An interesting question and perhaps the most frequently asked when trying to determine the limit of insurance necessary to protect your property in case of loss. In insurance lingo, this concept is known as “insuring to value.” When trying to determine what this limit should be, most people immediately think of the market value of their property. However, market value has no bearing on the cost to rebuild or repair in case of loss. Frequently, clients insist that their property be insured for the selling price they believe they can get in today’s market, or for the price they paid when they purchased the property. This thinking can inflate the cost of the insurance, or worse yet, leave one improperly (underinsured) insured at the time of a loss. So what standard should be used to determine the correct limit of insurance?
Keep in mind that land doesn’t burn and, therefore, doesn’t need to be repaired or rebuilt. So it follows, that even if you paid separately for the land and the structure, you don’t need to include the value of the land in the limit of insurance you choose. Structures can, and do, burn including both the main structure as well as any “appurtenant structures” such as garages for example. When establishing the value of your property you want to choose a limit of insurance that reflects the cost to repair of rebuild in case of partial loss or total loss. When in doubt a good rule of thumb, used by insurance carriers, is $175 to $200 a square foot. (Keep in mind that this figure is only to be used as guide when trying to determine insurance to value.) Since inflation is often a factor in contracting costs, many insurers include automatic percentage increases in their policies which range from 2% to 8% a year to cover such contingencies.
There is also an 80% rule which is utilized by insurance carriers. This rule, called “Coinsurance,” requires that a homeowner or building owner have a limit of insurance that is equal to at least 80% of the total replacement cost of the structure. A breach of this requirement, results in a penalty that can leave the property owner a participant, or a “coinsurer,” at the time of loss. In short, the insurance company will only pay a loss based on the limit of insurance carried, to the limit which should have been carried to meet the 80% requirement. Often clients think that they can save money by choosing an arbitrary building limit, until they encounter this situation at the time of loss and then it is too late!
For example, I own a home with a replacement cost of $300,000. (Some of my neighbors have recently sold similar homes on my block for upwards of $450,000. Remember, however, that the price I can sell my home for has nothing to do with the limit of insurance I need. If I were to build an exact duplicate of my home on some exotic island it might sell for over $5 million, but the replacement cost is still that same $300,000.) 80% of $300,000 is $240,000 which is the limit of insurance I need to meet the 80% requirement. Any lesser amount will generate a penalty. As a consequence, I won’t be paid in full at the time of loss. Let’s say that I decide to insure my property for $200,000. Subsequently, I have a loss and the damages are approximately $100,000. Even though this is not a total loss, undoubtedly, I will suffer a coinsurance penalty. Here is how this works: $200,000/$240,000 = 91.67% and the carrier will only pay me 91.67% of the loss or $91,670. The remaining $8,330 is my portion of this loss, and on top of this, the carrier will further reduce my payment to reflect the deductible I chose when I took out my policy.
Remember, any renovations or major changes to structure such as adding a room or extending the property will change this requirement, so it is imperative that you review your policy limits with your agent on, at least, an annual basis!
– Karen Skoler, CPCU