5/11/2018 By Agent Ken CobbBy Agent Ken Cobb
A question I’m often asked by current and prospective clients is why the amount of coverage on their home seems to be significantly higher than its market value. People will look at the policy Dwelling limit and compare it to a recent appraisal or tax valuation and notice that the numbers just don’t look quite right.
The reason that many homes are insured for more than their market value is that a Homeowners policy is usually intended to allow you to replace your home if it burns down, rather than just pay you the market value after a total loss. So most Homeowners policies are written based off a home’s estimate reconstruction cost – regardless of what the market value of the home might be.
My realtor friends tell me that it currently costs more to build than to buy. Meaning, that you can buy the same amount of home for less than it would cost you to build it new. While the market value of the home is dependent on a variety of factors often collectively referred to as “market conditions”, the cost to build a home on a given lot is solely dependent on construction costs.
The difference between the cost to build and buy can be especially out of whack with an older home. In many cases, older homes tend to be worth less in the real estate market than newer homes. However, it will cost just as much to rebuild an older home as it would if the home was brand new. (In some cases, it can cost a lot more to rebuild an older home if you want to build it back the way it was, if it uses vintage construction materials, for example.)
When putting together a new Homeowners insurance policy, I calculate a replacement cost estimate, typically using either CoreLogic or e2Value online software. To create the estimate, I input basic information about the home, such as the home style, square footage, location and type of components. The software then provides an estimate of what it would cost to rebuild the home like it is now. In most cases, this estimated replacement cost is used as the proposed amount of coverage for the new policy, subject to the review and agreement by my client.
As the name suggests, a replacement cost estimate is just that – an estimate. It is basically an average of what similar homes cost to build in the local area. While some software gets more detailed than others, a replacement cost estimate is not the same as an actual contractor bid to rebuild a home. It can run high or run low, and there is no guarantee that it is adequate or correct. Therefore, I always encourage my clients to review the amount and make sure that they are comfortable with it. Ultimately, it is your decision as the homeowner how much to insure your home for (subject, of course, to the rules and parameters of the insurance company as well as state law).
Sometimes I’ll run a replacement cost estimate on a brand-new home and it will come back well above what it just cost to build the home. Part of this may due to the estimate just being a lot off in this case. But in many cases, the cost to rebuild a home can be higher than the cost to build it the first time, especially if the home was built as part of a subdivision where the builders were working on multiple homes at once. When homes are being built as a group, there can be a lot of savings from what we call “economy of scale”. Not only may the contractor get a better deal on materials from buying in bulk, but the electrical, plumbing, heating, roofing and other subcontractors often charge less per home as well, since it is more efficient for them to work in a block of homes in same neighborhood. (More about why may cost more to rebuild than it did to build the first time.)
While we see replacement cost estimates come in higher than the market value more often than not, this can work the other way too. This is often the case with lake homes, where a large portion of real estate value is in the land itself. Insurance policies do not insure land. If the home burns down, the owner will still have the value of the land; so the insurance policy only needs to pay to remove the debris and rebuild the home. (I have also seen this same phenomenon down in the metro area, where regular lot values are often much higher than they are here in northern Minnesota.)
But getting back to the more common scenario in our area, where the home’s estimated replacement cost is greater than its market value. The question often comes up, “Do I really need to insure my home for this much?” When a client asks me this question, I often reply with a question of my own, “If your home burns down, would you be happy just cashing out and walking away from the property, or would you want to at least have the option to rebuild?”
More often than not, my client replies that they’d like the option to rebuild. However, for clients answering that they would just want to “cash out” (or would rebuild much smaller), many carriers offer the option to insure for less than the estimated replacement cost. (When doing this, it’s important to make sure that the policy is written correctly to avoid a co-insurance penalty.) Properly written, we can often insure a home for as little as 50 or 60 percent of its replacement cost, but keep in mind that you will often pay a higher rate for the limit you do buy. So you may not save as much premium as you might think by purchasing a lower limit. This is because most Homeowners claims are not total losses, and the insurance company knows that they will have to pay the same amount to repair your home after it is damaged in a storm or by leaky pipe, regardless of whether you insure at 60 percent or 100 percent of replacement cost.*
As I mentioned earlier in this post, a replacement cost estimate is just an estimate, and it might be wrong. It might estimate high. It also might estimate low. For this reason, many carriers offer (or even automatically include) “Extended Replacement Cost” protection. This feature basically says that as long as you have kept your home insured for its estimated replacement cost and notified the carrier of any improvements or additions to your home, your carrier will pay over and above the policy limit, if necessary, to rebuild the home. This feature is usually capped at a percentage of the Dwelling limit, most frequently providing up to an additional 25 percent in protection.
*Assuming that the standard Homeowners co-insurance penalty has been properly modified or removed to avoid being underpaid on a covered repair for a partial loss.
About the Author
Agent Ken Cobb
Ken is the owner and principal agent at Pine Country Insurance. Active in the insurance industry since 2000,Ken uses his years of personal insurance knowledge and experience to assist clients in customizing insurance coverage to fit their needs. Ken considers himself a "farmer" rather than a "hunter"; rather than focusing on writing a lot of new policies as quickly as possible, he works on cultivating long term relationships based on trust with his clients. When writing new policies and meeting for annual reviews, Ken spends time with his clients explaining and helping them understand their insurance, and he is also pleased to share his knowledge with his blogging audience as well.
Ken Cobb is owner of Pine Country Insurance and has been active in the insurance industry for over 15 years. Meet Ken.
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