Homeowners insurance replacement cost and market value are often treated as though they mean the same thing.
They do not. Understanding the difference matters because the amount your home could sell for may be very different from the amount it would take to rebuild it after a major loss.
Market value is the amount a willing buyer may pay for your home. Replacement cost is the amount it would cost to replace your home as it is today.
Those two numbers can be close, but they can also move in different directions. A home purchased 10 years ago may now have a much higher market value. At the same time, the cost of labor, building materials, and other parts of the construction process may also have increased. If the replacement cost listed on an insurance policy has not kept pace, the homeowner could have a meaningful gap in coverage.
Consider a home with a current market value of $700,000 and an insurance policy showing a replacement cost of only $450,000. That creates a $250,000 difference between the two figures. The concern is not simply that the numbers are different. The concern is whether the policy would provide enough coverage if the home had to be rebuilt. The replacement-cost amount should not lag significantly behind the home’s current value.
That is why homeowners insurance should not be something you purchase and then ignore for many years. A regular review can help you understand what the policy covers and whether the replacement-cost amount still reflects current conditions. Reviewing the policy about every two years can be a reasonable way to keep the information from becoming outdated, especially if it has not been evaluated in the last five or six years.
Important items to review include the following:
- The replacement-cost amount currently listed on the policy.
- The home’s current market value.
- Whether labor and material costs have changed since the policy was last reviewed.
- Whether the policy includes adjustments that increase replacement-cost coverage over time.
- The deductible and how much you could comfortably pay out of pocket.
- The premium change that could come with higher coverage.
Reviewing every couple of years does not mean you need to increase the coverage that often because it is important to note that increasing replacement-cost coverage may also increase the insurance premium. After reviewing you may want to sit down with your insurance agent or broker and discuss potentially increasing coverage.
The deductible can be an important part of that review. It represents the amount the homeowner would need to pay out of pocket. Policies that once carried deductibles of $250 or $500 may now have deductibles of $1,000, $2,000, or more.
A higher deductible can lower the premium, but it also increases the amount that must come from the homeowner’s own resources. Someone with enough cash flow or available assets may decide that a higher deductible is manageable. Someone else may prefer a lower deductible because a larger out-of-pocket expense would be more difficult to absorb.
The goal is not to select the lowest premium or the highest possible coverage without considering the rest of the situation. The goal is to understand the tradeoffs. Replacement cost, market value, premium, deductible, cash flow, and available assets all work together.
Homeowners insurance is easy to overlook until it becomes necessary. Reviewing the policy before a loss occurs can help reduce the chance of discovering too late that the coverage amount no longer reflects the cost of rebuilding the home.
Financial Enhancement Group is an SEC Registered Investment Advisor.
This content is for educational purposes only and is not intended to be financial, investment, or tax advice. Please consult with a qualified advisor regarding your specific situation.
