The challenge of insuring to value

One of the constant challenges for personal lines underwriters and agents involves the issue of insuring to value. Underwriters and agents have long haggled over the proper amount of coverage for Coverage A for many a property. The insurer wants the property insured for the amount it will cost to rebuild it, so they charge a fair premium for the exposure.

Unfortunately, many insureds don’t understand this principle and think the property should be insured at its market value. At times, there is a significant discrepancy between what homes are selling for in a particular neighborhood because of market conditions and the actual cost to rebuild the dwelling as it was before the loss.

Insuring for replacement

Insureds don’t realize that if the house is completely destroyed, it will have to be rebuilt. Instead of looking at what the house next door sold for a few weeks ago, the insured needs to consider the current cost of labor and building materials. Those costs will determine the replacement cost of the property, not the sales price of similar houses.

Another thing insureds fail to realize is that any improvements made to the dwelling over time do not automatically raise their insurance coverage limit. That beautiful new deck with the outdoor television and large barbeque pit, the man cave downstairs complete with bar, pool table and fireplace, that new media room or mother-in-law suite, and the list goes on, all add value to the house. Unfortunately, while insureds think of increasing the potential selling price of their home, they don’t always associate that with the need to update the value of their insurance to cover the replacement cost of those upgrades in the event of a loss.

In addition, there are catastrophic losses where entire subdivisions are destroyed. When a large area suffers a disaster like a wildfire or severe tornado, area contractors will have more business than they can handle, and building materials may be in short supply. If the entire subdivision burned, it is quite possible that the area’s lumber supplier may have also been destroyed, adding to the cost of its replacement. Contractors will have difficulty obtaining materials and finding an adequate number of workers, and may have to hire more subcontractors at higher wages, driving up the replacement costs. While that does not cause premiums to increase at the time of loss or rebuilding, dwellings in an area prone to such disasters will be rated accordingly, and the true replacement costs must also be considered.

The supply chain disruption

In 2020, a global pandemic arrived affecting, among other things, worldwide supply chains, and causing a significant increase in the prices of many goods. As of February 2022, lumber prices had tripled from their pre-pandemic rates, and they continue to maintain that level today. This increase in costs and shortage of materials has driven up the cost of building or rebuilding a home by roughly $19,000. With the added supply chain issues arising out of the Russian invasion of Ukraine, the numerous container ships stuck in ports, plus the adverse effects on the oil supply, the cost of goods and services is expected to continue escalating.

Insuring a home at its replacement value will become more expensive as many are updated and improved. Then, there are the adverse effects of inflation. Homeowners and agents must consider these factors when determining a home’s insurance replacement value.

The impact of underinsurance

So what happens when a home is underinsured? It is a matter of degrees. If the home is insured to at least 80% of its replacement cost, then the loss will be covered up to the policy limit. More may be paid if the insured adds an endorsement that increases the replacement cost.

However, if the home’s insured value is less than 80% of its actual replacement cost, the valuation parameters are different. The policy will pay either the greater of the actual cash value of the damaged portion of the building, or the proportion of the cost to repair or replace (after the deductible) that the damaged part of the building bears up to 80% of the replacement cost of the building. This concept is called “insurance to value.” When a building is insured at its true replacement cost, it is insured to its value. If the building is insured at less than its true replacement cost, then it is underinsured. It is overinsured when it is insured at more than its true replacement cost.

We’ll use a total loss scenario for the following example of underinsurance.

A property is insured for $200,000. The actual replacement cost of the property is $300,000. Eighty percent of the replacement cost is $240,000. That is the amount the property should have been insured for. Therefore, the amount of the insurance, $200,000, is divided by the amount the insured should have had, $240,000, which calculates to 83%. The 83% amount is then multiplied by the amount of the loss, $200,000, to determine the amount the insured receives. The $200,000 multiplied by .83 is $166,000. Therefore, the insured will receive $166,000 for the loss, not the $200,000 Coverage A amount listed on the declarations. The policyholder was not insured to 80% of the replacement cost of the property, meaning the property was underinsured with respect to the true replacement cost of the building.

While this situation typically is not the case, especially not when building costs are at their highest, there may actually be occasions when an insured property is overinsured. Overinsurance happens when a building is insured for more than its replacement cost. This could happen when an insured looks to make sure he is fully compensated, so he inflates the value of the building to more than what it would actually cost to replace it with like-kind-and-quality materials. This inflation could be for sentimental reasons, such as a generational family home, or simply because the insured wanted to build in extra insurance to capture potential upgrades to the home. It’s also possible the house is the most expensive home in the area based on market value. Regardless, the insurer will only pay the true replacement cost to rebuild the home with its same functionality as before the loss. The insured will not be able to recoup any additional money above the true replacement cost, regardless of the insured value. Further, the additional premium paid to insure the building at its excess value cannot be recouped. To determine if a building is overinsured, use the same basic formula used to calculate underinsurance.

For example, if a property is insured for $300,000 and the actual replacement cost of the property is $250,000, 80% of the replacement cost is $200,000. That is the amount for which the property should have been insured. Therefore, the amount of the insurance, $300,000, is divided by the amount the insured should have had, $200,000, which yields 1.50%. In this case, the insured will only receive the replacement cost value, $200,000, and will lose the excess 50% or $100,000, in value.

Christine G. Barlow, CPCU, (cbarlow@alm.com) is the executive editor of FC&S Expert Coverage Interpretation, the authority on insurance coverage interpretation and analysis for the P&C industry.

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