The replacement cost of a home on a homeowners insurance policy has always been a large part of the policy renewal discussions among home owners, insurance agents, and insurance companies. This is due to the significant role a home's replacement cost plays in insurance pricing as well as its lack of correlation to other home valuation methods like market value and assessed value.
During this discussion, there are several questions raised by home/condominium/cooperative owners who are seeking to better understand their home's replacement cost. Some of those questions are listed below.
- Why is the replacement cost more than what I could sell my house for?
- Why does the replacement cost go up every year?
- Why is the replacement cost more than what it cost me to build the house?
These are legitimate questions with clear and logical answers, and a better understanding of those answers can help home owners achieve their desired outcomes.
At the core of this debate is the general understanding that home owners want to obtain the best coverage at the best possible price. Insurance agents want to ensure their client is well-protected for a catastrophe and sell a policy. Insurers want to provide the best coverage for the client and receive an adequate premium for the risk exposure. Each party's interests are aligned on the coverage aspects, but they start to conflict when it comes to pricing.
This article will provide a basic understanding of a home's replacement cost and what home owners can do to determine their home's replacement cost. It will also answer many of the questions that arise about a home's replacement cost to help interested parties better understand the impact this important number can have on their lives. Lastly, it will provide strategies and tips to assist home owners with managing this critical aspect of their homeowners insurance coverage over time.
Home Replacement Cost Valuation Defined
The replacement cost of a structure is defined as the cost to rebuild a physical structure after it is damaged from a peril like fire, flood, or wind. Here are some of the factors that are included when developing a replacement cost estimate.
| Hard Costs | Soft Costs |
|---|---|
| Millwork (windows, doors, cabinets, etc.) | General contractor (overhead, profit, etc.) |
| Appliances | Architects |
| Concrete block and brick | Designers |
| Hardware (wood, steel, etc.) | Skilled labor |
| Asphalt roofing | Craftsmen |
| Concrete | Debris removal |
| Gypsum products (drywall) | Demolition |
| Paint |
The replacement cost of a structure depends on these factors as well as others, such as the quality of the materials. Additionally, the costs associated with the removal of the destroyed structure need to be included. It is important to understand the factors that make up a replacement cost estimate so that it can be distinguished from other home valuation methods.
What Types of Valuation Methodologies Are Applied to Homes?
There are three primary valuation methodologies used to evaluate real property. They are listed below, along with their purpose.
| Valuation Methodology | Valuation Purpose |
|---|---|
| Replacement cost valuation | To determine the level of insurance coverage needed to protect the home owner, bank, and other interested parties from financial loss caused by a physical damage loss to the home |
| Market valuation | To determine the listing price of a home for sale |
| Assessors/taxable valuation | To determine the property tax to be paid by the homeowner |
Each valuation process has its own purpose, and each is arrived at in its own unique way.
Market Value versus Replacement Cost
Home owners may compare the market value of their home to its replacement cost and find the numbers are very different. The fact is that the market value of a home and its replacement cost are separate and distinct numbers.
Here is an example that demonstrates this difference.
| HOME IN LOS ANGELES, CA - 1723 RD ROSCOMARE | |
|---|---|
| MARKET VALUE | REPLACEMENT COST |
| Listing price: $1,849,000 | Replacement cost: $1,000,000 |
| 3 beds | Year built: 1965 |
| 2 baths | Architectural style: Ranch |
| 1 half-bath | Cooling system: Central A/C |
| Living space: 1,916 sq. ft. | |
This example shows a home with a lower replacement cost than market value, which is not always the case. It should be noted that the values of a home may be reversed depending on its size, location, and quality of construction.
What Can Impact the Replacement Cost of a Home?
One of the major challenges with estimating the replacement cost of a home is that there are many factors that could cause the replacement cost to increase after a loss that are unknown when the replacement cost estimate is being developed. Some of those factors are listed below.
- Demand surge after a catastrophe
- New technologies being used in home construction (Internet of things devices, green building, etc.)
