Every day in America, insurance agents find themselves answering this very question…and for good reason.
Homeowners are bowled over when a property they purchased for $200,000 is required to be insured for $300,000 or more.
You may be wondering how this is possible, especially in a market where home prices are falling daily.
Your Home Has Three Different Values
Every home has three different values at any given time. It is necessary to recognize all three to understand the insurance company’s calculations…especially the difference between actual cash value and replacement cost.
1. Market Value – This is the value any one individual or entity would pay you at any given time for your home. It fluctuates wildly based on the economy…shocker, right?
2. Actual Cash Value – This is literally the current value of the wood, nails, drywall, roof, brick, etc. The actual cash value of your home, known as ACV, decreases by the minute. Each day that passes, the physical materials which make up the construction of your home depreciate – do not confuse this with the value of a home depreciating.
3. Replacement Cost Value – This is the estimated cost to rebuild your home from scratch; including today’s material and labor costs, removal of debris from the initial loss, cost of permits and architectural drafting, among other things.
How does the insurance company calculate replacement cost of a home?
Insurance companies have the most accurate data regarding what a home costs to rebuild. How? Well, they ‘re the ones who pay to re-build every home that has ever been destroyed (assuming it was properly insured).
That said, no matter how unique a home is from a decorating standpoint, it can only vary in location, size, and the materials used to construct it. Once the location, size and construction materials are known, the process is pretty simple.
Your insurer compares your home to the thousands, if not millions of similar homes they have rebuilt and estimates the cost to rebuild yours accordingly.
For example, if your home is 2,000 square feet, built mostly with semi-custom materials and fixtures, and located in Dallas, Texas, there isn’t much rocket science left. Odds are your insurer has rebuilt or repaired a few hundred similar homes in the area.
But my home has dropped in value, why do I have to insure it for more?
This is another common question insurance agents regularly field. The insurance company isn’t the slightest bit interested in the market value of your home. They stick with measurable constants, such as current cost for labor and materials and depreciation based on the functional life of any piece of property.
Those of you who are thinking, “my house isn’t worth XYZ,” or “I couldn’t sell my house for half that,” are already thinking on the wrong track when it comes to insurance.
You certainly didn’t call your agent and ask them to increase your insurance premium because your home was worth more in 2003-2005, did you? Furthermore, you certainly wouldn’t want your insurance company adjusting your premium every six months based on the most current economic conditions.
When your home was built, there were probably dozens, if not hundreds of other homes being built in the same neighborhood. Applying the concept of bulk purchase, the original cost to build your home would have been greatly discounted because of all the contractors and builders working in the area.
An individual who has built a custom home on their own plot of land will gladly tell you the cost is astronomical compared to having “The Victorian – Model 3” built on lot 207-b in a tract housing development.
So what’s the verdict?
Taking this information into consideration; it should be obvious which loss cost valuation method you should choose to insure your home.
Replacement cost coverage is the safest way to insure your home…if you love it enough to rebuild it with “like” materials to get it back to where it was before the loss. Your lender will likely require that you have a replacement cost homeowner’s policy anyways, which should make the decision pretty simple.
If the home is in poor shape (which may make it ineligible for replacement cost coverage), you own it outright, or it is literally not worth the value to insure for replacement cost, you may choose an actual cash value policy.
This doesn’t mean the insurance company will write you a check for whatever number you pull out of thin air to insure your home for. In the event of a loss, an adjuster will come to (what was) your home and estimate its actual cash value, which is your replacement cost minus depreciation.
In a worst case scenario, this may lead to a court battle between you and the insurer to determine how much money they owe you.
Read more: How are homeowners insurance rates determined?