher and your granite countertops. The kitchen walls are damaged and all the food in your kitchen needs to be replaced.

Thankfully, you have a homeowner’s insurance policy in place. After you pay a deductible, replacement cost coverage will pay for your walls, your food and brand new appliances and materials. Even if your dishwasher was ten years old, you’re entitled to a new one with a replacement cost policy.

This is unlike an Actual Cash Value policy, which will consider depreciation when settling your claim.

Actual Cash Value Valuations at the Same Loss

If your homeowner’s insurance policy includes an Actual Cash Value (ACV) valuation, the insurance company will depreciate your belongings before paying your claim. So, instead of a new dishwasher worth $1,000, you get enough money to buy another ten-year-old dishwasher, worth $80. Your cabinets, your refrigerator, everything that needs to be replaced will be depreciated first.

So, a replacement cost valuation is clearly better for most homeowners. But they do cost more.

Now that we understand replacement cost, let’s examine extended replacement cost.

What is Extended Replacement Cost Coverage on a Homeowner’s Insurance Policy?

Extended replacement cost coverage supplies further protection for homeowners. It will pay to replace your home after a covered loss, beyond your home valuation, usually in the amounts of 10% or 25% (though 50% is not unheard of).

It costs more, but the purpose is to protect you against issues like inflation, increasing labor costs and increasing costs of materials when you need to rebuild after a covered loss.

Thinking back to the kitchen fire, let’s imagine a total loss. Your family escapes, but the entire home burns! If your home was insured for $200,000, and you have extended replacement cost up to 25%, that means the insurer will pay up to $250,000 to build a new home.

• Financially, the homeowner is “indemnified,” or made whole again after the loss of a home worth $200,000.
• If you plan to leave this property empty, the insurer will give you a check for the full $200,000 but no more.
• But if you plan to rebuild, you will have that extra 25% to do it (or whatever amount is defined in your policy.)
• However, depending on the market conditions, it might be difficult to rebuild a home of the same size with $250,000.

Now we begin to understand the limitations of extended replacement cost coverage.

The Limitations of Extended Replacement Cost

ERC will only pay up to the policy limits. Consider how lumber prices skyrocketed in 2021, though they are settling down at the time of writing, July 2021. If the price of building materials is 700% above average, there’s no way a homeowner will be able to rebuild a home with a check worth 125% of the valuation of a home!

The good news is that you can choose to walk away from that burned property. Your homeowner’s insurance will pay for debris removal, so you can take your $200,000 and buy a different home. Sell this vacant land or sit on it until lumber prices are reasonable again.

Extended replacement cost coverage can be crucial for some homeowners, but not all.

Do I Need Extended Replacement Cost Coverage?

That depends on your situation! We can imagine situations where ERC is unneeded. Perhaps you own several homes. You have your primary residence in the city, a few rental properties in the suburbs and a vacation home up in the mountains. That vacation home is where you’re happiest.

If your primary residence burns down, maybe you’d prefer to keep your claim settlement, sell the vacant city property to a developer and kick back at your summer home. If this is you, extended replacement cost is probably not necessary.

Perhaps you inherited a second home. Maybe it’s old and needs a lot of repairs. If that inherited home were to burn down, you wouldn’t care to rebuild it, you don’t live there. You’d rather sell the land. In that case, you don’t need ERC coverage.

But it’s a key coverage if you plan on rebuilding a new home on the same lot!

How do I know if I have Extended Replacement Cost, Replacement Cost or Actual Cash Value?

The front of your insurance policy has a declarations page (aka dec page) which sums up your coverages. “Coverage A” is the estimated cost to rebuild this home if it burns down today.

• Your dec page will tell you if you have extended replacement cost, replacement cost, or actual cash value coverage.

Know that the cost to rebuild a home is not always equal to the market value and has nothing to do with the mortgage amount. You might pay $150,000 for a home but insure it for $200,000 – depending on the costs of labor and materials in your area. So ultimately, your decision to buy extended replacement cost coverage depends on your future plans.