How Much Should I Insure My Home For?
Here is a question I hear from my customers a lot: “I can’t sell my house for that much, so why do I have to insure it for that much?” With the downturn in property values, many people find themselves insuring properties for more than they are worth–and they want to know why.
Another issue that comes up, especially among my property investor clients, is that they pick up a home for only $50,000 and invest another $20,000 in it, but don’t like it when I insure the property for $200,000. They ask: “I only have $70,000 in the property, why do I have to insure it for $200,000?”
When this happens, I have to remind my clients that they are purchasing a replacement cost policy and the cost of replacing a home has little to do with the property’s market value or how little you paid for the property.
Replacement cost coverage defined is: “the amount of money it would take to repair, replace or rebuild your home with materials similar to the kind and quality used in constructing your home.”
The 80% rule is another important part of the replacement cost concept. The 80% rule simply means that your structure must be insured to at least 80% of its replacement cost in order for you to be fully covered. If your home is not insured to 80% of the replacement cost, your insurance company is not obligated to cover the entire cost to rebuild your home, or even pay the full amount on partial loss claims. In the event that a homeowner purchases insurance that is less than the minimum 80%, the insurance company will only reimburse the homeowner a proportionate amount of the required minimum coverage that should have been purchased.
Here’s an example of guaranteed replacement cost coverage: let’s say an investor/homeowner purchased a home that suffered a complete fire loss. Let’s also say the day before the total loss the property had a market value of $200,000 (down from $300,000 before the market downturn). The homeowner decides to rebuild the structure from the ground up and discovers that the cost to do so will be $300,000. Unfortunately, the property owner only insured the home for $200,000 (less than 80% of the replacement cost), so now he/she is out of pocket for the additional $100,000 to build the new home. Had the owner carried at least $240,000 in coverage (80% of $300,000), his/her insurance company would have paid the entire $300,000 replacement cost.
The same principle applies to partial losses. Let’s say the loss was only for $32,000. Using the formula above, the insurance company would only cover $21,333 (the loss amount multiplied by the coverage level divided by the replacement cost, which in this case is $32,000 * ($200,000/$300,000). At first glance, you might assume that since the amount of coverage is greater than the cost of the damage ($200,000 vs. $32,00), the insurance company should reimburse the entire amount. However, because of the 80% rule, this is not necessarily the case.
I also like to ask my investors when they don’t want to insure their investment properties for the full estimated replacement cost: “I understand you only have $70,000 invested in this property, but if it burned to the ground and it cost $200,000 to rebuild, will you be happy when the insurance company only gives you a fraction of that? Or, if you had a $50,000 partial loss and the insurance company only gives you $17,500, will you be satisfied?” $50,000 * ($70,000/$200,000).
That is why we at L&M Insurance Group insure properties for the full estimated replacement cost value.
So now you may ask, how do you determine the replacement cost value of my property? That’s a great question and I will discuss it in my next blog.