If you are currently in the market for homeowner's insurance, you should be aware of the two types of settlement clauses: Replacement Cost and Actual Cash Value. It is true that a homeowner's policy automatically provides contents coverage up to 40% of the amount for which your home is insured. So you may be of the opinion that choosing one type of loss settlement over the other is immaterial. But this automatic coverage typically provides for the actual cash value of any clothing, furniture and other household items that have been damaged, destroyed or stolen.

Why does this matter? Actual cash value means that any claim that is paid will be calculated by taking the cost of the item less depreciation. The following example demonstrates exactly what that means:

Let's say that you insure your home for $200,000 and that your particular loss settlement clause provides you with the upper limit of automatic actual cash value contents coverage of 40% of the value of your policy, or $80,000 in this particular case. On average, it would seem that $80,000 is an adequate amount of coverage for most of us. But is it? Since the policy allows for actual cash value, this does not mean that you are guaranteed to receive $80,000 if you sustain a devastating loss.

First, you will only be paid for items that you can prove that you had. The insurance company will request that you complete a loss-claim report and in most cases, provide some sort of documentation that substantiates your ownership of any damaged items. (Take-away: If you have not completed your home inventory or hired a home inventory professional to complete it for you, now is the time!). If faced with a situation like a theft, storm, fire or any other type of loss situation, chances are that your recollection of everything that you owned would not be as complete as you may think. You would likely be distracted by the situation, focusing primarily on the safety of your family, your job, your home and your things.

Second, remember that the automatic contents coverage in this case is actual cash value. So if the sum of what you paid for everything that is damaged or lost totals $80,000, you are in for an unpleasant surprise! The total value of the items that you lost will be adjusted for depreciation. For example, let's run through the calculations for an HD television. Assume straight line depreciation and a useful life of 7 years. If you paid $1,000 for your HD television (and you can prove it by providing documentation from your completed home inventory!), 3 years ago, the actual cash value of your television is about $570. In 3 years time, a television that you paid $1,000 for has lost 43% of its value according to your loss settlement clause and that's the amount that you would receive for your claim. If your insurance policy in this situation had a replacement cost loss settlement clause, then you would receive the full $1,000 for your television.

Selecting a replacement cost loss settlement clause for your homeowner's policy will likely cost you a little more in terms of your insurance premium. But for most, having the peace of mind knowing that they will receive the maximum value of any incurred loss is worth the little extra.

And for those that already have homeowner's insurance: now is a good time to make sure you know which clause you have and to make any necessary adjustments. Don't wait until you're faced with a devastating loss to address this most important issue!