One of the questions most frequently asked by homeowners is “why is my home insured for more than its market value”. This is perhaps one of the most misunderstood areas of luxury homeowners insurance and the most difficult to explain.
The question is undoubtedly valid from the perspective of the homeowner who looks at recent sales or local real estate listings. It can also be true if someone has recently refinanced or purchased a home and received a “comparable” assessment. But, how can the value of the homeowners insurance be equal to or greater than the market value of the combined home and the land it sits on? Is that right and why?
A home should be insured for its replacement cost. But what is a home’s replacement cost? If you can go out and buy a similar home in a different but similar location is that replacement cost? If I don’t want Replacement Cost, is there something else?
Types of Insurance Coverage Policies for High-End Homeowners Insurance
There are three broad types of insurance coverage:
- Guaranteed Rebuild Insurance
- Replacement Cost Insurance
- Actual Cash Value Insurance
Guaranteed Rebuild Insurance
Guaranteed rebuild insurance pays whatever it really costs to rebuild your home using like material, quality of construction, and technique. The basis of this insurance coverage is the appraised replacement cost value of the home based upon an inspection performed by the insurer.
Replacement Cost Insurance
Replacement cost insurance refers to the cost of reconstructing your home and its unique features in today’s marketplace using similar materials, design, and technique at your current location up to today’s building code. In the case of antique homes, similar material and technique can be very expensive. In simple terms, you can’t rebuild a deluxe, custom home using builder grade materials with unqualified day laborers. The basis of this insurance coverage is an estimate by the insured, and in some instances, a calculator provided by the insurer. If the amount is inadequate, the homeowner is responsible for the inadequacy and there may also be coinsurance penalties depending upon the policy.
Actual Cash Value Insurance
Actual Cash Value is defined as Replacement Cost less depreciation and wear and tear. For higher value homes and antique homes, Guaranteed Rebuild is the only way to go.
Homeowners Insurance Replacement Cost vs. Market Value
Market value reflects what someone is willing to pay for your home in today’s market which is influenced by demographic as well as much broader economic variables such as jobs, growth, interest rates, taxes, income, etc. Market value does not reflect what it would cost to rebuild your home. Perhaps one explanation of why new home construction has been down for so long is the fact that it is cheaper to buy an existing home than it is to build a new one. Regardless, residential real estate prices have little bearing on the insurance coverage you need.
Construction costs, including labor and material, continue to increase. In general, long term construction inflation is roughly double consumer price inflation. Since 2013, according to the Federal Reserve Bank of St. Louis, lumber rose approximately 19%, and for the same period, sheetrock went up 21%. Since 2013, labor costs for the construction industry have increased by 18%. Overall, according to the US BLS, 2018 residential construction costs have increased by 45% since 2003 despite a 5% drop in 2009, so material and labor continue to grow. As material and labor costs increase, so does the replacement cost insurance of your home.
Factors Influencing Cost
Essentially, it costs considerably more to rebuild your home than you think. Some argue that the cost is 40% to 50% more depending on a variety of factors including:
- Location affluence – It costs more to live and attract qualified builders in affluent insurance areas. The cost to build the exact same home in Peoria IL as one in Fairfield County CT is materially different. Even within Fairfield County, there is a difference between towns.
- Is it a total loss or a partial loss? In most instances a partial loss is more expensive than a total loss due to the detailed planning and matching of materials needed to repair and rebuild around existing structures. Restoration contractors provide different expertise, have different skills and charge a premium.
- Building a single home is more expensive than multiple homes due to the loss of economies in purchasing and labor utilization.
- Replacement using like material means exactly that. If you have plaster on wood lathing walls or antique wide pine flooring or other unique features that were destroyed, that is what is replaced. Your insurance policy reflects replacement which means exactly that.
- Depending upon the location, surrounding buildings, other structures and landscaping the use of heavy equipment may be impossible. In an urban area, parking may be impossible and necessitate continual movement of support vehicles and staging. Similarly, in cities and other locations with condominiums and coops, there are often noise abatement restrictions or limited access which limit when work may be done.
- Rebuilding begins with demolition, deconstruction of the damaged structure and personal property including hauling and tipping fees to dispose of the material. This is part of the cost to replace and rebuild your home.
- Prior to rebuilding and immediately following the discovery of the loss requires loss prevention and risk mitigation services to prevent further damage such as retaining a firm to abate and minimize further smoke or water damage.
- Replacement cost includes fees for engineering and architectural services, permits and legal fees associated with repairing or building your home and dealing with the local regulators.
- Rebuilding to code can add a significant cost to reconstruction. There is a continual increase is local and state government oversight with a goal towards increased safety. In some states recent legislation attempted to require an indoor fire suppression (sprinkler) systems to prevent or at least reduce damage from fire. In some local communities in Fairfield County there are requirements to add such devices to new construction depending upon the size of the home.
- Can you rebuild or must you first raze the structure? Some jurisdictions actually may require the demolition of a structure depending upon the extent of the damage. Does your policy cover the destruction of your home directed by local ordinance or law?
- Natural calamities such as hurricanes, tornado, earthquake or wildfire that destroy wide swaths of homes result in material and labor shortages due to local demand. This in turn raises prices.
- The older the home, the greater the cost to reproduce the unique features given the difficulty in sourcing some of the materials as well as the specialized craftsman necessary to rebuild the home.
- Rebuilding costs also include transportation of materials and the contractors’ overhead and profit in addition to the cost of materials and labor.
- Insurance inflation is real. When a GC or builder understands the cost is being borne by an insurer and in addition, there is an urgency to return you to your home, costs tend to escalate.
- Mainly, it costs considerably more to rebuild your home than you think. Market prices of existing houses have little bearing on the insurance coverage you need. Instead, you should focus on what it would cost to rebuild your unique home.
It’s also important to note that lowering the insured dwelling limit may have little impact on the premium given the numerous other factors that impact cost such as:
- Credit Rating and prior loss experience
- The town and its fire protection class
- The year built and year of upgrades of your home
- Your home’s construction (wood frame vs. masonry)
- Proximity to wet or dry fire hydrants
- Personal risk management devices such as central station alarms and automatic generators
- Home’s use – Full time personal vs. Seasonal with or without caretaker
- The insured value of personal property and contents
Homeowners should focus on what it would cost to rebuild their home. According to numerous sources, including the Insurance Information Institute and Marshall & Swift/Boeckh, a leading provider of building cost information, the majority of homes in the U.S. are underinsured by approximately 20%. As a result, when a loss is incurred, the impact can be devastating. Statistics also suggest that seven out of 100 insurance policyholders have a claim each year. Think about this – if you are part of the 60% that are 20% underinsured, and your home’s insured value is $2 million, its replacement cost would be $2.5 million. You would have a $500,000 out-of-pocket underinsured exposure, which could be devastating!
So, it is extremely important to understand what replacement cost insurance is, how it is determined, and how your policy will respond. Luxury homeowners should focus on what it would cost to rebuild their home today and work with their affluent insurance agent to find other ways to reduce costs rather than arbitrarily reduce the limit because of comparable sales.