2.2 Valuation: ACV, Replacement Cost, and Functional Value
Key Takeaways
- ACV = Replacement Cost − Depreciation; the broad evidence rule and fair market value are alternative ACV measures in some states.
- Replacement cost pays full new-for-old with no depreciation, but only after the insured actually repairs or replaces.
- Insurers typically advance ACV and release recoverable depreciation once repairs are documented.
- Functional replacement cost pays for a less costly functional equivalent, common for older buildings.
- Agreed value suspends the coinsurance clause; market value is rarely used because it includes uncovered land value.
How Much the Policy Pays: Valuation Methods
The peril determines whether a loss is covered; the valuation method determines how much the insurer pays. The same $20,000 roof loss can settle very differently depending on the valuation basis written into the policy. Examiners love numeric questions here, so master the depreciation math.
The four valuation methods tested on the national portion are actual cash value (ACV), replacement cost, functional replacement cost, and agreed value / stated value.
Actual Cash Value (ACV)
ACV is the cost to repair or replace minus depreciation for age, wear, and obsolescence. The classic formula:
ACV = Replacement Cost − Depreciation
Some states and courts instead use the broad evidence rule (considering market value, replacement cost less depreciation, and any other relevant evidence) or fair market value. On most exams the depreciation formula is the default answer.
Worked example: A roof costs $20,000 new and has depreciated 75% due to age. ACV = $20,000 × (1 − 0.75) = $5,000. The insured receives $5,000 (less any deductible). A 50% depreciated roof would pay $10,000.
Replacement Cost (RC)
Replacement cost pays the full cost to repair or replace with new materials of like kind and quality, no deduction for depreciation. To control moral hazard, RC settlement is conditioned:
- The insured must actually repair or replace the property; until then, the insurer typically pays only ACV and holds back the recoverable depreciation until repairs are completed.
- The insured must carry insurance to value (usually 80% coinsurance or more — see 2.3).
Worked example: That same $20,000 roof on an RC policy pays the full $20,000 (less deductible) once replaced. Initial payment may be the $5,000 ACV, with the remaining $15,000 recoverable depreciation released after the insured submits proof the roof was replaced.
Functional Replacement Cost and Agreed Value
Functional replacement cost pays to replace damaged property with a functionally equivalent but less costly item — e.g., replacing ornate plaster walls with modern drywall, or a slate roof with asphalt shingle that performs the same function. It is common for older or historic buildings where exact replacement is uneconomic.
Agreed value / stated value suspends the coinsurance clause: the insurer and insured agree in advance on the value (often via a statement of values and a signed agreed value endorsement), and the insurer pays up to that figure without applying a coinsurance penalty. Market value (price a willing buyer pays) is rarely the property-policy basis because it includes land value, which property insurance does not cover.
Claim Payment Comparison — $20,000 Roof
| Valuation basis | Depreciation | Amount paid (before deductible) |
|---|---|---|
| Replacement cost | None | $20,000 |
| ACV (50% depreciated) | $10,000 | $10,000 |
| ACV (75% depreciated) | $15,000 | $5,000 |
| Functional RC (asphalt vs. slate) | N/A (lesser item) | Cost of functional equivalent |
Trap: RC does not mean “we pay you $20,000 in cash immediately.” The insurer pays ACV first and releases recoverable depreciation only after the property is actually repaired or replaced. If the insured never repairs, settlement stays at ACV.
A building's roof would cost $30,000 to replace new and has depreciated 60%. The policy settles losses on an ACV basis. Ignoring any deductible, how much will the insurer pay?
Coinsurance Interaction and Recoverable Depreciation Timing
Valuation and coinsurance interact on every commercial property claim. The settlement order is: (1) apply the coinsurance ratio, (2) subtract the deductible, (3) cap at the policy limit. Under replacement cost, the insurer first pays ACV (replacement cost less the recoverable depreciation) and releases the held-back depreciation only after the insured submits proof the property was actually repaired or replaced.
| Step | Replacement cost claim | Amount |
|---|---|---|
| Replacement cost of damage | New cost | $20,000 |
| Less depreciation (held back) | 25% | ($5,000) |
| Initial ACV payment | RC − depreciation | $15,000 |
| Recoverable depreciation released after repair | Proof submitted | $5,000 |
Trap: if the insured never repairs, settlement stays at ACV and the recoverable depreciation is forfeited. Replacement cost is not an immediate cash windfall.
Under a replacement-cost policy, when does the insurer release the held-back recoverable depreciation?
Market Value, Stated Amount, and Total-Loss Settlement
Candidates must separate four value bases that show up as distractors. Market value is what a willing buyer would pay; it includes land and is rarely the property-insurance basis because land is not insured and market price swings with location and demand. Stated amount is a figure the insured declares (common on specialty/mobile equipment) that caps recovery but does not, by itself, suspend coinsurance the way agreed value does. Functional replacement cost pays to restore function with cheaper modern materials. ACV subtracts depreciation.
On a total loss, many states apply a valued policy law: for certain real-property total losses by a covered peril, the insurer must pay the full face amount of the policy regardless of ACV, to discourage insurers from collecting premium on over-stated limits and then under-paying.
Exam tip: if a question gives you replacement cost, an age, and a useful life, compute depreciation as (age ÷ useful life) and multiply by replacement cost to find the depreciation, then subtract for ACV. Always check whether the policy is RC or ACV before answering — the same loss settles very differently.