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November 7, 2018

The True Value of Homeowners Insurance

Please read important disclosures HERE.

I have a vivid memory from the morning of Monday, October 9, 2017. As I stepped out of my home in San Francisco to begin the work week, I noticed a heaviness in the air. The normal sky had been replaced by a ceiling of smoke and the unmistakable smell of fire was everywhere. I initially thought that nearby Golden Gate Park must be burning and I promptly jumped on my phone to check the news for details. What I quickly learned was that this fire was actually burning many miles north in Sonoma County. It would eventually be known as the Tubbs Fire, the most destructive wildfire in California’s history.

The True Value of Homeowners Insurance

Many lessons were learned during the recovery that followed the Tubbs Fire and other wildfires since. We learned that evacuation orders must be followed, freeways don’t always double as firebreaks, and clearing vegetation around your home can make a difference. We also learned the true value of a homeowners insurance policy.

It’s fairly easy to fall into the cycle of buying a homeowners insurance policy when you purchase your home and then paying the premium each year without giving much additional thought to the policy’s design. When a claim arises, however, the policy details make all the difference in how much protection is provided and whether the claim experience is a good one.

The details of a homeowners insurance policy are important. By understanding these details, policyholders can be better equipped to choose a policy that makes the most sense for them. Let’s start by asking the most basic question.

How Much Will the Insurance Pay?

The most important provision in a homeowners insurance policy is how the value of a loss will be determined by the insurance company. There are three valuation options to consider, each providing a different level of protection.

  • Actual Cash Value – the replacement cost minus depreciation.
  • Replacement Cost – the cost to replace the property today with materials of similar quality.
  • Extended Replacement Cost – the cost to replace the home even if the replacement cost exceeds the policy limit, usually up to 25% above the policy limit.

Actual cash value provides the least amount of insurance for the lowest premium. Despite the premium savings, we believe actual cash value policies should be avoided. The claims experience is likely to be less favorable, with the looming potential of a negotiation with the insurance company to determine the actual cash value at the time of loss. The last thing any of us wants to do is have a disagreement with our insurance company, especially if it could result in litigation down the road.

Replacement cost coverage is the most common valuation provision found in homeowners insurance policies. It is the amount it would cost to rebuild your destroyed (or damaged) home exactly as it was originally constructed. Depreciation is not a factor in the cost.

This all sounds great, but keep in mind that the insurance amount is also subject to the policy’s limit. During the time you own your home, inflation must be accounted for, and replacement cost coverage puts the responsibility squarely on the policyholder to ensure that the limit keeps up with inflation.

For example, let’s say back in 1995 you purchased a 2,000 square foot home in San Francisco for $400,000. At the time you also purchased a homeowners insurance policy with a $400,000 limit and you have continued to renew the policy each year with no changes. It’s now likely that the home is significantly underinsured relative to how much it would cost to rebuild it today if a total loss were to happen.

Extended replacement cost provides the most insurance coverage and predictably comes at the highest premium. In exchange for higher premiums, policyholders not only get the most protection but also some peace of mind that the insurance amount will be sufficient to cover even the most severe damage.

It’s common for people to simply seek the lowest possible premium for homeowners insurance. This approach seems rational since the likelihood their house will be destroyed is statistically very low. With little risk of ever using the insurance, why pay more for greater protection? Additionally, some agents showcase low premium/low coverage options in order to win the business, with little regard for whether the policy adequately fits the client’s needs.

These issues came to light in a negative way after the recent wildfires. Many homeowners discovered only after the fire that their coverage was insufficient. While some carried an insurance limit of $200/sq. ft., contractors were quoting rebuilding costs in a significantly higher range. In fact, a number of policyholders are suing the well-respected insurance company USAA for having “systemically underestimated” the replacement cost of homes and causing policyholders to be underinsured and unprotected. USAA is not alone as many homeowners felt they didn’t get what was expected from their insurance company when the time came to pay the claim.

Other Key Factors to Consider

A year after the fire, rebuilding efforts move forward at a snail’s pace and the claim experience has been long and frustrating for many. For those who have their insurance with direct-writer companies such as State Farm, Farmers, and USAA, filing a claim involves calling a toll-free number and dealing directly with the insurance company. What about that agent who originally sold the policy? He or she likely has little to no ability to help or impact how the claim is adjusted.

While the direct-writer companies aim to serve the insurance needs of the middle market masses, a higher end of the marketplace also exists, which can be accessed via independent brokers. Instead of representing one insurance company, the broker represents his or her client and stands completely independent of the insurance companies they place business with. They shop coverage around to competing companies such as AIG, Chubb, and Travelers and compare different offers to determine what’s best. They can also serve as a valuable advocate during a claim and be a helpful and educated voice when dealing with insurance companies. The policies typically come with higher costs, but the higher quality of coverage along with the broker’s expert advice and service may be worth it.

Beyond the cost to repair and rebuild a house, homeowners insurance policies cover a number of additional types of financial losses and expenses, including the value of furniture and other personal property, potential liability issues, and expenses incurred while displaced from the home. These factors should also be considered carefully as part of any insurance assessment.

There are things that can be done right away to help ensure that your homeowners insurance policy is adequate. First, educate yourself on the true replacement cost value of your home and ensure that the insurance policy limit is appropriately aligned. You can determine value with online tools or by asking your insurance agent or broker, an appraiser, or contractor. Next, ask your insurance agent or broker whether extended replacement cost coverage is available and what the additional premium would be to add it.

If you feel you could benefit from a comprehensive review of your homeowners and other insurance policies, B|O|S can refer a number of independent insurance brokers who are well-equipped at determining the right coverage for you.

Filed under: Financial Planning

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