We’d like to thank Tom Ayres, Partner at Daigle & Travers Insurance, for so thoroughly explaining why homes are often insured for more that what the homeowners paid for them. Required reading for first-time homebuyers — but an excellent refresher for all homeowners, particularly in these times of ever-rising replacement costs and frequent natural disasters.
The most commonly asked question when buying homeowners insurance is “Why is my home insured for more than what I paid for it?” On the surface, this is a completely valid and fairly reasonable thing to call into question when you don’t have the proper understanding of what a purchase price is versus what homeowner’s insurance is designed to do. It all starts with understanding the difference between market value and replacement cost.
Market Value vs Replacement Cost
Making sense of this conundrum starts with understanding that what you paid for your home is a reflection of its market value. Market value is a reflection of the real estate market value at a certain point in time and is vulnerable to fluctuations due to various factors including economic developments. This includes personal opinion. Your opinion of value may differ from someone else’s opinion. If you pick the home up and move it to a less desirable town, the value can drop dramatically and vice versa.
Homeowners insurance policies on the other hand base their dwelling coverage on “replacement cost.” Insurers define that as the cost to rebuild your home with like kind and quality, following a loss, based on the costs the insurer is charged by contractors for labor and materials. Replacement cost, very simply put, is based on the actual cost of labor, lumber, cement, and other construction materials at today’s prices. These numbers are more concrete in nature vs an opinion-based number. So, in short, we are talking about two entirely different valuation methods.
Factors Influencing Replacement Cost
Homeowner’s insurance policies are obviously reactionary. There must be a loss (or insurance claim) first, thus triggering the rebuild. Those costs associated with the claim add to the rebuild cost. Debris removal, soft costs such as architect’s fees, dry out costs, and more must be accounted for in your dwelling coverage. To do so, most insurers assume a total loss scenario to properly rate a policy. This means they must account for even the removal of a foundation as well. Fire losses can degrade the integrity of cement so they can’t rationalize that rebuilding will start on the current foundation. In reality, the cost to rebuild a home is never truly known until after the dust clears following the rebuild. It is not an exact science, which is why including an endorsement for Guaranteed Dwelling Replacement or Extended Replacement Cost Coverage is so critical to covering the costs above your dwelling limit.
Additionally, it is really important to note, that for the most part insurance companies are charged more for the cost to rebuild than you would as an individual. That is largely due to time. The insurer is paying for speed. For instance, a homeowner’s policy also pays the costs for you to live elsewhere while the home is repaired. The longer it takes to repair, the more costly the loss. That said, most insurers acknowledge that they are simply charged more than you would be as an individual and they account for it.
There are a number of other factors that impact the replacement cost of the home that market values may not account for. For instance, the age of the home. Antique homes may be less desirable from a market value perspective, but from a replacement cost standpoint, the cost to duplicate what is physically there costs significantly more to replicate since it differs from today’s modern construction methods. The quality of the material matters. Higher quality materials used in a construction always directly impact replacement cost but less the market value.
10 Things You Should Know About Home Insurance:
Home insurers require that you insure your home 100% to replacement value based on their estimates or appraisal.
The dwelling coverage limit is also the premium driver on your insurance policy
Homes are bought based on “Market Value” while insurance is based on “Replacement Cost.”
You must factor in debris removal and the costs of a claim to the rebuild cost which means if you pay $1m to build your home, you can expect the rebuild cost to always be more.
Estimates by insurers to rebuild your home can vary dramatically.
Homes that were built in large subdivisions benefited from economies of scale that can’t be duplicated at the time of loss.
Construction material inflation rises at nearly twice the consumer price index, often outpacing general inflation and market values.
The location of your home impacts the cost to rebuild…which directly impacts the cost of your insurance.
How is replacement cost defined? There are notable differences between carriers paying for “like kind and quality” vs. a carrier that pays for “functional” replacement cost. The latter of which represents a decline in quality.
The age of your home impacts the cost to rebuild. If your home was built prior to 1940 it is very likely that the home was built using construction methods that are no longer normally used, but yet must be duplicated by most insurance contracts.