Real Estate Value vs. Insurance Replacement Cost Value

Does it seem that the value the insurance company says you need to cover your home is out of whack with the local Tax Assessor or Zillo values? It is true that real estate values around our area are commonly lower than the value required by your insurance company.  That’s not always the case. Depending on the economy and demand for houses, the comparison could be flip flopped!

The cost for you to buy an existing home is usually less then to have it built new. That difference is not just for the custom features you get when building new. It is the costs of new building materials, building and fire code changes, and the increased cost of labor. 

In the suburbs of Boston, the residential real estate market is booming. It’s not uncommon for a house to have increased in value by 40-50% over the prior year. If you owned a lot last year and sought quotes to build a new house on it then, the construction costs have only gone up about 6% this year. That swing is serving to invert to cost to replace or buy existing.

When the insurance company agrees to insure your home for its “Replacement Cost”, it is based on the assumption that the home must be replaced in its entirety—even the concrete foundation. Years ago when I joined the North Scituate Fire Department, there was a longstanding joke that “we hadn’t lost a cellar yet”. Not true! In most total loss fire, the foundation is replaced. Concrete may not burn, but the reality is that extreme heat causes expansion and possibly conversion of tiny moisture droplets to gas (steam). Both factors result in it becoming weakened. That is compounded when the fire department sprays cold water on your hot foundation.   After a fire, the foundation must be structurally evaluated before rebuilding on the old foundation. Knowing that the foundation may have been compromised, most builders won’t risk the liability that comes from rebuilding on that old foundation.

When you purchase an insurance policy, it is a contract. In return for you paying the premium, they agree to provide you with coverages against loss; fire being the most common focus of homeowners. The terms of your policy establish an agreed maximum value that the insurance company is obligated to pay for the replacement of your home, if it ever comes to that. The rates contemplate how many fires are actually partial losses and how few are total loss fires. Before companies began including penalties in the policy for not insuring to the proper replacement cost, may people took their chances and only insured to the balance on their mortgage. They figured such limits satisfied the mortgage company’s financial interest and they played the odds that there would never be a “total loss”. Policies were being written for “replacement cost” when an insufficient limit had been purchased. That prompted the addition in a policy known as the “co-insurance clause”. Simply explained, if at the time of your partial or total loss, your home were not insured to at least 80% of what it would have cost to rebuild new, then you only are able to recover the percentage of coverage you have on the home. If you insured a $400,000 home for $200,000, you’d be able to collect up to 50% of your loss

Problem arose when a homeowner in good faith took out an insurance policy thinking they were insured to the full value of their home, but inflation caused building costs to increase beyond their covered limit,– resulting in homes being under insured. To manage that, insurance companies began allowing customers to select an automatic percentage for policies to increase each year.  As long as you select the average rate of inflation, your home stays properly insured. In the years leading up to the economic crash of 2008, home values were increasing 8% annually or more. However, for a couple years after, construction costs faced a negative rate of inflation. Very few consumers thought to change that inflation clause on their policy. I was able to show insureds that they were buying insurance for a home that was commonly 150% of its actual replacement cost. 

In dealing with the demands of agents, insurance companies began to offer a better option; an agreement to pay up to 125% of a building’s “scheduled” value at the time of a loss. Most insurance companies currently utilize a computer program to prepare an estimate of your home’s replacement cost. Being within that 25% range gives ample flexibility.

In the 1970’s the method utilized to calculate a home’s replacement cost was a complicated procedure of flipping through a series of 3 ring binders to calculate cost factors for every feature of your home– from the number of bathroom fixtures to the number of electrical outlets in each room. That was known as the Marshal Swift Appraisal system. Between 1975 and 1980 a company called Boeckh patented a computerized version of that process.  The process compares labor rates and costs for building materials by zip code.  Today there are many companies promoting the accuracy of their valuation software but they all are using the various components of the Marshal, Swift and Boeckh companies. That common thread results in each company’s valuation system resulting in close to the same Replacement Cost value for a given home.  Where the added value comes in, is when the insurance companies update your respective home’s replacement cost at each subsequent policy renewal date.

I pride myself on the accuracy of the calculations we prepare in my office. I’m old enough to have been trained on the original Marshal Swift programs, the Boeckh system, and many of the newer systems being introduced. These newer systems rely on the accuracy of municipal tax assessor records but offer over ride options. If you are dealing with an on-line company, an 800 company or even another agent who quotes your insurance from their office, you may discover a surprise down the road. It is our procedure to visit every property we are preparing quotes for.  We commonly find errors in the tax assessor reports; discover structural changes (an addition) not yet recorded in the tax records; or other modifications such as a finished basement.  By visiting your property before beginning a policy, you are being given confidence that your home is properly insured. I don’t want you over insured; but definitely not under insured.