Whether you just bought a new home (congratulations!) or are just looking over your existing policy, you may be wondering “Why is my coverage amount more or less than my home value? How much home insurance do I actually need? Shouldn’t my policy coverage just cover the market value of the house?”
When acquiring insurance for your new home, you probably expect that your coverage will be equal to what you paid for it. I mean, that number is technically the value of the home, right?
Even though that seems like it makes the most sense, as is often the case in the world of insurance, things don’t always make sense until you dive a little deeper.
Let’s begin by talking about how homeowners insurance policies work, then get into why your coverage amount may be different than what you paid.
What is included in a homeowners policy?
Homeowners insurance protects your property and its contents from disasters such as lightning, wind, hail, explosions, fire, vehicles, theft, vandalism, and more depending on the coverages, you elect.
Homeowners insurance is mandatory for anyone financing a house and highly recommended to any homeowner to protect their property and possessions.
Components of a homeowners policy:
There are four parts to section 1 of a home insurance policy: dwelling, other structures, personal property, and loss of use.
(There is also section 2, comprising personal liability and medical payments to others, but we’ll talk about those another time.)
When an insurance company is determining the limits of your homeowners insurance, it first establishes your dwelling coverage (based on replacement value, which we will discuss below. The rest of the coverages are calculated as percentages of that dwelling’s coverage.
Dwelling: coverage protecting the actual structure of your home and any attached structures like garages and decks/porches
Other Structures: coverage protecting other structures in your yard, such as sheds, detached garages, pools, fences, and driveways; the limit is typically 10 or 20 percent of dwelling coverage, but you can choose to buy more
Personal Property: coverage for all the property in your home that is not part of the structure; the limit is typically 50 or 70 percent of dwelling coverage
Loss of Use: coverage for the cost of living (hotel stays, ordering food from restaurants, etc.) if you were to be displaced due to home damage; the limit is typically 20 or 40 percent of dwelling coverage
Concerned about how the value of your insurance coverages is affecting the cost of your premium? Read this article to learn more about how home insurance cost is determined.
How dwelling coverage is determined:
The limits of your homeowner’s insurance are based on replacement cost because simply put, that number is how much it would cost if you needed to replace your home. It’s worth first making sure you understand the difference between Market Value and Replacement Cost, as they are not the same thing.
Market Value vs. Replacement Cost:
Market Value: Also known as actual cash value, (ACV), market value is the value of your home if it were sold today. This includes multiple variables, such as depreciation, land value, location, and the current state of the real estate market. The Texas Consumer Bill of Rights prohibits lenders from requiring you to purchase insurance on your property in excess of the replacement cost of the dwelling as a condition of financing a mortgage.
Replacement Cost: Replacement cost is what it would cost to rebuild your home if the structure were to be completely destroyed/burned down, etc., regardless of where it is located.
For example: imagine a three-bedroom, two-bathroom, 2,100 square foot home. If it was built on a small piece of land in McKinney, TX it might sell for around $400,000. If the same exact house was built at the same time on a large piece of land in Highland Park, TX, it might sell for $1,200,000.
Even though there is over an $800,000 difference in the market value of the two homes (because of land and location), the replacement value of the two homes is exactly the same, because they cost the same amount to build.
If your limit was instead based on market value and your home was destroyed, insurance might not provide enough for you to rebuild your home or might give you much more than you need.
How replacement cost is determined:
To determine replacement cost, agents use a cost estimator tool, including factors such as square footage, the number of rooms, HVAC systems, materials, roof-style, fireplaces, wood stoves, garages, decks, and more as well as zip code to determine the cost of labor and materials to determine an estimate of your premium.
Once the cost estimate is established, an inspector comes out to evaluate the property in person to make sure everything was accurately covered in the cost estimate, adjusting it if necessary.
Generally, the dwelling limit is supposed to be set at 100 percent of the replacement cost. If your dwelling coverage is issued at less than 80% of the replacement cost, coverage for damage could be limited.
In addition to the replacement cost, dwelling coverage may also include “extended replacement,” which ensures extra coverage if rebuilding were to cost more than anticipated. This scenario might occur if there were a natural disaster and several houses were destroyed. Since the demand for materials and labor would be higher, your home would cost more to rebuild.
Extended coverage can usually be added to a policy at either 25 or 50 percent of dwelling coverage, or guaranteed replacement (no cap).
Some unethical agents might set the dwelling limit at less than 100% of replacement cost and cover the gap with extended replacement, but this is irresponsible and could lead to claims issues for the policyholder.
Once the limits have been set and the policy has been established, your policy will be reviewed each year and typically increased 3-4% due to inflation of materials and labor costs.
Why dwelling coverage might be less than market value:
Generally, when a person gets a homeowners policy, the dwelling coverage is less than what they paid for the home.
While this may cause concern, there is nothing to worry about as long as the limit was quoted at 100% of the replacement cost.
When you bought the house, you paid for the structure itself, but also the land it is on. Since you would not need to pay for the land if you rebuilt the home, it does not need to be included in your insurance limits.
You might notice a bigger gap in the difference between market value and replacement value if your home is in a desirable location.
Again, the dwelling coverage is just there to pay you to rebuild the home. You already paid for the land in the desirable location — you don’t need to buy it again to rebuild.
Why dwelling coverage might be more than market value:
In some cases, you might find your dwelling coverage amount is higher than the sale price of the home.
Unless there was some sort of mistake in calculating your replacement value, this does not mean you are overpaying for your insurance.
Usually, this just means you got a good deal for your home. Maybe your home was priced low, or you purchased a bank-owned property or short sale. The real estate market could also be a good place for buyers when you purchased it. Regardless of the reason, you paid less for your home AND land than it would cost to rebuild the home.
Another reason your dwelling coverage might be higher than the sale price is if the home is in an undesirable area, which lowered the market value.
Certain homes that are older may also yield higher dwelling coverage. Because the home has depreciated, you may have got it at a lower cost, but if you were to build a house of a similar size with similar materials, it would cost more than what you paid for it.
Rarely, very high-value homes may need coverage above market value because of uncommon features such as large windows, HVAC technology, or custom home automation systems.
In this scenario, it is not unheard of for the cost estimator to estimate too low because its standard questions did not uncover all the features in the home. An accurate value will be determined once the inspector reviews the home in person.
Know your homeowners’ policy:
If you’re looking at your home insurance policies and some numbers don’t seem to add up, we know that can be a cause for concern.
That’s why it’s important to understand how your homeowner’s insurance works and how the cost is determined. This will allow you to feel confident you aren’t getting cheated and are paying for exactly what you should be.
So to learn more about the cost of homeowners insurance, read this article: How Much Does Homeowners Insurance Cost in Texas?
If you have any questions feel free to reach out to me at Johnathan@riskwell.com, or call me directly at 469-678-8082.