Homeowners Insurance: What is “Replacement Cost”?
Replacement cost is the actual (not theoretical) amount of money it will take to replace the home you live in, assuming that it is completely destroyed by a covered peril or insured occurrence. This amount of money can be determined by making estimates based on the cost of materials, labor and other monetary factors that should be taken into consideration when a construction crew has to rebuild a structure from scratch.
As noted above, the term “Coverage A” is used in the insurance industry to denote dwelling coverage. What does dwelling insurance cover? Dwelling coverage is usually listed as a dollar amount, which represents the maximum an insurance company will pay in the event of a covered loss. Of course, if the damage is not total, the reimbursement will be for less.
However, if the damaged home costs more to replace than the stated amount of dwelling coverage (or Coverage A), the insurance company will not pay for the additional amount. At that point, the homeowner is responsible for whatever amount of money it takes to replace the home.
The insurer is then only “on the hook” for the amount stated under Coverage A in the policy, the dwelling coverage amount, and nothing more.
Replacement Cost for Average Homes
Replacement costs for homes vary widely based on location and many other factors. A common guideline, however, is $125 per square foot for a typical home. This is what you should use as a ballpark, or even a minimum estimate of your own home’s replacement cost. If your policy covers up to this amount, that’s the absolute maximum that the insurer will pay out if the home needs to be completely rebuilt.
Homeowners should be keenly aware that the replacement cost of their home could be much higher than that amount. If you have a reason to believe your replacement cost is higher, then speak with your insurance agent and raise the amount of your dwelling coverage.
Replacement Cost for Custom Homes
Custom homes have much higher replacement costs, based on the fact that it will take more materials, costlier materials plus the labor to rebuild them. On average, experts give us the estimate $200-$250 per square foot as the replacement cost of custom homes. Here’s an example of how the dwelling coverage could work in the event a custom home suffered total destruction by an insurance-covered peril, like a fire.
Example: The homeowner’s dwelling coverage on a 2,000 square foot custom home has been set at $500,000, or $250 per square foot. After the fire, builders begin work on rebuilding the entire home and are nearly 90 percent finished after spending the full $500,000.
At this point, the homeowner is responsible for any amount of money required to complete the project. If, as noted in the example, the workers were indeed 90 percent finished, and the remaining cost was $55,555, then the homeowner would have to pay the construction company that amount.
It’s important to remember that “ballpark” estimates for typical and custom home replacement values are educated guesses. They don’t pertain to specific situations or particular homes. What’s the lesson? Always get as much or more dwelling coverage than you think you’ll need.
What is the Danger of “Under-insuring”?
The example above demonstrated something else: there is a potential risk of being under-insured when it comes to dwelling insurance. In the example, the owner was more than $55,000 under-insured and ended up having to pay out of his own pocket to complete the construction job.
If you are under-insured, you face two problems. The first one, as in the example, you have to pay to finish a nearly-complete construction project in order to have a place to live. Second, you might not be able to come up with the money, which could mean serious financial and living problems. Fortunately, there are a couple of ways to avoid being under-insured.
Two Ways to Avoid Being Under-insured
Generally speaking, there are two common ways to avoid the many problems associated with being under-insured.
— Extended Replacement Cost: It’s possible to purchase extended replacement cost coverage that will literally “extend” the amount of your stated dwelling coverage by a fixed amount or by a percentage of your original dwelling coverage amount. If, for example, your dwelling coverage is $300,000, an extended provision might push that maximum amount out by $50,000.
In the event your home needs to be replaced, you’d have $350,000 of coverage to handle the construction bill.
— Guaranteed Replacement Cost: Guaranteed replacement cost is an even better deal for homeowners insurance because it does what its name implies; it guarantees the full replacement cost regardless of that value. Of course, it costs more money to add extended or guaranteed replacement cost provisions to a policy, but both types of added coverage offer homeowners peace of mind.