A homeowner’s policy covers your residence, but you already knew that.
What you might not know is that not all homeowner’s policies are created equal. The biggest challenge with homeowner’s (and auto) policies is that the policies are familiar—everyone already has one and thinks they know everything they need to know about it already. Yet, with insurance, it’s what you don’t know that can hurt you the most. Let’s start with the basics.
Homeowner’s policies have two parts—the first part covers your property and the second part provides liability protection.
Part 1 – Property Coverage
Depending on the type of homeowner’s policy, your home will be protected against various perils such as fire, windstorm, hail, vandalism, etc. Land is not insured.
The contents of your home are also protected. Most homeowner’s policies will automatically cover the contents up to a maximum of one-half of what you insured the structure for. For example, if your home is insured for $500,000, you will automatically have $250,000 in content protection. Not all of your contents are automatically protected. Homeowners routinely overlook certain limitations on property coverage.
Policies usually restrict the amount of coverage on jewelry, furs, gun collections, flatware, and animals. Automobile coverage, business-related claims, and credit card losses are almost always excluded. In addition, property that belongs to someone else—even if it is in your home—is generally excluded unless the property belongs to a relative who lives in your home.
Part 2 – Liability Coverage
- Liability insurance.
Homeowner’s policies also provide liability protection for damage or injury incurred inside or outside of your home. This is usually the first line of defense if you are involved in a lawsuit that wasn’t the result of an automobile accident. For example, if a guest in your home slips and falls on the patio, the liability protection from your homeowner’s policy will pay the judgment up to the policy’s limit. If the judgment is greater than your policy’s limit, your umbrella liability policy will provide additional coverage.
Liability protection is not limited to lawsuits caused on your property. If your son is involved in a basketball game at his school’s playground, and accidentally elbows another player and breaks his nose, your homeowner’s policy will pay his medical payments and any judgment up to the limits of the policy.
Liability protection is not limited to injury claims. If you leave your sprinkler system running while on vacation and the water floods your neighbor’s basement, your homeowner’s liability policy will pay for the property damage to your neighbor’s home up to your policy’s limit.
Unlike content coverage, the amount of liability protection varies considerably and is not set by a formula based on the amount of dwelling coverage.
There are three different types of homeowner’s insurance coverage.
- An HO-3 insurance policy is the most comprehensive policy you can buy for a house—that is, it covers against the most perils. Even though this is the “Rolls Royce” of policies, it won’t typically cover your home from damage as a result of earthquakes, floods, tidal waves, war, termites, or nuclear accidents.
- An HO-6 policy is for condominiums and co-ops. Since the common areas, exterior walls, and structure are covered by the homeowner’s association’s insurance policy, condo/co-op owners only need coverage for their internal walls, personal property, and liability.
- As a renter, the only coverage you need is for your personal property and liability. The apartment owner is responsible for buying insurance for the building. An HO-4 policy provides renters the protection they need.
Do I need homeowner’s insurance?
Their home is the single largest asset for many people. A comprehensive financial plan would not be complete if you failed to ensure adequate protection for your home and your personal property. If you could buy an inexpensive insurance policy protecting the value of your investment accounts from a market crash, would you? Of course! The question is not do you need it, but what kind do you need.
There are two types of coverage and most homeowners do not know the difference until it is too late.
- Actual cash value. This type of homeowner’s policy will reimburse you the actual cost of the dwelling or property at its fair market value immediately before it was damaged. If you purchased a dresser for $1,500 eight years ago, it may only be worth $300 today. If it was destroyed by a fire, an actual cash value policy would only reimburse you $300. This kind of policy has obvious problems. Insurance should be like a childhood “do over” or the computer’s “undo” function. The purpose of insurance is to make you whole again—to replace what you lost. If your dresser is destroyed, you need to buy a new one. Can you buy a new dresser for $300? If the dresser you owned was $1,500 eight years ago, it will probably cost a lot more than $300 if you needed to replace it today. This is the problem with cash value insurance. It will only pay you what the property is worth, not what it will cost to replace it.
- Replacement-cost. Although it will cost more, this is the type of coverage you should try to have. A replacement-cost policy will reimburse you for the actual cost of replacing the damaged dwelling or contents—regardless of the property’s age or condition. If a similar dresser is now worth $2,300, the insurance company would pay you this amount so you could replace the dresser that was destroyed. Replacement-cost coverage actually does make you whole. It provides that childhood “do-over” as much as it is possible after a loss.
A little known caveat with replacement-cost coverage is that the policy should rebuild your home based on current building codes in the event of a loss. For example, if new homes being built require double pane windows in order to be built to code, you want to make sure that your replacement-cost insurance policy will pay to have double-pane windows installed in your home if your home is destroyed. Not all policies cover this. If your home is destroyed, you want to make sure that you won’t be out-of-pocket for any costs, even those as a result of new building specifications that were not required when your original home was built.
