When Should I Make Changes to My Homeowners Insurance?

The average price of new homes sold during March 2012 rose 8 percent from February, jumping $21,500 from $269,700 to $291,200, according to the Census Bureau. That suggests real estate prices may have bottomed and begun rising.

But does it suggest that the average homeowner should increase the amount his or her home is insured for by $21,500?

The short answer is: Probably not.

Look at Replacement Costs, Not Market Value

It’s a good idea to re-evaluate homeowner’s insurance annually. You may want to change coverage or carrier to reflect new circumstances or save money, but just because sales prices of new or existing homes go up — or down — doesn’t mean you should adjust the amount you are covered for.

The basic reason is that your homeowner’s policy does not insure your home for what someone might pay for it or what you paid for it. The stated value of a home insurance policy is intended to reflect the replacement cost for the structure on the land. That is, what it would cost to rebuild it if it were destroyed by fire, flood or other catastrophe.

“The replacement cost — the price of completely rebuilding a home at its current location, with comparable construction materials — is generally a different dollar amount than a home’s market value — the price someone would pay to buy the home,” explains Loretta L. Worters, vice president at the Insurance Information Institute, a New York City-based industry group. “Therefore, the policy should be based on the cost to rebuild the home, irrespective of whether the value of the home goes up or down.”

Determining Replacement Costs

“Insurance companies calculate replacement costs by looking at the materials used, square footage and prevailing labor costs in the area,” Worters says. Other factors include how many stories it has, the number of bathrooms, whether there are other structures, such as a garage, and features such as, fireplaces or arched windows.

Rebuilding costs may go up if you add a bathroom, enlarge the kitchen or make other improvements. “Rising building costs also have an impact,” Worters says.  “Residential construction costs have gone up eight of the past 10 years, including 5.9 percent in 2011.”

“Rising prices for building materials and fuel drive these increases,” she says. “Although demand for building materials has been weak in recent years, production has also slowed, so further price hikes are expected,” she adds.

If real estate values in your area have stayed down or even kept falling, you should still be wary of basing the amount you are insured for on what your home might sell for. “Homeowners who look only at the market value of their home while discounting the reconstruction costs may find themselves dangerously underinsured,” Worters warns. That’s because even though real estate values may have dropped, reconstruction costs have not.

In some circumstances, such as a major disaster that pushes up costs for materials and labor, replacement might cost more than normal. If this is a concern, you may want to ask your insurance carrier or agent about an extended replacement cost policy. This provides additional coverage of 20 percent or more over policy limits.

Inflation Guard Coverage

Another option, inflation guard coverage, automatically adjusts rebuilding costs to reflect changes in construction costs. Sometimes a badly damaged home must be rebuilt under newer and more costly building codes. Ordinance or law coverage pays a specific amount toward these costs.

The Bottom Line

The key thing to remember is that your policy needs to cover the cost of rebuilding your home — not what it would sell for. “Quite simply,” Worters says, “you should have enough insurance to rebuild your home in the event that it is completely destroyed.”

“When Should I Make Changes to My Homeowners Insurance?” was written by Mark Henricks.