The most important number to know on your insurance policy isn’t the price. This isn’t meant to be a controversial statement or a “hot take”. It’s a simple statement of fact.
Now, if I asked you what number actually is more important, can you guess what it is? Hopefully some of you could, but I’m guessing many are scratching their heads trying to figure it out.
OK, I’ll end the suspense. It’s what insurers call your “Coverage A Value”. All clear now? Probably not.
Coverage A is also known as the dollar amount you insure your home for, more commonly called your “replacement value” or “insured value”. While these two terms are often used interchangeably – and should be identical – they are often very different in reality.
Why is this so important? We’ll address that below, as well as why it’s essential to make sure you and your insurer agree on the proper replacement value.
Save Me Time!
- Your replacement value is what it would cost to rebuild your home after a total loss.
- There’s a good chance your home’s insured value doesn’t equal the replacement value.
- If it’s too high, you’re paying too much. If it’s too low, you’re at risk of not being able to rebuild after a total loss.
- Your policy’s insured value also sets the value for several other coverages.
The Rest of the Story
There are a lot of reasons you should pay attention to the replacement value in your policy. Some will probably be obvious, but others less so.
There is a lot to cover here, so we will divide this into two articles. This one will mostly explain how replacement value works while the next will address what can go wrong if your insured value and replacement value differ.
When you compare insurance policies, you should always look at their assumptions about your insured value. One easy way for an insurer to show you a lower price is to use too low an insured value.
Replacement Value Explained
So how is replacement value supposed to work?
When you buy insurance, you are buying protection up to and including the complete loss of your home. You may think the insurance company automatically will replace your home no matter what. This is not always true.
Your insurance company will pay you up to the insured value specified in your policy (actually, sometimes they will pay more if you buy extra coverage…we’ll come back to that later).
If your insured value is lower than the actual replacement value, you won’t be able to rebuild your home to the same standard as you currently have.
So it’s really important to get this right! To get it right, you have to know what the definition of replacement value is.
It is not what you paid for your home or what you can sell your house for or what it’s appraised at for taxes.
The only thing that matters for your insured replacement value is what it would cost to rebuild your house. This isn’t a number you’re probably used to thinking about, but it’s the number insurance companies prefer to think about so they force you to use it. Very customer friendly, I know!
An Inexact Science
You might ask how am I supposed to know what it costs to rebuild my home? Exactly. Guess what? The insurance companies don’t really know either (more on that later too)!
They will provide an estimate for you, but it is often inaccurate and you should try to independently verify it with your own estimate.
So what’s the main difference between what you paid for your home and what it would cost to rebuild it? The simplest way to think about this is the value of the land. The insurance company doesn’t care how much your land is worth.
Assume you bought a new home for $500,000. What should you insure it for? If you can, you’ll want to find out what unbuilt lots in your neighborhood have sold for.
If you can estimate that your land is worth $100,000, then that implies your house itself would cost $400,000 to build. So $400,000 is the replacement value you should insure it for.
Are we done? Sadly, not yet. You’ll actually want to insure for a little more than this. Why? Because if you actually had a total loss there will likely be some additional costs such as debris removal (i.e. removing the wreckage) or a shortage of repair materials you’ll want to plan for.
Now are we done? I wish I could say so, but unfortunately not. As mentioned earlier, there is one more step. The insurance company will provide their own estimate of your replacement value. This may be similar to yours, but it could well be different. Sometimes, it is very different.
Don’t assume they necessarily know better. They are using models that are meant to be good for most people, but don’t work well for every home. In some cases, these models bear no resemblance to reality.
If you believe the insurer’s estimate is faulty, you can ask your agent to present your own estimate to the insurer and see if they will let you use it. If the insurer won’t budge and there is a large gap between your view and theirs, you should probably look for another insurer. Otherwise, you may end up with a big problem if you ever have a large claim (we’ll cover that in the next article).
There is one other option to consider. You can add a coverage called extended replacement. This adds another 25% to your insured value. What this means is, if it costs more to rebuild your home than expected, your insurance will still pay for it (generally up to another 25%).
To revisit our example from earlier, if you have a $400,000 insured value and you buy extended replacement, then if you have a full loss, and rebuilding costs were more expensive than expected, insurance would pay you up to $500,000 to rebuild.
Why might you need this? The most common cause is due to what’s called “demand surge”. This is when a whole neighborhood or city is affected at once. There may be a shortage of supplies or contractors and repair prices will spike above normal.
In this case, your normal replacement cost is probably inadequate and the extended coverage will help cover the “demand surge” price inflation.
Homes that have risk of hurricanes, tornadoes, or wildfires would have greater need for extended replacement. If you think your greatest risk of a full loss is something that would only affect your home (such as a fire), then you are less likely to need extended coverage.
One more thing we should cover before Part II. Several of your other coverages are determined by your insured value. Your coverage limits for your possessions, your “other structures” and your payments for “loss of use” (if you need to stay in a hotel after damage to your home) are all set as a percentage of your insured value.
This means if your insured value is too low, those other coverages may be too low and if it’s too high, you may be buying more of those other coverages than you need. We’ll discuss this in more depth in the next article.
Speaking of which, we covered a lot of ground in this article, so rather than make it any longer, we’ll pause here and continue in the next article with yet more reasons you want to make sure to get your replacement value accurate.