Are you adequately insured on your Homeowners insurance coverage?

It was not that long ago that many homeowners in California could purchase “guaranteed replacement cost coverage” for their dwelling, and thus not really worry too much about the potential cost of rebuilding if they suffered great damage or even total destruction.  This type of insurance covered the cost of rebuilding — no matter how high the ultimate amount — even if it exceeded the original policy limit.  But too many big and often simultaneous claims over the years — such as the disastrous Oakland Hills Fire in 1991 – put an undue burden on insurance companies and caused the industry to essentially stop offering this type of coverage.  The highest payout is now usually limited to a specified value or an extended but limited percentage or dollar amount above that specified value.

As this new underwriting environment evolved, it led to increasing concerns that homeowners were becoming (unwittingly) underinsured, even if insurance companies were increasing coverage limits to reflect normal inflation.  Normal inflation after all, may not be sufficient to cover the kind of inflation that really “counts,” such as that associated with current construction and materials costs.  This risk of underinsurance was particularly pronounced if the house had been owned for a long time — with guaranteed coverage in place — and without careful re-examination of the adequacy of coverage along the way.  Insurance companies — and their agents who are paid to find and keep business — were typically reluctant to tell consumers that they should be accepting higher premium costs for more, albeit accurate, coverage, because policy holders were likely to balk at the higher expense and move their relationship to another company.  And yet, it was the job of agents to sell products consistent with what they were promoting, offering enough coverage to actually cover rebuilding.

In 2010, a new California state law was passed to reconcile these needs of consumers and limits tolerable to the insurance industry by mandating that the insurance industry provide clear disclosure of policy terms and limits.  AB 2022 set forth a standard and a more understandable disclosure form describing the terms of coverage, written in plain and simple language, to be provided each and every year during renewal.  This “notice to consumers” lists the available choices that homeowners can elect for different degrees of residential dwelling coverage, from most basic to most robust.  This new approach put the burden of full disclosure on insurance companies, but also requires consumers to be informed and engaged in order to make smart choices.

The California Residential Property Insurance Disclosure form includes the following information, with my underlining to draw your attention.  Policyholders need to determine what is most suitable to their own overall needs, based on personal circumstances, capabilities, and budgeting priorities (including the associated cost of the underlying annual insurance premium):

• Actual Cash Value Coverage: pays the costs to repair the damaged dwelling less a deduction for physical depreciation.  If the dwelling is completely destroyed, this coverage pays the fair market value of the dwelling at the time of loss.  In either case, coverage only pays for costs up to the limits specified in your policy.
• Replacement Cost Coverage: is intended to provide for the cost to repair or replace the damaged or destroyed dwelling, without a deduction for physical depreciation.  Many policies pay only the dwelling’s actual cash value until the insured has actually begun or completed repairs or reconstruction on the dwelling.  Coverage only pays for replacement costs up to the limits specified in your policy.
• Extended Replacement Cost Coverage: is intended to provide for the cost to repair or replace the damaged or destroyed dwelling without a deduction for physical depreciation.  Many policies pay only the dwelling’s actual cash value until the insured has actually begun or completed repairs or reconstruction on the dwelling.  Extended Replacement Cost provides additional coverage above the dwelling limits up to a stated percentage or specified dollar amount.  See your policy for additional coverage that applies.
• Guaranteed Replacement Cost Coverage: covers the full cost to repair or replace the damaged or destroyed dwelling for a covered peril regardless of the dwelling limits shown on the policy declaration page.  [This type of coverage is no longer commonly offered or available.]
• Building Code Upgrade Coverage: also called Ordinance and Law coverage, is an important option that covers additional costs to repair or replace a dwelling to comply with the building codes and zoning laws in effect at the time of loss or rebuilding.  These costs may otherwise be excluded by your policy.  Meeting current building code requirements can add significant costs to rebuilding your home.  Refer to your policy or endorsement for the specific coverage provided and coverage limits that apply.  [This coverage is optional, and is in addition to other coverage choices above.]

Of course, determining proper homeowner’s insurance coverage can itself be a daunting task; whether it is being put in place for the first time with a new home purchase, or being considered once again during the annual renewal period (which invites anew any lingering questions about adequacy or whether any changes or new limits apply or should be added).  And the process usually comes with lots of paperwork and verbiage as well as detailed questions and considerations… all in small print!  But it’s more important than ever before to “get it right.”

In addition, while the mandated annual disclosure document is useful and explains levels of basic coverage well, it does not address other possible conditions or restrictions on coverage that could limit how such funds could be received and spent or what type of rebuilding might be permissible or not… and understanding these aspects of coverage are also important and will protect you from surprises.  For example, something called the “cash out option” — which is not available on standard coverage and not even on all high-end policies — enables homeowners to take cash instead of being required to rebuild at the same location.  This feature could make sense if the homeowner is ready to move anyway and would rather not hassle with rebuilding, perhaps to downsize or because children are grown and there is no longer a need to stay in a certain school district.  In some cases, this type of settlement could be greater than market price; and for this reason and the potential moral hazard, it is difficult to find such extra coverage.

