If your car is totaled or needs expensive repairs as the result of an accident, your insurance company will pay out the claim based on the value it has assigned to your vehicle. Despite the importance of that value, many people don't know how insurance companies calculate it. Worse, some make the costly mistake of thinking that the insurance company will simply value their car based on the original price they paid.

This article will demystify the valuation process for your vehicle so that you can make an informed decision when purchasing a policy and know what to expect after filing a claim.

Cash Value

Auto insurers often refer to the cash value of a vehicle, but the term can be ambiguous to those who aren't familiar with insurance jargon. A car's cash value is simply its perceived value after depreciation has been factored in. In other words, it's an estimate of the current value of the vehicle, not its value at the time of purchase. Although you may value your car just as much as you did the first day you drove it off the lot, once it has driven a total of 70,000 miles over the course of five years, its cash value will be significantly lower than the amount you handed over to buy it.

To calculate the cash value, auto insurance companies consider the make and model of the car as well as other factors like wear and tear and mileage. They compare this information to figures in internal files they keep about all different types of cars.

Kelley Blue Book

Auto insurance policyholders can use a reliable resource called the Kelley Blue Book to look up the average cash value for the vehicles they insure. Because it can be used to generate estimated cash values for cars based on their make, model, mileage, and other figures, it's a great resource for policyholders who want to get an idea of what amount insurance companies will likely value their car.

Replacement Value Coverage

Although insurance companies typically value cars at their current cash value, it is possible to purchase replacement value insurance that will cover the full cost of buying a new vehicle similar to the totaled vehicle. This kind of coverage can significantly increase the amount of money an insurance company must pay out for a claim.

For example, if you own a 2010 Ford Mustang that cost $30,000 when you bought it new, by 2015 its cash value may only be $20,000. But with replacement value coverage, your insurance company will cover the cost of a new 2015 Ford Mustang with a value of approximately $30,000, representing the equivalent of the price that you paid for the 2010 Mustang.

This is an enticing option, but as with all insurance, increased coverage usually entails increased premiums. To figure out which policy makes the most sense for you, consider the premium cost, your car's make and model, and the potential amount you might recoup in the event of a claim.

Leased Cars

Coverage and valuation for leased cars can be quite different than it is for owned vehicles. This is because some auto insurance policies only cover the lease value of the car. That means that if a car is leased for $1,500 per year for two years, the policy may only provide $3,000 of coverage. This may be an issue if the car has a replacement value of $10,000, which would leave $7,000 to be accounted for in case of a major accident.

Luckily, gap insurance provides coverage for the difference between the lease value insurance and the remaining value of the car. This type of insurance prevents the policyholder from being held responsible for any remaining losses if a claim is filed.

Summary

A lot of factors will go into deciding which auto insurance policy is most suitable for you. But making an informed decision requires knowing what the insurance company will actually pay to replace or repair your vehicle. Knowing the valuation process, and especially the difference between cash value and replacement value, will allow you to make the right choice.