Homeowners Insurance … And Renters Too
Article by R. Joseph Ritter, Jr. CFP® EA
Is it possible to understand homeowner’s insurance? In this article, we will take a look at some of the more common issues that deserve special attention when insuring your home.
The replacement cost of your home may be quite a bit different from its market value or purchase price. Most insurance policies provide replacement cost coverage on the physical structure of your home. In the housing boom and bust, many people saw their home values deflate while their insurance values rose. Some no doubt called their agent to complain or even reduce the coverage limits. This could be a costly mistake.
Replacement cost refers to the cost of rebuilding or repairing your home and does not factor the intrinsic value of your land, location or desirability of your home. Replacement cost looks strictly at the cost of construction. While home values may be going in one direction, the cost of building materials may be going in the opposite direction.
There is an option feature known as inflation guard which automatically adjusts the replacement cost of your home to keep up with the costs of construction. This automatic feature can be helpful to ensure you do not have any gaps in your coverage, but should still be reviewed periodically with your agent.
What happens if your replacement value is too low? The biggest problem could be not having enough insurance to cover a catastrophic loss. Buried deep within your policy there is probably a coinsurance provision which requires that you maintain insurance equal to at least a certain percentage of the replacement cost. This percentage is typically 80% to 90%. If your home is insured for less than the stated percentage, then you will not receive the full amount of the loss or the policy limit in a catastrophic loss. The amount you receive is based on a formula. Let’s say the replacement cost of your home is $150,000, and the limit of your insurance is $125,000. The coinsurance provision is 90%. Your home suffers damage of $15,000.
Ignoring any deductible, the loss payment would be $13,889. Here’s how it is calculated:
$125,000 (policy limit)
$135,000 (90% of replacement cost, or 90% of $150,000)
The result of his calculation is 92.5926%, and this is then multiplied by the loss. The insurance company will pay 92.5926% X $15,000, or $13,889.
If you are not sure if the insured value of your home is correct, then you can obtain an appraisal or request that the insurance company assess your home’s replacement cost.
For personal property coverage, you want to have replacement cost coverage. Replacement cost covers the cost to replace an item. Actual cash value arrives at essentially the same value but subtracts depreciation before paying for the loss. If a loss in your home damaged your appliances that would cost $2,500 new and they were 5 years old at the time of the loss, actual cash value would pay probably one-half to two-thirds of the replacement cost. Replacement cost coverage pays to replace the item. Actual cash value coverage pays what the item is worth.
Another factor to consider is the limit of coverage on collections, jewelry, electronics, cash, gold/silver, and other valuables. Most policies have low coverage limits for valuables, and in today’s world it would not be uncommon for a homeowner to exceed the limit of, for example, electronics with an expensive flat screen television, stereo equipment, digital camera, laptop and desktop computers, tablets, etc. You should review your coverages and bring to your agent’s attention any special items that may exceed the stated values. In most cases, you can obtain additional coverage for these items, and your agent can provide you with details and premium costs. If in doubt, ask!
One final point to consider on homeowner’s insurance is which form of policy to use. If you own your primary residence, the HO3 form is the most standard and widely used. It offers the best coverage and is most known among insurance agents.
Things get more tricky when you retitle your residence but continue to live there. Common examples include transferring title into a trust or business, an adult child owning a parent’s residence, and separated spouses owning homes in only one of the spouse’s names. Who needs insurance? Both the owner and the occupant need insurance. Because they have separate and completely different interests in the residence, the policy may need to be written on a form other than the HO3. The same goes for all other instances where the owner is not also the occupant. Whether they will be protected to their full satisfaction under the HO3 is a very technical question but one which must be asked.
Even more complicated is a situation when the homeowner dies but the house continues to be owned either by the estate or a trust of which the owner was the grantor. An insurance policy suitable for the homeowner may not be appropriate for the legal representative of the estate or the trust. Again, tough questions have to be asked.
It cannot be stressed enough that if you’re not confident the agent is able to competently answer the questions, then you have to get another agent or request that the agent confirm in writing with the underwriter that the policy will work. In most cases, an improper insurance policy is not caught until there is a claim, but at that point it is too late to rectify the problem. Your right to receive payment on a claim is determined by your insurable interest in the property, and in this case, you must demonstrate insurable interest at the time of the loss. Thus, it is entirely possible to have a useless insurance policy on your home.
If you rent your residence, your belongings inside the residence are uninsured unless you obtain a renters insurance policy. Such a policy covers only your possessions, and it also provides you with liability coverage similar to the coverage in a homeowners policy. Renters insurance is usually inexpensive and a wise investment.