In the broadest sense, replacement value is the total cost involved in replacing damaged items with new items. Depending on the item that must be replaced, the value may be less than, equal to, or even more than the purchase price of the damaged item. Calculating the actual value will depend on whether the item has appreciated or depreciated in value, and whether or not there is a way to replace the item with something of similar value.
The concept of replacement value is often included in various types of insurance coverage. Homeowner’s insurance typically covers the cost of replacement associated with repairs that must be done to the house or other buildings on the property if they are damaged by fire or some type of natural disaster. Both homeowner's and tenant’s insurance normally provides coverage on personal items such as furniture and other belongings and will provide the policy holder with reimbursement based on the replacement value of items that are damaged or stolen. Typically, the terms of the policy will provide the formula that is used to determine the insurance replacement value when the policyholder submits a claim.
In a business setting, replacement value refers to the cost that would be incurred if equipment or machinery relevant to the operation of the business would need to be replaced. For example, the business may wish to purchase a new phone system for the office. In order to determine the replacement value, it will be necessary to evaluate various systems on the market and determine what it would cost to purchase a new system that includes at least all the features present in the currently installed phone system. In this scenario, there is a good chance that the reason for the replacement is to acquire a phone system that includes more features than the current phone equipment, so the replacement value is likely to be more than the purchase price of the old system.
Appreciation and depreciation may also enter into the calculation of the replacement value. Items such as antiques and jewelry tend to appreciate in value, while some furnishings and household appliances would depreciate with age. When this is the case, effort is made to determine the current average market price for a similar item and adjust that figure upward or downward as required.
There is no one universal method for determining replacement value. For this reason, it is important to understand the terms outlined in the insurance coverage and how they apply to reimbursing the policyholder in the event an insured item must be replaced. In some cases, the formula will be relatively simple and relate closely to the current market value. At other times, a larger number of factors will be involved in the calculation process. This will mean the importance of current market value is likely to be minimized significantly.