Which Home Value Should Be Covered by Your Home Insurance
When you buy homeowners insurance, you certainly want to protect your home at the right amount. But you may be surprised if your policy’s dwelling coverage amount is much different from the home price. If it is higher, you may think you are overpaying for insurance. If it is lower, you may wonder if you have adequate coverage.
The reason your coverage value may be different from your home price is that insurance companies typically cover homes at the replacement value, not the market value. So what’s the difference between a home’s market value and its replacement cost? The market value of a home is the price for which you could sell it. The replacement value is how much it would cost to rebuild the home with similar materials if it were destroyed.
Reasons for Differences in Values
One reason the replacement value may vary significantly from its market values is that a home’s market value includes the value of the underlying land, whereas the replacement value does not. If your home is destroyed, the new home can be built on the existing land. Most insurance policies therefore exclude the value of the land and consider only the cost of replacing the dwelling.
The location of the land also can have an outsize effect on the home’s market value. A small home with a fantastic water view, for example, could command a higher market value than a large home located in an undesirable neighborhood. The cost of rebuilding the smaller waterfront home, however, would be less than the cost of rebuilding the larger home.
Additionally, market values tend to be cyclical and can fluctuate significantly, whereas home construction costs tend to be stable and change more gradually.
Homeowners may be tempted to insure their home for less money if their home has lost value. But if the home were destroyed, and its market value at which the house is insured is less than the replacement value, insurance will not cover the full cost of replacing the home.
In fact, insurance companies would not fully cover the cost of damage to a home unless the home is insured for at least 80% of its replacement value. In this scenario, the homeowner must either come up with additional money or build a smaller home.
How is the Replacement Value Calculated?
Insurance companies determine a home’s replacement value by using software called a Replacement Cost Estimator, or RCE. The tool considers such factors as square footage, the type of material the home is made of and the home type, to estimate the cost of replacing the home based on the current cost of building materials, labor, permits, etc.
If you renovate or add on to your home, it’s important to notify your insurance company so it can update your policy. Otherwise, you may not be adequately covered if you lose your home. A replacement cost estimate is different from an appraisal, which considers additional factors, such as the neighborhood in which the home is located, the home’s condition, and comparable property sales in the area.
Insurance companies will sometimes send an inspector to evaluate a home in person. This is typically done for larger homes, or for homes with unusual characteristics. A historic home, for instance, may warrant a more careful valuation. Such homes may require special insurance or require special endorsements added onto an existing insurance policy at an additional cost.
For example, an “ordinance and law” endorsement covers homeowners if new ordinances or regulations have been passed since the home was built that would prevent it from being rebuilt on the same lot. Such an endorsement may cover the cost of purchasing land upon which to rebuild the home — something a typical homeowner’s insurance policy, which only covers the dwelling, wouldn’t cover.
In addition, you should ensure your home is sufficiently covered because most home insurance policies include a “coinsurance clause.” This clause specifies that the home must be insured at a certain percentage of its replacement value (typically at 80% or 90%) in order for the insurance company to provide full coverage for damages.
When in doubt, consult a knowledgeable insurance agent to ensure your home is adequately covered. Given the potential complexity of homeowners insurance policies, it’s a good idea to take the extra effort to consult an expert so you can tailor the policy to your exact needs.
– Written by Steven Wyble, last updated in December 2022.