Paying the Price for Underinsuring Your Home

You have finally made it on to the property ladder, by saving up enough to buy the home of your dreams. But have you put a similar effort into protecting your investment, in the event that the worst should happen? Keeping up with insurance coverage can be a tricky affair but it is something most homeowners do not give enough thought to.

Many people assume that by taking out a homeowners policy, paying their premiums and not submitting any claims, they would be entitled to full protection from their insurer should disaster strike. Unfortunately, this is not necessarily the case.

Insurers require homeowners to have insurance coverage for an amount equal to at least 80% of the replacement value of the home. Failing to maintain sufficient coverage means that in the event of a claim, insurers will proportionately reduce the amount they pay out, even in the event of a partial claim. According to one recent survey, 64% of homes in the U.S. are underinsured, with the average shortfall around 18%.¹ This means that a large number of homes in the U.S. are likely to be insured for less than the 80% requirement for full claims coverage.

The amount of home insurance is something that most homeowners put very little effort into. For the majority it would have been part of the mortgage process and they would have left it up to the insurance firm to calculate the correct level of coverage. However, unless the company asked a series of very in-depth questions when the policy was applied for, or even better, came out for an inspection, the chances are that the policy is way below the 80% limit. This means that, in the event of a claim, the homeowner will have to pay the costs for the shortfall proportion. For example, if only 75% of the value of the property is covered, if a claim is submitted, the homeowner will be forced to pay 25% of the total claim, even if it is a valid claim under the policy.

Even if you manage to get the value of the property right when you take out your insurance, chances are that you will file the policy in the bottom drawer and forget about it unless a loss occurs. But in order to stay within the 80% ratio, it is necessary to keep your coverage updated and re-price the value of your home on a regular basis. However, research suggests that more than half of American policyholders were unaware that they had to review their policy (2). In the current economic climate this is more important than ever as the effect of inflation means that the replacement costs are rising rapidly and driving up the cost of replacing your home. For example, the price of lumber rose by 18% in the last 12-month period, a factor that could have a significant bearing on the overall value of a property. Some insurers tie their policies automatically to inflation but this is far from standard procedure for all types of coverage.

The other significant effect that the credit squeeze is having is that far less people are moving house. Rather than stump up for the costs of realtor, legal and other fees, many homeowners are taking advantage of the relatively cheaper costs of renovating and improving their current properties. Of course, property improvements usually lead to an increase in their overall values, a change that once again means that likely insurance coverage is out of date. Some estimates suggest that around $100-$150 billion of home improvements are carried out each year, nearly all of which are not being notified to the insurer.²

So, you have a policy, which is pegged to inflation and having worked out the increased market value of your property with the renovations added and updated your coverage, you may think you have all bases covered. Wrong again.

A common mistake that many homeowners make is to insure their home for the market value of their properties. However, in reality the amount you could sell your home for is completely irrelevant when it comes to your policy; your insurer is only interested in the amount it would cost to rebuild your home and replace your belongings. If the worst happened and your home was either damaged or destroyed, your insurer would not be trying to sell the property, as it would be liable to either rebuild or repair it. Therefore, the costs it considers are not related to the property market, but the price of building materials, labor and other related costs. This is another key reason why many Americans fall foul of the 80% rule, because rebuilding and repairing homes is often more expensive than simply buying one.

The good news is that it is possible to evaluate just how much insurance you should have on your property and there are a number of programs available to help you calculate the correct amount of coverage. Factors such as roofing an cladding as well as square footage need to be taken into account, and for as little as $8 it is possible to gain access to a program that assesses the true value and provides you with a report. In the event of your property being damaged, having a professional report that details the composition of your home could save a significant amount of time and negotiation.

Of course, the replacement of the structure of your property is only part of any claim. The costs of any damages internally must also be taken into account. This is where many people find they receive far less than they anticipated.

There are two fundamental ways in which the value of possessions is calculated in the event of a claim. These are the actual cash value and replacement cost content. While actual cash value sounds like the better option it can leave claimants virtually empty-handed if the articles in question were old or well used. A claim for actual cash value takes depreciation into account and only pays out what the items were worth, not how much it would cost to replace them. Replacement cost content does exactly that. Rather than cover how much the article was worth, it pays the policyholder the equivalent sum to replace it with a similar item.

Getting home insurance right is not as straightforward as it first appears, but with a bit of research it is possible to ensure that if the worst occurs, you will not be left out of pocket and regretting not taking the time to work out the proper coverage.

1. Marshall & Swift/Boeckh, Insurance to Value Index for Residential Properties, November 3, 2011.
2. Insurance Information Institute, How Often Should I Review My Policy?, March 2011.