Homeowner’s insurance is required by lenders in order to close on a residential property. It’s an expensive item on the closing statement because lenders usually insist that the annual premium has been paid in full for the first year.
And policy terms can be confusing and easily misunderstood by the homebuyer, so it’s important to really understand what type of protection you are buying and assess how much financial risk you are willing to take.
Building Coverage Limits
One of the first questions that you have to figure out is how much total coverage to have on the buildings and other structures on the property. There are many other insurance decisions to make about types of perils covered, deductibles, etc., but the most basic item is how much coverage you need on the property itself.
To answer that, you need to understand the difference between Rebuilding Costs and Market Value.
Rebuilding costs reflect the costs to rebuild in the event of a total loss. Market value reflects the total current value of the entire property, both buildings and land.
Among other things, it also reflects the value added by your location, school district and neighborhood amenities. Those are not construction costs.
Using purchase price as a rule of thumb can result in either paying for more coverage than is required or in not having enough coverage when you most need it.
How Do You Calculate Rebuilding Costs?
Here’s where it gets kind of tricky. The simple answer is to take the square footage of the building(s) and multiply by the estimated cost to construct those building(s) at today’s construction costs.
But the best you’ll be able to find for that is a range of dollars per square foot. Local contractors, your insurance broker and the insurance company may be able to give you ranges, but in the end you have to make an educated decision.
Square footage construction costs vary by the level of finishes & upgrades you have in the house, what the general cost of construction is in your area, the ease or difficulty of getting materials and supplies to your property, etc. And, if you are rebuilding after a disaster, you’ll have costs associated with demolition and cleanup too.
What’s the Best Approach?
Talk with your insurance broker for advice and maybe with a builder in your area so that you feel comfortable with the amount of coverage. Some insurance companies will help you find the right coverage level, but they usually don’t review this until after you’ve moved in.
Once you own the property, the company may send an inspector out to evaluate it and will adjust the coverage amount based on their data and expertise. Sometimes this is an optional free service you can request. Other companies simply do it as a routine process, whether you want them to or not.
Policy Coverage Questions to Ask
Some key questions to ask about your property coverage include, but aren’t limited to:
- Is there an annual inflation adjustment built in to cover future building cost increases?
- What coverage do you have for increased costs due to having to re-build to newer and stricter building codes?
- Is the building coverage for actual replacement cost?
- What risks are you insured against (e.g., named perils or all-risk)
- Are there any specific hazards that are excluded (e.g. sinkholes if you live in Florida)?
And, lastly, if you are tempted to under-insure because you want to cut your costs, exercise caution. Most insurance policies have a provision that significantly reduces your coverage in the event of a claim, if you are shown to have been under-insured.
Your home is a major financial asset, so protecting it is important. Review any policy carefully and ask your insurance broker to explain anything you don’t understand or are unsure about.