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Homeowners Insurance“The market value of my home has dropped significantly.  Yet, my insurance company wants to raise the amount of coverage on my homeowner’s insurance.  Shouldn’t the amount of insurance be reduced?”

 The short answer is probably not.

A homeowner’s insurance policy is a contract designed to repair or replace the home should it be damaged or destroyed by a covered cause of loss.  And, it often costs more to replace a home than it does to build the same home starting with a vacant piece of property.  This makes it necessary to carefully choose an amount of coverage that is sufficient to replace the home should it be destroyed.

Many factors affect the market value, or selling price, of a home.  They can include the age of the home, its condition, its location, the overall economy and what a buyer is willing to pay for it.  On the other hand, the cost to replace the home is based on the cost of labor and materials to put the home back the way it was before the loss.  For example, let’s say the cost to replace a particular home is $250,000.  The market value of this home could be one amount if the home was situated on a small urban lot, another amount if the home was located on a moderate-sized lot in a suburban city, and another amount if the home was on 10 acres in a rural setting.  Now, let’s say that this home suffers a total loss due to fire or tornado.  The cost to replace the home will be the same regardless of where the home is located – even though the market value may vary substantially.

“But, even though I paid $300,000 for my home 12 years ago, and the replacement cost is estimated to be $250,000, I could only sell it for $150,000.  I want to reduce the amount of insurance to $150,000.  If I have a total loss, I should have enough money to buy another home similar to it, right?”

The problem is that a homeowner’s insurance policy has a built-in kicker that is rarely discussed, and is designed to protect the insurance company in the event a person purchased an insufficient amount of insurance.  The Loss Settlement section of the standard homeowner policy (ISO Form HO-3) says that:

  • IF the amount of insurance is at least 80% of the cost to replace the home at the time a loss occurs, the insurance company will pay the full cost to repair the damage or replace the home (up to the amount of insurance and less the deductible).
  • IF the amount of insurance is less than 80% of the cost to replace the home at the time a loss occurs, the insurance company can then settle on an Actual Cash Value basis rather than replacement cost.

What is Actual Cash Value (ACV)?  While it is not defined anywhere in the policy, ACV is commonly understood to mean the cost to replace less depreciation.  Depreciation can be influenced by a number of factors including the age and condition of the home.  But, the ACV can also be swayed by market values, etc.  The truth is that, if you are subject to an ACV settlement, there is no way to know how much you might receive if a loss occurs.  If you are unfortunate enough to suffer a total loss, chances are that you would receive the full amount of insurance.  However, only a very small percentage of all homeowner claims are a total loss.  The vast majority are partial losses.  This is where the biggest problem comes in.

Let’s put this into perspective by using an example.  For the sake of discussion, let’s say the roof was replaced 10 years ago and that the normal life of a roof is 20 years.  The replacement cost of the home (the cost to rebuild the home) is $250,000.  Six months ago, you called your agent and reduced the amount of insurance to $150,000.  Your policy has a $500 deductible.  The now roof needs to be replaced due to severe damage from hail and the roofing contractor says repairs will cost $10,000.  The loss is reported to the insurance company and you receive a check … for $4,500!

Why did you receive $4,500 when the amount of the loss is $10,000? 

  • The amount of insurance was $150,000 on a home with a replacement cost of $250,000.  That is less than the 80% requirement in the Loss Settlement provisions.
  • When the amount of insurance is less than 80%, the insurance company pays Actual Cash Value instead of Replacement Cost.
  • Remember the definition of Actual Cash Value – the cost to replace less depreciation.
  • The roof used 10 years of its 20 year life, or 50%.
  • The cost to replace is $10,000, less 50% ($5,000) = $5,000
  • Your policy had a $500 deductible - $5,000 less $500 = $4,500

If the home had been insured for its replacement cost, the settlement would have been $9,500 instead of $4,500 ($10,000 less the $500 deductible).

Before rushing to reduce the amount of insurance to save a few premium dollars on your homeowner’s policy, remember the Loss Settlement provisions and their requirements.  Ask yourself - Is saving a few dollars in insurance premium worth the potential disappointment after a loss?

Michigan Homeowners Insurance professional at Insurance Planning Service is a valuable source of safety and insurance information. Don’t hesitate to contact an agent at 800-220-5582 to discuss your questions or to receive a free quote on Michigan homeowners insurance.

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