Home destroyed by Hurricane Elena (Photo credit: State Library and Archives of Florida)
I recently received a call from a friend of mine asking questions about his newly acquired rental property. He had just moved from a duplex where he owned the entire duplex and lived on one side. Having purchased a home and finding a new tenant to replace where he was living, he was surprised and upset when his insurance on the duplex nearly doubled.
After some debate he decided to reduce the replacement cost of the building that the insurance company had placed on the building from $500,000 to $250,000. This, of course, sent red flags flying in every direction in my brain.
His first question to me was why his insurance nearly doubled. The reason was that since he was no longer a tenant in his own duplex the insurance company assesses that as more risky and adjusts the premium accordingly. He further commented that the replacement cost was just too high and that he hadn’t paid nearly $500,000 for it and even $250,000 seemed high.
This is what I explained to him. When an insurance company assesses the cost to rebuild your home, a number of factors go into that assessment. They will look at the price and kind of materials to rebuild, labor, style of the home, basement or not, landscaping, number of bedrooms, bathrooms, and more. When the home was first built, almost always the materials and labor were cheaper and chances are the home was built (if in the city) in conjunction with several homes in the subdivision. Big trucks, cranes, etc. could be used to build the home. Now it may take several workers with wheelbarrows to do the same thing so as not to infringe on the neighbor’s rose bushes.
In addition, insurance doesn’t care what you paid for the home, just what it costs to rebuild it. If the duplex was purchased for $125,000 in 1973, that $125,000 had much more purchasing power than it does today in 2013.
This leads to the heart of this story – the coinsurance clause.
Many insurance policies contain a clause that states that your home needs to be insured to at least 80%of its reconstruction cost. This means that in the duplex above, the home needs to be insured for at least $400,000. As long as a building is insured for at least 80% of the reconstruction cost then the insurance company will pay the full replacement cost of the home.
If not, a formula is used and you can guess it’s not to the insured’s advantage. For the duplex above, let’s say we had a $100,000 loss from a fire. In this case the policy would use the formula which is what the duplex is insured for ($250,000) divided by what it at least has to be insured for ($400,000) multiplied by the amount of the loss ($100,000).
So: ($250,000 / $400,000) x $100,000 = $62,500.
In this case, the insured would only get $62,500 for a $100,000 loss! This example also ignores any deductible which would bring that amount even lower.
Before we got off the phone my friend was now very concerned he was under-insured. He promised to look at his policy and get back to me to see if the coinsurance clause applied to him.
I highly suggest our readers consider doing the same.
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Sterling Raskie, MSFS, CFP®, ChFC®
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