For additional protection, I highly recommend obtaining “replacement-guarantee” coverage. This is a special type of policy that guarantees the insurer will pay the full cost to rebuild your home even if the cost is more than the amount of coverage on your policy. With the cost of materials and construction increasing steadily, if you can afford it, you should have this kind of protection.
Be careful. Some homeowner’s policies will have replacement-cost coverage for the dwelling but not for the contents or vice versa. Make sure that both your residence and its contents are covered by replacement-cost.
Insuring Against Things That Typically Aren’t Included In A Standard Policy
Although most homeowner’s policies protect against many perils, they do not protect against them all. Even the Rolls Royces of policies specifically exclude earthquakes and floods. Depending on your location, some of these excluded perils may be real and all too often threats to your greatest asset. To remedy the situation, you must obtain a separate policy specific to the excluded perils.
Certain agencies offer up to $250,000 of basic flood insurance through the federal government’s National Flood Insurance program. You must purchase any additional protection through a private insurance company. If you live in an area prone to flooding or where there is even a slight chance of flooding, purchase a flood policy.
You may also need earthquake insurance. Finding an insurer that will cover earthquake damage may be difficult. Fewer companies are providing this protection, and of those that do, most have a high deductible (10%-15%) and may put restrictions on content coverage. California homeowners can purchase insurance through the California Earthquake Authority—a state agency providing limited earthquake policies, but these policies have a 15% deductible and only cover a maximum of $5,000 of content protection.
When deciding on these additional policies, remember that homeowner insurance is to cover the one time out of a million that something will happen to your home. However, don’t neglect coverage just because it is unlikely you will need the protection. If there is any chance, weigh the costs of insurance against the costs of a potential claim. If you can afford the premium but cannot afford the cost of replacing your home, get the additional policies.
Personal content protection is usually set at one-half the value of your dwelling’s limit. While this may be more than enough for your personal property, if you own jewelry, furs, antiques, or artwork, you will need additional coverage—even if these items are valued within your policy limits. Why? These items have specific limitations on most homeowner’s policies. For example, jewelry has a cap of $1,000. If you lose your wedding ring worth $4,500, your standard homeowner’s policy will only pay $1,000. If you own valuable art or antiques, these will be significantly underinsured unless you separately schedule them under your policy.
To schedule jewelry or other items on your policy, ask your insurance company specifically what they require. Typically, they will need a detailed description of the property with pictures and literature to substantiate their value.
How much homeowner’s insurance do I need?
According to Marshall & Swift/Boeckh, 64% of homes were underinsured by an average of 27% in 2003! They cite that one of the reasons for this huge amount of underinsurance is that construction costs have been increasing dramatically.
With any insurance policy, the more coverage you want, the more you have to pay. The easy answer is that you need enough to make you financially whole and no more. How much it takes to make someone financially whole varies considerably based on the type of coverage.
- Dwelling coverage. Insurance on the physical dwelling should be at least 80% of the value of the property for two reasons. One, part of your house’s value lies in the land. Since homeowner’s insurance only covers the structure and not the land itself, 80% is a good amount of insurance. For example, if a house is valued at $1,000,000, a homeowner’s policy for $800,000 may be sufficient. Two, if a home is insured for less than 80% of its value, the homeowner will be required to pay a coinsurance penalty, which is like an extra deductible, on any claim. For example, if a $1,000,000 house is only insured for $400,000, the homeowner must pay 50% of any claim out of their own pocket—since they were only insured for 50% of what they should have been ($800,000). They call it “co” insurance because you and the insurance company are insuring the property together. By not insuring the home for what you should (80% of its value), you are basically telling the insurance company that you want to be responsible for paying the percentage of coverage that you lack. In this example, since you chose to not cover 50% of the home, you are responsible for 50% of the value of all claims. You are not an insurance company, so don’t act like one. Get at least 80% coverage for your dwelling.
- Personal content protection. Again, this coverage is typically set at one-half the value of your dwelling’s limit. Calculate the cost to replace all of your personal contents. If it is less than one-half of the value of your dwelling coverage, this coverage probably protects you. If your contents are worth more, contact your insurance company and increase the limit for personal contents.
- Restricted personal items. Remember, if you have antiques, artwork, or jewelry valued at more than your policy’s limits, get them scheduled on your policy immediately for their replacement-cost.
- Liability protection. I strongly recommend an umbrella liability policy that sits on top of your automobile and homeowner’s policy. Increase you homeowner’s liability premium so there is no gap in liability coverage between your homeowner’s policy and the umbrella policy. Most umbrella policies start coverage at $500,000, so your homeowner’s policy would need liability protection up to $500,000. Check with your insurance company to make sure there is no gap in liability coverage.
The proceeding blog post is an excerpt from The Six-Day Financial Makeover: Transform Your Financial Life in Less Than a Week!, available now on Amazon.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.