Market value and replacement cost: Comparing apples to oranges

Unfortunately, many property owners make the mistake of insuring their buildings for the purchase price or estimated market value. In one remarkable case, we assessed the insurance value of a large house (excluding contents) in a remote rural location at R3.5 million.
The owner was unhappy with our valuation as he stated that an estate agent had recently estimated his property’s value to be around R1.5 million. His concern was that our valuation would result in his property being grossly over-insured.
Replacement cost is not market value
This client – like many others – is confusing market value with replacement cost. (Replacement cost is the value used as the insured value).
A property’s replacement value cannot be determined by an estate agent. Only a qualified and experienced professional valuer can determine the value at which your property must be insured to ensure sufficient cover. It is important to remember that this value is estimated based on what it would cost to demolish and reconstruct the building in the case of total destruction, for example, a fire.
Market value is the cost at which a property will sell on the open market.
Back to our case study: In addition to this location having some security concerns, the building also was in a bad state of repair – both of which negatively affect the market value but not the replacement value.
In the event of total loss, we estimated that it would cost him around R3.5 million to clear the site and re-build the house to its original state.
This meant that, in reality, he was underinsured by almost 60% as a direct result of confusing his home’s market value with its replacement cost.
This kind of scenario is, unfortunately, not unique – we are often faced with similar situations where property owners are underinsured, often by 50% or more.
Without a clear understanding of the difference between these two definitions, the property owner will face a hard reality at claim stage when the insurer will inevitably apply an average and the owner’s claims will not be paid out 100%. In the case of total destruction, the owner may lose their home due to being completely under-insured.