Property Insurance Limits in a Declining Real Estate Market

It wasn't that long ago insurance agents were explaining to property owners and mortgage brokers that they didn't need an $800,000 homeowners policy on a 2000 square foot house, even though that was the market value. Property insurance valuations can be done on three valuations, replacement cost (what it would cost to rebuild), actual cash value (replacement cost less depreciation), or agreed value (a fixed number agreed with the underwriter).

The vast majority of property insurance is written on a replacement cost basis. The idea is that if there was ever a total loss to the building, most people would want the ability to rebuild. Replacement cost includes the increased (or decreased) cost of updated building methods and includes the cost of construction to current building codes. Replacement cost is not market value. Market value is what someone is willing to pay for the building and the land in its current state. Replacement cost does not include the value of the land, which can not be destroyed. Just a few years ago, in the booming real estate market, replacement cost was usually less than the market value of the home. Insurance agents were constantly explaining to insureds that just because their house appraised for double purchase price several years prior does not mean that the insurance value needs to be increased. This fight was often lost with the mortgage company with the processor saying over and over again "we need to insure the mortgage value" or "that's not what the appraisal says." Many homes went over insured, and premiums were inflated.

Now most homes have declined in market value. Especially in urban settings, market value of the home is now replacement cost. So what's a homeowner to do? Well, it depends on your objective. If there was a significant loss would you rather rebuild at the same location, or take one of the comparable properties on the market at a lower cost? If you would want to rebuild, you need to make sure the insurance policy limit covers the cost to rebuild. Sometimes that can be found on an appraisal, but most mortgage companies don't require it to fund the loan, so it's often not done. If it wasn't done, your insurance agent can help you determine a replacement cost for you. This number could be higher than the purchase price.

If you would just buy a new home for market value (assuming it's still less than replacement cost), than you would want to insure your home for actual cash value. This is the replacement cost of your home, less depreciation, and is closer to fair market value. The cost per thousand of insurance is slightly higher, but the overall policy cost can be much less. As always, don't let someone else make your choice. Your mortgage broker isn't interested in protecting you and your insurance agent doesn't know what you want. Both replacement cost and actual cash value are good options. In light of deflated home values and foreclosures, evaluate all your options.

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