Homeowners' Insurance Coverage: How Replacement Cost Coverage Helps Pay for a Rebuild

If your home were to be destroyed, would you want your insurance company to pay you enough to rebuild with, or only enough to match the cash value of what you lost?

You just purchased a new house, and your insurer informs you that the policy coverage limit will be far greater that the amount that you paid for the house. Already struggling to come up with the cash required to pay the premium, you want to know, "Why?"

It's likely that your insurer is—for very good reason—urging you to buy coverage that is sufficient to reach the home's replacement cost rather than its actual market value.

What Replacement Cost Coverage Means

Replacement cost is the amount of money it would take to repair, replace, or rebuild a home with materials similar to the kind and quality used in constructing it, up to a preset limit. (If your policy were to pay 100% of the costs to rebuild the home you had before, that would be a rare and different type of coverage, called "guaranteed replacement cost.")

One positive feature of choosing replacement cost coverage is that, even as your home ages and possibly declines in physical condition, the policy will make no deduction for depreciation (a decrease in value over time due to age or wear and tear).

By contrast, another type of possible coverage known as "actual cash value" uses a method for settling loss claims that's based on the amount of money needed to repair or replace your home based on its depreciated value. This means you would in all likelihood receive less money to rebuild or replace your home than you would have with replacement cost coverage.

Reasons to Choose Replacement Cost Coverage

Construction costs increase over time, and the cost to rebuild your home with similar materials and workmanship could be higher than the amount for which you could sell it. While the market price of a new home includes the cost of construction, the market price of a used home might go down because of age and deterioration.

Factors such as changes in building codes, for example if new, additional, or more expensive components were required upon reconstruction for things like energy efficiency or fire safety, only increase the likelihood that replacing all or part of your home will cost more than the home's market value.

And if your home is damaged in a disaster that affects nearby homes, expect local construction costs to go up, due to high demand.

Most insurers require that a house be valued at its replacement cost in determining adequate coverage. Your mortgage lender may require your to obtain replacement cost coverage as well, as a condition of your loan.

What's more, some states have enacted legislation protecting consumers from the risks of not obtaining replacement cost coverage. In Florida, for example, homeowners' insurance companies must at least offer replacement cost coverage.

Policy Limits on Replacement Cost Coverage

Where replacement cost is used in determining coverage, the policy limit is usually set for at least 80% of the home's replacement cost. If you fail to insure your home for at least 80% of the replacement cost, your insurer may assess a penalty on partial loss claims.

For example:

  • If the replacement cost of your home is $125,000, 80% of that gives you $100,000 in coverage. So, if you insure your home for $100,000 and suffer fire damage of $20,000, your insurer will pay the full $20,000 loss claim.
  • If you insure your home for only $80,000 to cover the mortgage, and then suffer fire damage of $20,000, your insurer will pay only a portion of the $20,000 fire loss, very possibly prorated based on the percentage by which your home was underinsured.

As you make improvements to your home, keep track of and report them to your insurance company. Each improvement increases the replacement cost of your home. You should check with your insurance agent each year to be sure that you have adequate coverage.

Optional Coverages to Add On

To make sure that you're not among the American homeowners who are underinsured (as most are), you might also want to include in your policy:

An inflation guard endorsement, which automatically adjusts the replacement cost coverage limits of your home to ensure that your coverage is adequate.

A scheduled personal property endorsement, which provides separate protection, over and above your policy limits, for such items of personal property as jewelry, furs, stamps, coins, and fine art. Normally, these items are covered on an actual cash value basis, with sub-limits that cap the items' replacement cost. Also called a personal article floater, the additional protection requires each item to be itemized and described.

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