Bottom line: there is no substitute for reading your policy and your annual renewal declarations carefully.  If you are ever unsure about your policy limits or coverage amounts, you should contact your agent or broker, or even your insurance company directly for clarification in writing.  You do not want to discover after a loss has occurred that you did not have the right coverage in place.

Moreover, there are different types of valuations placed on property — for different reasons — and each needs to be understood and distinguished.  For example, the property value or “market price” is the price at which it is bought or sold (and on which property taxes are calculated) and this is not the same as an adequate insurance value.  Indeed, the sale price of a property is generally well above what is necessary for adequate insurance purposes since the land on which the dwelling sits is included in the sale price. The current market value also reflects qualitative forces like local economic conditions, school districts, and other community resources… and even the extra premium price that some will pay for views and other “subjective” factors.

But none of this has anything to do with the cost to rebuild — either partially or from scratch — any of the structures on the property that might get damaged or destroyed.  Reconstruction cost includes all costs incurred to fully rebuild the pre-existing home as quickly as possible.  It is based on the cost of materials and labor, and is driven by current demands for construction products and services in the area at the time of need.  It is ideal to have the coverage limit on one’s dwelling structure be high enough to enable one to rebuild the home if it is completely destroyed by a covered peril.  It might be tempting to keep valuation amounts low to help reduce annual insurance premium expenses, but it is not prudent on an overall risk management basis which is what insurance and insurance planning is all about.  Instead, homeowners should avoid being underinsured.  You don’t want to be “penny wise and pound foolish.”

The same mandatory “notice to consumers” lists a number of things to keep in mind when calculating dwelling coverage limits:

• The cost to rebuild is almost always different from the market value.
• Dwelling coverage limits do NOT cover the value of land.
• The estimate to rebuild one’s home should be based on construction costs in your area and should be adjusted to account for any special features in the house.  These features include — but are not limited to — the square footage, type of foundation, number of stories, and the quality of the materials used for items such as flooring, countertops, windows, cabinetry, lighting, and plumbing.
• The cost to rebuild should be adjusted each year to the rate of inflation.
• Coverage limits for contents, separate structures, additional living expenses, and debris removal are usually based on a percentage of the limit for the dwelling.  If the dwelling limit amount is too low, then these additional coverage limits might also be too low.

There is also a phenomenon called “Demand Surge” which should be taken into consideration.  After a widespread disaster, the cost of construction can increase dramatically as a result of unusually high demand for construction labor and materials, and this can increase the cost of rebuilding.  As a result, homeowners should consider increasing their underlying limits or purchasing “Extended Replacement Cost” coverage to help mitigate this possible outcome.

Having given some thought to the right type and amount of coverage, it is also helpful to be familiar with what is covered by Homeowners insurance.  Standard Homeowners policies provide coverage for disasters such as damage due to fire, lightning, hail, explosions and theft.  However, they do not cover floods, earthquakes or damage caused by lack of routine maintenance.  Flood insurance is separately available from the National Flood Insurance Program (NFIP) and from some private insurers.  Earthquake coverage is available from private insurance companies or, here in California, also through the California Earthquake Authority.  [Further analysis of these important topics is beyond the scope of this article.]

The standard Homeowners policy contains two sections.  Section I defines property coverages (A,B, C, and D) and Section II defines liability coverages (E and F).  Here is a brief and typical listing and description of the underlying individual coverages:

• Coverage A – Dwelling
• Coverage B – Other Structures
• Coverage C – Personal Property
• Coverage D – Loss of Use
• Coverage E – Personal Liability
• Coverage F – Medical Payments to Others

While also beyond the scope of this article, there are other elements in a well-crafted insurance plan.  Personal Liability insurance — often called Umbrella insurance — puts an extra layer of protection over your assets if, for example, someone slips on your front doorstep.  If automobile and homeowner’s policies or policies on second homes can be combined with the same insurer, it can result in cost efficiencies because the underwriter can view your overall risk exposure.  Moreover, “riders” to help cover special and/or unique personal belongings and Scheduled articles (like expensive jewelry) should also be considered.  If you are a renter, Renter’s (or Tenant’s) Insurance provides protection for your own personal assets and also liability protection in case someone becomes injured in your (rented) residence.

Finally, it’s probably good practice to make your Homeowners policy readily accessible by “digitizing” it by scanning and saving it electronically since hard copy documents may eventually be inaccessible or destroyed.  It also makes sense to “archive” all belongings and document a complete layout and appearance of the structure(s) to support your entire coverage and to help with any necessary claims — by taking photos and/or videos (and keeping them somewhere secure like a safe deposit box).

Mother Nature is still the “boss.”  We live in a world — particularly a state like California — with many potential risks and perils.  Recent news events about destructive and costly fires underscore this reality.  So determining appropriate and adequate homeowners insurance coverage is critical, to make sure that enough is in place should it ever be needed.  While we do not sell insurance products at Sand Hill Global Advisors, we can help homeowners think through these basic considerations and complement the advice and assistance that they are getting from their insurance professionals.  We provide objective, trusted and independent advice to help our clients achieve financial success.