If you haven’t read our prior article on replacement value, you should probably read that first (or at least skim it to make sure you already understand the concepts).
This second article will dive more deeply into unexpected problems that can arise if you have an insured value in your policy that differs from the necessary replacement value.
Save Me Time!
- If your insured value is too low, you may not be able to fully rebuild if you lost your home. You also may find yourself short for other coverages that are derived from your insured value.
- If your insured value is too high, you are likely overpaying for your insurance as well as buying more limit for additional coverages than you need.
The Rest of the Story
There are two main areas where things can go wrong if you have the wrong insured value.
First, you may have issues rebuilding your home after a complete loss. Second, unfortunately, insurers provide a lot of your other coverages as a percentage of your insured value. This means you may have too little or too much of those coverages.
Rebuilding Risk
The worst thing that can happen to you – other than losing your home – is finding out you don’t have enough insurance coverage to rebuild afterwards. There are two potential ways this can happen.
The 80% Pitfall
The worst case outcome you want to make sure to avoid is having a loss (complete or even partial) where your insured value in your policy is LESS than 80% of the true replacement cost.
In this case, not only do you not have enough coverage to rebuild for a full loss, but you may find the insurer will penalize you for being underinsured on a partial loss!
Let’s walk through two examples. In each case your replacement value should be $400,000 but you are insured for $288,000 (i.e., 72%).
- A fire burns down your home. It costs $400,000 to rebuild. You only have $288,000 of coverage.
Outcome: You need to come up with $112,000 or build a smaller home.
- A fire breaks out on the first floor, but the home is saved. The total damage is $200,000. You have $288,000 of coverage, so you expect the insurance company to send you a $200,000 check (less your deductible). Not so fast!
Outcome: They only pay for $180,000 (less your deductible). Why? Because you needed to have $320,000 of coverage (80% of $400,000) to be fully covered.
Your $288,000 of insured value is 90% of $320,000, so the insurer only pays 90% of your $200,000 damage, which is $180,000. You are responsible for $20,000, in addition to your deductible.
Getting Stale
You may be thinking “why do I have to worry about that? My agent has me covered”. If only it were that simple. If you are diligent and review your replacement value with your agent at each renewal, then, yes, you will likely be well above 80%.
But what if you are the type who “set it and forget it”? You’ve had the same insurance since you bought your home and haven’t looked at the insured value in the policy since. Are you still sure you’re at 80% of the true replacement value?
Over the years, as building costs go up, your “real world” replacement value is likely increasing. While some insurers do boost your insured value each year for “inflation” (which is really a disguised price increase) that may or may not keep up with the actual cost of replacement in your area.
But the more likely reason you may have slipped below 80% is you’ve made home improvements. Since you last checked your policy’s insured value, have you upgraded the kitchen, built an addition, finished the basement? Have you told your insurer?
If not, you may be at risk of being below 80% replacement cost.
Demand Surge
There is a second way you may find your replacement coverage falls short, even when you have the best intentions. That is when rebuilding costs spike after a catastrophe due a shortage of materials and labor.
Most people estimate their replacement cost assuming they can rebuild their home at the same cost as if they were building a new one. If your home is the only one in town that needs to be replaced, that is probably true.
However, what if hundreds or thousands of people in your town lost their homes at the same time? There won’t be enough contractors to go around and prices will rise. In this case, you will probably find your replacement coverage inadequate, even if you thought you used a conservative estimate.
If you live in an area with elevated catastrophic risk, you may want to consider the enhanced replacement coverage mentioned in the first article.
More On The Multiplier Effect
We briefly covered last time how your insured value serves as the basis for many other homeowners’ coverages, as your coverage limits are defined as a percentage of your home’s insured value.
Traditionally, you will find your contents (i.e. possessions) are insured for 50% of your insured value of the home, your other structures at 10%, and your additional living expense limit at 30%. Some insurers will let you buy higher percentages, but rarely can you go lower.
Note, there is no logical reason to use these percentages as a basis for determining the best coverage for you. They are old practices that never went away.
To better illustrate this flaw, if you move from San Francisco to Pittsburgh and bought the same sized house, you would expect the new home to cost less. Let’s say it’s 50% less.
However, the amount of stuff you have (your contents) hasn’t changed. But because your home costs 50% less, you will have 50% less coverage for your contents. Does that make sense to anyone???
Or what if you live in a city? You probably don’t even need other structures coverage because you don’t have any land where you can put a fence or a pool!
So let’s go through some scenarios where having too high or too low a replacement value can be bad for you.
Adding Insult to Injury
We have discussed at length the risk of having too low an insured value if you lost your home. However, there is one other big problem. There is a coverage you have called “loss of use”. This pays some of your living expenses (rent, food, etc.) if you are unable to use your home.
Obviously, the time you’re most likely to need your loss of use coverage is if your home has to be rebuilt. However, as noted, your coverage for loss of use is typically 30% of your insured value.
That means if your insured value is too low, then you will have less coverage available for paying your bills while waiting for your home to be rebuilt. Talk about being kicked when you’re already down!
Buying More Than You Need
Let’s look at the other side of the coin. If your insured value itself is too high, you are paying for more insurance than you need.
Not only are you overpaying for the actual risk of losing your home, you are buying too much contents, other structures, and loss of use coverage!
In other words, you are overpaying over and over and over again! If insurers let you lower the percentages you buy for those coverages, you could adjust this, but they normally don’t. So overinsuring your replacement cost can really be expensive.
As mentioned earlier, this can also happen if you have the correct replacement value, but you live in an expensive real estate market. You are forced to buy more contents and other structures coverage than you need.
Looking For Goldilocks
While we mainly addressed problems with too low an insured value, carrying one that is too high means you are overpaying for insurance.
Many insurers try to push very high replacement estimates on customers to get more premium out of them by scaring them about demand surge or the 80% rule.
The lesson here is you want to think of your replacement value sort of like Goldilocks. You don’t want it too low. You don’t want it too high. You want it juuuust right!
Maybe someday insurers will divorce these other coverages from your insured value and let you choose what you need, but until then, the best way to balance not having enough coverage vs. paying too much in premium is to spend a little time making sure you have the appropriate replacement value in your policy.
