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Clients at Risk: Confusing Home Market Values With Rebuilding Costs

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What’s a tempting way for a client with a home insured for $2 million to potentially lose $600,000?  He or she can cut the amount of coverage for their home by 30%, thinking that it doesn’t need as much insurance because home prices have fallen by a similar amount since mid-2007.  But this attempt at reducing premium payments—so tempting with the weak economy and housing market— is based on a dangerous misconception. 

The amount of coverage needed to adequately insure a home does not necessarily track its market value.  In fact, recent data shows that while market values continue to decline, insured values are holding steady or going up. If the client’s home were destroyed by fire, most homeowners insurance policies would not provide enough insurance to rebuild it. The family would have to settle for a smaller home or cover the insurance gap out of their own pocket. 

This problem is not theoretical. ACE’s survey of 600 independent insurance agents found that inadequate insurance for the home was one of the most likely and serious problems of being underinsured. Another study by Marshall & Swift/Boeckh, a leading worldwide provider of building cost data and estimating technology, found that 64% of American homes were underinsured. 

Home market values and insured values do not correlate because they depend on a vastly different set of factors. The market value of a home can be influenced by mortgage rates, the number of homes for sale versus the number of potential buyers, the quality of the school system and other community services, the ease of commuting to major work centers, and more. 

By contrast, the insured value of a home depends entirely on the potential cost of rebuilding the home if it were destroyed. Therefore, changes to the insured value of a home must reflect changes in the cost of construction materials and labor. Evolving building codes, debris removal regulations and other factors can also affect the cost of rebuilding. Surprisingly, these factors are driving rebuilding costs up. 

Prices of construction materials have increased due to global demand, especially from Asia. For instance, in the first quarter of 2011, steel pipe was up 12.9%, copper was up 7.8%, lumber and plywood was up 2.3%, and crude petroleum, which affects both material and transportation costs, was up 17.1%. 

You would think that at least labor costs would have decreased, considering the high rate of unemployment in the construction sector.  But skilled labor costs actually held steady in the first quarter, rising about 0.1%. Why? Workers simply dropped out of the labor pool, and union rates are slow to move even when demand drops. 

Regulations have also been getting tougher. Environmental concerns have driven up the cost of removing and disposing debris from the destroyed home. New lead paint removal requirements have raised the cost of renovations. (Sources for all the above data above include the Bureau of Labor Statistics, Engineering News Record, Producer Price Index and Random Lengths Composite Price.)

As a result, advisors should encourage homeowners to resist the temptation to reduce coverage.  Instead, to ensure the home is properly insured, they should seek policies that provide full replacement cost coverage. Offered by only a few carriers that specialize in insuring high-value homes, full replacement cost coverage promises to fully rebuild the home with similar quality materials and craftsmanship no matter how much it costs in relation to the coverage limit in the policy. 

In effect, this coverage shifts the responsibility for properly estimating the cost of replacing the home to the insurance company. Therefore, the carriers will often send an expert to a newly insured home to document its features and estimate the replacement cost. In subsequent years, the company will adjust the value to reflect changes in construction costs so that the home stays adequately insured.


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