The Home Insurance Mistake You May Be Making
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The Home Insurance Mistake You May Be Making

Think that if you lost your home in a disaster, insurance would pay to rebuild it? Think again. Most homes are significantly underinsured. Here's how to make sure you don't get a shock.

Common Coverage Options

Last June, after an electrical fire gutted their century-old Brooklyn home, Steven Lawitts and Nancy Ranger counted their blessings. No one was hurt, and they expected their homeowner's insurance would cover them. Even though they had been careful to maintain their replacement insurance policy with inflation protection, they didn't bargain on the estimated $50,000 needed to upgrade their original plumbing system, which couldn't be replaced as it was but had to be brought up to code. "Turned out our policy didn't cover that," says Lawitts.

A whopping 61 percent of American homes are underinsured by an average of 25 percent, according to a recent report by Marshall & Swift/Boeckh, a company that tracks building costs in North America. Anyone with a mortgage must carry some form of home insurance, and more than 95 percent of homeowners do. But, like Lawitts and Ranger, these families may eventually find that even though they're insured, they will be responsible for substantial out-of-pocket costs if they're forced to rebuild and don't want to settle for a lesser home than the one they were in.

One cause of underinsurance is confusion about what's covered by very different policies with very similar names. Here's an overview of the most common options, so you can determine what's best for you.

  • Guaranteed Replacement Coverage. These policies cover whatever it takes to restore part or all of your house as closely as possible to the way it was, without financial limit. They guarantee that if your house is destroyed, it will be rebuilt to the same structural specifications and out of comparable materials (although they do not necessarily insure that one-of-a-kind materials will be replicated). Although these are not the least expensive of policies, the premiums are usually not unreasonably high. Unfortunately, these policies are increasingly rare, in part because insurance companies are reluctant to issue and fulfill them, owing to soaring costs.
  • Replacement Coverage. While it doesn't guarantee that your house will be replaced as is and in full, this kind of coverage does insure your property up to a specific dollar amount, without any depreciation. The financial risk here stems from the rising cost of construction. A replacement amount that seems sufficient when you first buy the house may not cover the costs of reconstructing it 10 years later.

Insurers also offer extended replacement policies, which add a cushion of an additional 20 percent to 25 percent of coverage to the value you and the insurance company agree to insure your house for. Depending on the amount stipulated, replacement and extended replacement policies "can both be good deals," says Jeanne Salvatore, vice president of consumer affairs at the Insurance Information Institute, in New York City.

  • Modified Replacement Coverage. This alternative lets insurers minimize the costs of repairing any damage done to older homes by using modern materials if they are less expensive than the original materials they are replacing. For example, when you have one of these policies, your original plaster walls might be replaced with Sheetrock.
  • Luxury Home Policies. If you want to be sure that those stained-glass windows and customized moldings will be replaced with items of equal quality, this may be the right option for you -- if you can afford it. Names for these policies vary, but Chubb and other firms specialize in such products for expensive homes. Bear in mind that, like most other forms of home insurance, these policies won't necessarily cover all of a home's contents. For jewelry, fine paintings, antique furniture, silverware, and other valuables, you'll probably need extra endorsements known as "floaters" or "riders."
  • Actual Cash Value Coverage. These policies are the least expensive but also the least desirable. The insurance company assesses the value of your house according to its age and condition, not market value. So although you'll have lower premiums, your policy won't give you enough to replace your home as it was.

Policy Supplements

In addition, there are supplements to those policies that you can use to customize your coverage:

  • Building Code Upgrade Insurance. When older buildings require major repairs or reconstruction, whatever's out of date will need to be brought up to the latest code standards. As a supplement to your basic policy, this upgrade will help with those costs.
  • Inflation Guard Endorsements. The value of your property, as well as the costs of construction supplies and labor, will most likely continue spiraling upward. This policy provides a buffer for those costs. "The insurer automatically raises the amount of insurance according to a formula that takes into account a variety of indexes that track inflation," explains Tim Wagner, director of insurance for the state of Nebraska.

The key to getting the coverage level you need is to select the right coverage amount. Homeowners often assume that since they were able to get a mortgage on their homes, their current protection is adequate, but that's not true. Some homeowners are covered only for the amount their home cost them to buy, not the total price of reconstruction. To get a more accurate idea of what it would cost to rebuild your home with the same materials inside and out, your best bet is not necessarily an insurance assessor or a real estate agent but local home contractors and builders, who will be able to assess more accurately the cost of rebuilding (which is often not the same as market value). To get a ballpark figure, call several nearby companies in the industry and ask for the price of construction per square foot.

After you've decided on your best policy choices, shop around. Even within a city, policies, coverage and prices vary widely. Independent insurance brokers, who work with multiple agencies, may be able to handle much of your preliminary legwork, and their commissions are usually paid for by the insurance companies.

Finally, once you've gotten the coverage you want, review it regularly. The details of policies can change from year to year, so be sure to read the updates from your insurance company. "When you get your renewal notice, do a side-by-side comparison," recommends Jim Hurley, director of public information for the Texas Department of Insurance. And be sure to factor in any home improvements you have made. If that new deck or renovated bathroom hasn't been reported, it won't be rebuilt.