Replacement value is central to home insurance pricing. Here’s why

By: Brennan Doherty on February 20, 2024

This article has been updated from a previous version.

Rebuilding a property from the baseboards up after a fire, explosion, or extensive water damage is any homeowner’s worst nightmare.

Fortunately, insurance companies in Canada typically offer comprehensive plans that cover replacement value — the total cost of rebuilding a home, from timber to labour.

What is replacement value?

Replacement value is the bedrock of home insurance premium calculations, governing the “building limit,” or total payout insurance companies are willing to give for replacing a home in the event of a total loss.

And as it turns out, replacement value has significant bearing on what you’ll pay for a home insurance policy.

“Under most packaged homeowners insurance policies, that building limit will have probably the single greatest impact upon how much the premium is going to be,” explains Stefan Tirschler, product and underwriting director at Square One Insurance Services.

Is replacement value and market value the same?

Not exactly. Market value represents the current worth of your home in the real estate market — not the price you paid for it. It reflects the amount a potential buyer would be willing to pay for your property under current market conditions.

When determining home insurance coverage, insurers focus on the replacement value because it factors in the value you may have added to the property as a homeowner after purchasing.

A property’s replacement value ultimately depends on its characteristics: square footage, landscaping, and even roofing materials.

It’s the replacement value, not the property value, that can significantly affect your premium.

How is replacement value calculated in the world of home insurance?

Most insurance companies use specialized software to calculate a home’s replacement value.

According to Tirschler, whenever insurance companies ask a homeowner for details about their home’s age, square footage, or flooring, the answers are fed into a software program to determine replacement value. This is far cheaper than sending in appraisers. It also happens to be pretty accurate.

“When you look at residential construction, it does become reasonably uniform,” Tirschler says. “When you’re choosing between different types of flooring and different types of windows, that’ll edit the cost a little bit, but it doesn’t necessarily change it a whole lot.”

But this software isn’t perfect — and Tirschler says many insurance policies offer guaranteed replacement cost coverage to compensate for an underestimate of a house’s replacement value. This is an endorsement, and it must be purchased on top of your regular base policy.

“If our estimate wasn’t quite right, don’t worry about it,” Tirschler says. “We will pay whatever it takes to rebuild your house.”

How does replacement value affect home insurance premiums?

How a house is constructed can change its replacement value, and the cost of a particular building material or finish is only part of the equation.

Everything from new building materials to local labour costs are calculated by assessors or, more often, assessment software. The final total forms a large portion of the premium you pay.

Take tile roofing, for instance: a material that is far more expensive than asphalt shingles. Tirschler says it might actually lower a home’s replacement value. Why? Because tile roofs can significantly lower the risk of hail or wildfire damage. In contrast, wood siding may be a lot less expensive than other types of materials, but it burns very easily.

It may be easy to assume that the size of a home is what matters the most when determining replacement value, but Tirschler disagrees.

“What I would say to customers is: What about your home is actually special?” he says.

Perhaps that’s a hardwood floor, custom landscaping, or a new deck. “That’s where cost differences really start to come into play.”

How home renovations/upgrades influence replacement value

Insurance companies may calculate replacement value when signing up a new policyholder, but the reality is homes change in value all the time.

A homeowner can renovate as they please, however, Tirschler cautions that they keep their insurance companies up to speed on everything they’re doing.

And, if the replacement value rises beyond what a homeowner agreed to when they signed their insurance policy, it might not be covered.

The rules around how much value a homeowner can add to their house before informing their insurance provider, or their deadline to do so, varies by company.

If a homeowner buys ‘guaranteed replacement cost coverage’ and doesn’t tell their insurance company about upgrades, Tirschler says, the insurance company might pull it – leaving them with whatever the appraisement software calculated in the first place.

The golden rule of replacement value

Premiums, as with anything in the insurance industry, are affected by many different variables: a homeowner’s history of claims, the insurance company they’re signing with, even the geographical location of the home in question. But replacement value is still one of the most important factors to consider when hunting for the lowest home insurance rates possible.

Tirschler’s advice for anyone who wants to renovate or alter their home after signing off on a new plan?

“Talk to your insurance provider before [the renovations] start,”he says. “And if you’ve looped them in during the planning phase, they can also let you know about which upgrades will have the greatest cost impact on your insurance premium.”