- Changing construction code requirements
- Limited availability of skilled labor after a catastrophe
- Government restrictions on site access enforced after a catastrophe
- Trends in materials costs
- Fluctuating fuel costs
According to CoreLogic's quarterly construction cost reports, construction costs are always increasing, and catastrophes can cause even greater increases than what is seen in normal times. These facts make it critical to properly estimate a home's replacement cost when coverage is being placed. Once an estimate is determined, a homeowners policy can be designed to contemplate the balance of the unknown risks that may arise.
How Do Home Owners Maintain Adequate Coverage?
There are several coverage options available in the insurance market to help home owners avoid being underinsured after a major loss to their home. Here are some of the most important ones to be aware of.
Inflation Guard
Each year construction costs increase, and the inflation guard will automatically increase the replacement cost of a home by a certain percentage at renewal to ensure the home continues to be adequately insured. These increases generally fall in the 2–5 percent range in normal times but can increase above that when there are events that significantly impact the cost of construction.
Most homeowners policies include an inflation guard feature, but not all do, so it is important to check for this. (Helpful tip: excess flood, wind, and other policies written through excess and surplus lines insurers may not include an inflation guard and should be checked annually to ensure the coverage limit is adequate.)
Guaranteed Replacement Cost Coverage
This coverage option has no limit on the amount that the insurance company will pay to rebuild a home. Once the replacement cost of the home is set (typically done by a professional replacement cost appraiser), a covered loss will be covered no matter how much it costs to rebuild. This is the best insurance coverage available to cover a home.
Extended Replacement Cost Coverage
This coverage provides additional coverage over and above the replacement cost of the home stated on the homeowners policy. Insurance companies may have different levels of extended replacement cost that offer higher coverage limits for an additional premium. Typical extension percentages are 125, 150, and 200 percent, which indicate how much the insurance company will pay over the replacement cost limit that is listed on the policy if needed.
Extended Replacement Cost Example
Dwelling replacement cost—$500,000
Extended replacement cost option—150 percent
Maximum limit the insurance company will pay in a total loss—$750,000
This coverage helps protect homeowners from situations that may cause them to be underinsured.
Calculating an Adequate Replacement Cost Estimate
There are three steps in generating an adequate replacement cost.
- Provide detailed construction data about the home.
- Assess the quality of materials and craftsmanship.
- Enter this data into a replacement cost estimation tool.
There are several replacement cost estimation software tools that insurance agents and insurers use to estimate replacement costs. Home owners should make sure any unique construction details about their home are included in the estimation process. Here are 11 of the most critical data points to include in an estimate.
- Type of foundation
- Type of construction (i.e., frame or masonry)
- Roofing materials and type of roof
- Siding materials and type of siding
- Whether the structure is located on a slope
- The square footage of the living space
- The geographic location of the property
- Number of stories and any nonstandard wall heights
- Materials used in interior features and finishes, such as the type of heating and air conditioning system, walls, flooring, ceiling, fireplaces, kitchen, and bath(s)
- Age of the structure or the year it was built
- Size and type of attached garage
Managing Home Replacement Cost
Homes are typically owned for many years, which means the insurance will be in place for a long time and updates will need to be made to the policy. Here are a few strategies to help manage a home's replacement cost over time.
- Desk appraisal. Every 3–5 years, work with an insurance agent to conduct a new replacement cost estimate. This can be done by entering updated information about the home into a replacement cost estimation program.
- On-site or virtual appraisal. If it's been 8–10 years after an initial appraisal, conduct a new professional appraisal of the home. This may entail the home owner or insurance company hiring a professional to do this. This will help ensure the home owner can purchase an adequate amount of insurance going forward.
- Renovations and updates. Always provide information about any renovations or updates that could increase the home's replacement cost. This includes additions, kitchen renovations, bathroom renovations, and the addition of other structures on the property. This information may also be used to apply additional discounts to a policy.
Conclusion
It is very helpful to work with a knowledgeable, independent insurance agent who specializes in estimating home replacement costs throughout this discussion. The specialist insurance agent knows how to work with underwriters, risk managers, and local builders to arrive at a consensus that is in the best interest of the insured. They will also have access to the tools and information needed to guide you through this important process. Taking the time to understand the makeup of a home's replacement cost and the strategies that can be utilized to manage it will help ensure that the home is adequately insured for a total loss.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
