What Replacement Cost Actually Means

Market value is what somebody would pay for a property today. It includes the land, the neighbourhood, the school catchment, and whatever the market happens to be doing that month. None of those things burn down.

Replacement cost is the cost of rebuilding the structure to its previous condition using current labour and materials. The land is still there after a fire, so it is not part of the figure being insured.

The two numbers move independently, and they can diverge in either direction. In an expensive city, market value is often far higher than rebuild cost, because most of the price is the plot. In a rural area with low property prices and high construction costs, the rebuild figure can be the larger of the two.

A rebuild estimate is built from the square footage, the construction type, the finish level, and the local cost of labour and materials. A house with hand-finished plaster and a slate roof costs more per square foot to rebuild than an identical footprint in drywall and asphalt shingle.

The figure also has to cover things that are easy to forget: demolition and debris removal, architect and engineering fees, and bringing the rebuilt structure up to current building codes even though the original was legal when it was built.

Because it is denominated in labour and materials, a rebuild estimate moves with construction inflation rather than with property prices. A period in which building costs rise sharply raises the number that should be insured even if the housing market has been flat.

Underinsurance rarely shows up as a refused claim. It shows up as a settlement that is correct according to the policy and still not enough to rebuild the house.

Many property policies also carry a coinsurance condition, which requires the sum insured to be at least a stated percentage of the full replacement cost. If it is not, the insurer pays a proportionally reduced amount even on a partial loss - the shortfall applies to a small kitchen fire, not only to a total loss.

Personal property is usually insured as a percentage of the building sum, which is a convention rather than a measurement. Whether it happens to match what is actually in the house is nobody's job to check unless the policyholder checks it.

Contents cover can also settle on either of two bases. Actual cash value pays what an item was worth at the moment it was lost, after depreciation. Replacement cost pays what an equivalent new item costs today. On a ten-year-old sofa the two answers are very far apart, and which basis applies is stated in the policy.

A rebuild figure set at purchase and never revisited drifts out of date in two ways at once: construction costs rise, and the house changes. An extension, a converted loft or a rebuilt kitchen all raise what it would cost to restore the property.

Some policies apply an automatic inflation adjustment each year. That helps with the first problem and does nothing about the second, because no index knows about the extension. A review after any significant work is the only thing that catches it.