What is the appropriate amount of coverage for your home? It should be insured for at least 80 percent of its re-placement cost when covered under a standard homeowner’s policy. Replacement cost refers to the amount necessary to repair or replace damaged building parts with items of like kind and quality. Some insurance companies even require 90 percent or higher figures when the guaranteed replacement cost option is offered. With this option, the policy pays the full cost of replacing your home, without any depreciation and often without a maximum reconstruction payment. (This gives you added protection if there is a sudden jump in construction costs due to a major shortage of certain building materials. Construction costs often “surge” following large catastrophes, such as hurricanes.) Note that guaranteed replacement cost coverage approaches can vary by state and is not even available in every state.
Many homes are either underinsured or over-insured. For example, some homes insured for long periods of time with one insurance company may have inadequate limits of insurance due to increased building costs. In many cases, homes have been remodeled and improved, and this information has not been conveyed to the insurance agent or company, resulting in severe underinsured home values. If your home is underinsured, you not only have inadequate protection for total losses, but you may also lack full protection for smaller losses.
Sometimes homes are mistakenly insured for their market value. However, market value is normally not indicative of the home’s replacement cost. For example, market value also reflects the cost of the foundation and the non-destructible land value, both of which normally survive intact if the house burns to the ground and has to be rebuilt.
In addition, some homes may be insured improperly to meet mortgage company requirements. Some mortgage companies incorrectly require the amount of insurance be at least equal to the mortgage balance on the house. The mortgage balance is also not reflective of the home’s replacement cost, which is often considerably more but can also be less. Insurance companies and agents often struggle in properly educating mortgage companies about these distinctions, but there is nothing to prevent you from insuring to actual replacement cost if that is indeed greater than the mortgage balance. The problem occurs when the mortgage balance is greater than the replacement cost, which will result in the purchase of a higher limit than needed.
The bottom line is that you should work with your insurance agent to determine the correct replacement cost and resulting insurance limit for your home. Most agents use sophisticated replacement cost estimating packages that can fairly accurately determine the replacement cost value of your home. Factors that these programs use to determine this figure include the following.
- Square footage of the home, including its configuration
- Construction costs for your community
- Exterior wall construction type, including frame, stucco, brick, or brick veneer
- Style of home
- Number of bathrooms and bedrooms
- Roof type
- Attached garages, fireplaces, built-in cabinets, and other special features, such as hard-wood floors
The more advanced replacement cost estimating programs require detailed information to improve the valuation estimate. For example, a rectangular-shaped home with 1,800 square feet will have a much lower replacement cost than a similar-sized home with an “L” shape. In other words, the better cost estimating programs require information about the number of corners in the home. The more detailed information your agent asks about your home, the more confidence you can place in his or her recommended limit of insurance.
As a final note, you should request an annual review of your homeowner’s policy to keep up with increasing building supply and labor costs. Also ask your agent about the advisability of adding an “inflation guard” endorsement to your policy or about the availability of guaranteed replacement cost coverage to help assure that your home is properly protected.