Is Your Home Underinsured?
Homeowner’s Insurance. These two words likely cause more dread and aggravation than joy. But that shouldn’t be the case. Homeowner insurance premiums keep rising and often seem unfairly high, but considering that you’re receiving protection for your single greatest asset it is still a tremendous deal. Like it or not, you need homeowners insurance, so reviewing your policy is extremely important.
I was asked to discuss the issue of “underinsurance” relative to a property (your house). In order to explain property underinsurance, a definition might be in order. I’ve seen many explanations, but think should be easily understandable.
Underinsurance. When the amount of insurance coverage (limit) is insufficient to replace or fully repair damages caused by covered perils (fire, wind, theft, etc.)
According to a 2008 survey by Marshall & Swift/Boeckh (MSB), 64% of houses in the United States were under-valued for insurance purposes. Of those, the average homeowner had only enough insurance to rebuild approximately 81% of his or her dwelling. (http://goo.gl/M5FaIv)
Most homeowner insurance policies provide coverage for your house, contents, liability exposures (a visitor slipping on ice on your front stairs) and more. Today I’ll focus on the property coverages and save any liability discussion for another blog.
Although all homeowner insurance policies provide property coverages, those coverages and limits are not the same across insurance companies, so I cannot over-emphasize the importance of reading your contract when you first receive it and then each subsequent renewal.
When I speak about “underinsurance” it typically refers to your house, but it can also affect outbuildings and personal belongings (contents including televisions and furniture). For many companies the insurance contract refers to these as Coverage A (dwelling), Coverage B (other structures) and Coverage C (personal property).
Before you can determine whether your home is properly insured (also known as insured to value or ITV) you need to understand the specific type of property coverage being provided by your homeowner’s insurance contract.
What? Doesn’t my homeowner’s insurance just rebuild or repair or replace my house if it is damaged by a covered peril? The answer is an unequivocal ‘usually.’
There are various ways to measure the “value” of your house and homeowners’ insurers offer several types of property coverage from which to choose.
- Market Value
The value of your home and land where it is located, in its current condition
- Actual Cash Value (ACV)
Often defined by insurers as the cost to replace with new property of like kind and quality, less allowance for physical deterioration and depreciation, including obsolescence)
- Functional Replacement Cost (FRC)
The cost to repair or replace your home using commonly used building materials
- Replacement Cost (RC)
The cost to repair or replace your home using ‘like kind and quality’ building materials
- Limited RC. Most policies have some maximum limit (e.g. 150% of Coverage A)
- Unlimited RC. Some polices offer truly unlimited replacement cost and will pay to replace a property, regardless of the Coverage A amount
- Other ‘hybrid’ type combinations
So why are various coverage calculations important when determining whether your house is properly insured to value? Let’s look at a real world example.
Fred Smith lives in a very small rural Indiana town. He recently purchased a house built in 1918. Fred paid $135,000 for this property, because property values in his town are still very depressed.
This 2,800 square foot, two-story house has many unique features including:
- Large front and rear porches
- Natural woodwork and hardwood floors throughout
- Two wood-burning fireplaces with exterior brick chimneys
- Lath and plaster walls
- Solid hardwood doors
- Many leaded glass windows
- Two (2) remodeled, custom full bathrooms plus a remodeled half bathroom
- A remodeled, custom kitchen with new stainless steel appliances
- Forced air heat (gas)
- Central air conditioning
- And many more amenities
Fred found himself a very nice place. So how much should Fred insure his house for? That depends. Let’s look at the numbers, including building calculations using the e2Value Residential Estimator (thanks to my friends at e2Value.com for allowing me to use their property estimating tools).
- The market value is the current purchase price of $135,000
- The first year property tax value should also be the purchase price of $135,000
- Full replacement cost, to repair with like-kind and quality materials, is approximately $550,000
- Functional replacement cost, to repair with currently used building materials and common building techniques, is approximately $460,000
- The estimated actual cash value, depreciated replacement cost, is most likely in the $250,000 to $300,000 range
- If Fred wants his plaster walls and custom woodwork repaired or replaced using original materials (“like kind and quality”), then he would want a full replacement cost policy and he should insure the home for $550,000. Typically the insurance company will require you to insure the house to 100% of the full replacement cost. If your coverage is less (typically below 90% or 80%), then any claim could be settled at ACV. This is known as a coinsurance penalty.1
- If Fred wants his plaster walls and custom woodwork repaired or replaced using drywall (materials of modern equivalent), then he would purchase a functional replacement cost policy and he would insure the home for $460,000. Again, Fred’s insurance company will generally require he insure the house to 100% of this value.
- There are not many insurance companies offering an ACV policy. If Fred were able to find an insurer offering such coverage, then Fred would likely insure the house somewhere in the @250,000 - $300,000 range.
As a reminder, an ACV policy pays for loss of or damage to the dwelling, other structures and personal property at the lowest of these amounts:
1. The actual cash value of the damaged property at the time of the loss
2. The amount required to repair or replace the property; or
3. The Amount of Insurance shown on the Declarations Page
In this scenario Fred should carefully assess the value of his personal property and any outbuildings to assure that he has enough coverage in the event of a total loss.
- Finally, if Fred were able to find a company offering a true Market Value policy, he would insure the house for $135,000 in the first year. Then in the event of a covered total loss, presumably Fred would take the $135,000 claim settlement and simply purchase another house in the neighborhood.
In this scenario, as with ACV above, Fred must carefully assess the value of his personal property and any other buildings on the property when purchasing the policy.
In my experience most homeowners purchase some variety of a replacement cost insurance policy. As a result, determining how much rebuilding the house will cost is critical. Insurance agents have access to many tools (e.g. e2Value; MSB) allowing them to calculate a highly detailed valuation and they will know the various insurance companies’ requirements. I highly recommend using a qualified insurance agent for this important assessment.
Finally, please remember that various homeowner policies offer differing levels and types of coverage. For example, many insurers now limit wind and hail roof damage to actual cash value settlements only. Other insurers may apply a separate, larger deductible to roof losses. The only way to know exactly what will be covered in the event of a loss is to read your policy and discuss the various coverages, limits, limitations and deductibles with a licensed insurance agent.
Jonathan Farris is a retired insurance executive and president of InsuranceRescue Services, LLC, a property & casualty insurance consulting firm based in Madison, Wisconsin. Mr. Farris can be reached at firstname.lastname@example.org.