When your vehicle is totaled in an auto accident, your insurance company pays you for the car's value – or, more accurately, it pays you for what it claims the value to be. You can put this money toward the amount you still owe on the totaled car, or you can use it to purchase a new vehicle. Nearly everyone who has been through this process can attest that the most frustrating part is accepting the auto insurance company's assessment of your car's value. Almost invariably, the estimate comes in much lower than you anticipated, and the amount you receive is not enough to purchase an apples-to-apples replacement. For many drivers, it is not even enough to cover what they still owe on the car.
Confounding the issue is the fact most car insurance customers are clueless as to the methodology used by insurance companies to value cars. The valuation methods of car insurers are esoteric, relying on abstract data, the specifics of which they are careful not to reveal. This information asymmetry makes it difficult for a consumer to challenge a low-ball offer from a car insurance company. However, simply knowing the basics of how insurance companies value cars and the terminology they use can bring you to a more auspicious place from which to negotiate.
The Car Insurance Valuation Process
When you report a car accident to your insurance company, the company sends an adjuster to assess the damage. The adjuster's first order of business is determining whether to classify the vehicle as totaled. An insurance company may consider the car to be totaled even if it can be fixed. Generally speaking, the company totals a car if the cost to repair it exceeds a certain percentage, usually 60 to 70%, of its value.
Assuming the vehicle is totaled, the adjuster then conducts an appraisal and assigns a value to the vehicle. The damage from the accident is not considered in the appraisal. What the adjuster seeks to estimate is what a reasonable cash offer for the vehicle would have been immediately before the accident took place.
Next, the insurance company enlists a third-party appraiser to issue its own estimate on the vehicle. This is done to minimize any appearance of impropriety or underhandedness and to subject the vehicle to a different valuation methodology. The company considers its own appraisal and that of the third party when making its offer to you.
Actual Cash Value Versus Replacement Cost
A huge distinction exists between the value of your car as determined by the insurance company and the amount it actually costs to purchase a suitable replacement. The insurance company bases its offer on the actual cash value (ACV). This is the amount that the company determines someone would reasonably pay for the car, assuming the accident did not happen. Therefore, the value takes into consideration depreciation, wear and tear, mechanical problems, cosmetic blemishes, and supply and demand in your local area.
Even if you purchased a car new and only drove it a year before the accident, its ACV will be significantly lower than what you paid for it. Simply driving a new car off the lot depreciates it as much as 20% and the insurance company dings you further for everything from the miles on the odometer to the soda stains on the upholstery accumulated during that year.
The amount of the ACV offer is also going to be less than the replacement cost – the amount it costs you to purchase a new vehicle similar to the one you wrecked. Unless you are willing to supplement the insurance payment with your own funds, your next car is going to be a step down from your old one.
A solution to this problem is purchasing car insurance that pays replacement cost. This type of policy uses the same methodology to total a vehicle, but after that, it pays you the current market rate for a new car in the same class as your wrecked car. The monthly premiums for replacement cost insurance can be significantly higher than for traditional car insurance.
Not being able to afford a comparable car with the money from your insurance company after an accident is exceedingly frustrating. That being said, there is another potential situation that can compound the stress of an auto accident even further.
Often, the amount an insurance company offers for a totaled car is not even sufficient to cover what is owed on the wrecked car. This may occur if you wreck a new car shortly after buying it. The vehicle has taken its big initial depreciation hit, but you have barely had time to pay down your loan balance. This can also occur if you have taken advantage of a special financing offer that minimized or eliminated your down payment. While these programs certainly keep you from having to part with a large chunk of cash to buy a car, they almost guarantee that you drive off the lot with negative equity. This becomes a problem if you total the car before restoring a positive equity position.
When your insurance check cannot pay off your car loan in full, the amount that remains is known as a deficiency balance. Because this is considered unsecured debt – the collateral that formerly secured it is now destroyed – the lender is especially aggressive about collecting it.
Like the replacement cost issue, this problem has a solution. Add gap insurance to your car insurance policy to ensure that you never have to deal with a remaining balance on a totaled car. This coverage pays for the cash value of your car as determined by the insurance company and pays for any deficiency balance left over after you apply the proceeds to your loan. Gap coverage, like replacement cost coverage, adds to your insurance premium. You should consider, however, that if you fall into one of the above scenarios, it could make a deficiency balance more likely in the case of an accident.