Often times I have conversations with clients about their home insurance policy. Typically the discussions focus on the amount of coverage for their home and how that amount of coverage is determined. Many people believe the coverage limit should be equal to their loan amount. Others think it should be based on the purchase price or the market value. In order to best discuss this topic, let’s start with the fundamentals.
The first coverage shown on the home insurance declarations page is the coverage for the dwelling. The dwelling is the main residential structure. The limit shown in association with the dwelling is referred to as the “dwelling value”. (Dwelling value is also synonymous with reconstruction value, replacement value, Coverage A and insured value.) The dwelling value on your policy reflects the amount of money the insurance company will pay to repair or rebuild the home due to a catastrophic event. Determining the correct amount of coverage for the dwelling is very important. To establish how much coverage might be needed to insure a home, insurance agents are provided with replacement cost valuation calculators. These calculators are independent of the insurance companies. Some of the prevalent valuation calculators used in the insurance industry are; Marshall Swift and Boeck (MSB), 360Value, ISO and e2Value.
There is a common misconception regarding the relationship of the dwelling value for insurance purposes and the other methods which are used to “value” a property. Appraisals, taxable values, loan amounts and dwelling values are all different means of expressing a specified “value” for a property. Unfortunately, these values rarely equal one another. For example; appraisals are indicators of what the property could be bought or sold for based on market conditions. Taxable values are determined by the municipality the property is located in. The loan amount is what the bank is willing to risk based on a variety of factors. The dwelling value shown on your home insurance policy reflects a reconstruction value. The reconstruction value includes considerations such as debris removal, labor, materials and architectural fees but does not include land value. So, there is no direct correlation in the determination of any of these values because each “value” is defined differently.
Since insurance agents are not typically General Contractors, Architects, or Builders; we rely on the valuation calculators as a tool to determine the limit of insurance for a home. But often times, the homeowner may wish to insure their home for an amount different from the amount determined on the reports. There are some governing conditions which stipulate how insurance agents are to offer coverage.
Dwelling Coverage and the “Valued Policy Law”
The “Valued Policy Law”- Florida Statute 627.702 (“Valued Policy Law”) states in part, that if there is a total loss by a covered peril to a building, the insurer must pay the amount provided in the policy for which a premium has been paid.
The language of this Statute creates a check and balance system within the insurance industry.
Risk:
Home insurance companies understand risk. Because the “Valued Policy Law” requires an insurance company to pay the full amount shown on the policy, the insurance company is not going to allow a home to be intentionally “over-insured”. Although “over-insuring” a home would yield more premiums for the company, the idea of collecting a higher premium does not warrant the potential risk of having to overpay on a claim.
Economics:
Home insurance companies, like most businesses, are in the business to make money. They make their money by selling policies. Higher premiums yield higher profits. Since the premium is primarily determined based upon how much coverage is provided on the dwelling, insurance companies are interested in maximizing as much premium as possible for every policy they issue without over-insuring the home. Conversely, with the intent to maximize its profit, insurance companies do not want to “under-insure” a home either. Therefore, insurance companies require insurance agents to insure to value. This means to insure the home for the full value of the replacement cost which is determined by the valuation calculators. This allows the insurance company to collect the optimal premium for the home they are insuring.
The Process
When an insurance agent discusses insuring a home with the owner, the agent attempts to fully understand the home and what might make it unique compared to other homes. The insurance agent then takes the information and inputs the data into the reconstruction calculator and a valuation report is attained. The reconstruction value indicated on the report is the value used when quoting through the various insurance companies. Premiums are based on several variables such as the year built, location, type of construction and the amount of coverage being requested for the dwelling. Once a quote is obtained and the homeowner agrees to the proposal, the policy is issued. After a policy is issued, the insurance agent submits all of the documentation collected in the underwriting process to the insurance company, including the valuation report. The valuation report is the justification for the amount of coverage determined for the dwelling value.
Since no system is perfect, there can be discrepancies when determining the reconstruction values depending on the calculator used or the data the insurance agent has entered into the calculator. The concern here is not necessarily in the inadvertent over-insuring of a home but there is great concern if a home is under-insured. The notion of “under-insuring” a home creates a potential of financial ruin for the home owner.
How does a home become under-insured? There are many reasons a home may become under-insured. Sometimes, if a home has been insured on the same policy for many years, the costs for reconstruction might eventually surpass the dwelling limits on the policy. Another reason might be that the home was significantly improved after it was initially insured and the insurance agent was not notified of the changes. Also, it is possible that the data input into the valuation calculator was not altogether accurate as a true representation of the home. This could occur as a result of an honest mistake or it is plausible it was done with the intent to create a lower value which in turn generates a lower premium.
To some home owners, under-insuring a home might seem like a reasonable risk. Most people believe that a catastrophic loss will not happen to them and the amount of money they can save in insurance premium is justifiable.
What most people don’t know is there is a clause in the home insurance policy called coinsurance. The coinsurance clause is a provision within the policy which stipulates; a financial penalty can be invoked if, at the time of a loss (claim), a home is insured for less than a certain percentage of the accurate value of the home (underinsured). A calculation may be used in the determination of what the loss settlement will actually be. Should the coinsurance penalty be applied, the amount paid would be less than the actual amount needed to cover the damages.
Home owners also need to understand that there are ancillary coverage features within the home insurance policy which are additional coverages for certain circumstances. Detached Structures, Personal Property, Loss of Use and Ordinance or Law are examples of these additional coverages. The limits provided for these additional coverages are based on a percentage of the limit of insurance on the home (dwelling). Therefore, reducing the dwelling value also automatically reduces the limits of other coverage limits within the policy.
So the combination of risk, economics and the “Valued Policy Law” interact to create a system where the insurance company is able to rate for the appropriate premium but more importantly, it ensures the home owner has the proper coverage for when the claim happens.
Meet with your insurance agent periodically. Ask them to review your home insurance policy with you and make sure your home is insured to value. A few minutes of your time will be worth avoiding a potential financial calamity.