Aug 6, 2021 4 min read

This week one of my license agents brought a concern to me. They had a customer who had a home insured with another company for $200,000 and was getting quotes from us and other companies to insure their home. Our first step in insuring a home is always to determine the replacement cost of the home. Replacement cost is a term referring to the amount of money an individual must currently spend to replace an essential asset with one of the same value. When dealing with a home, simply what would it cost to rebuild the home would be its replacement cost. My agent had determined that the replacement cost on the home would be $360,000. I asked was she sure of the value, and she said not only had she arrived at that number, so had the other companies that the customer was getting quotes from.

The customer told her they were not concerned about rebuilding the home, and if anything happened they were going to take the $200,000 and move to Florida. The problem is insurance does not work that way. When a property is insured for less than 80% of its replacement cost, the insurance company has the right to depreciate the settlement. Depreciation is calculated by evaluating an item’s replacement cost value, then determining its life expectancy.

Let us assume your home is insured for less than 80% of its replacement cost and the roof is destroyed in a wind storm. Twenty years ago you installed a new roof that was designed to last 30 years. The cost of replacing your roof today is $18,000. Its life expectancy was 30 years. Each year it loses $600 in value ($18,000/30years = $600). Your roof is 20 years old, so it has depreciated $12,000. The settlement for your claim is $18,000 minus the deprecation of $12,000, minus your deductible, which, let’s say is $1,000. The payment you would receive is $5,000.00.

Assuming you insured your home for 80% or more of the replacement cost, the same claim would result in you getting a settlement of $17,000 ($18,000.00 – deductible of $1,000).

Understanding why it is important to insure your home at a value that averts depreciation is the first step. How to determine that value is not as simple as it may seem. Some customers assume the purchase price (market value) is the same as replacement cost. Market value includes factors like lot size, location and age of dwelling. The best way to determine replacement cost is to use one of the replacement-cost calculators provided by your insurance company. These calculators ask multiple question about your home like square footage, number of bathrooms, floor coverings, etc. Then they allow for the construction cost in your location based on zip code to arrive at the replacement cost of your home. This is how my employee determined the above replacement cost for the customer she was quoting.

Starting with the correct replacement cost, two important things must be done to make sure that you have the correct replacement cost in the future. First, ask your insurance company if they adjust your coverage each year to allow for inflation and how do they do it. A simple 2% increase every year may not be enough. The best way is to use the construction cost index for your zip code. Second, inform your agent of any structural changes or upgrades you have made to your home. A new roof, extra bathroom, swimming pool, parents’ apartment – all should be brought to your insurance company’s attention.

Waiting until claim time to determine if you have the right coverage is never a good idea.

Bob Hollick is a State Farm Insurance agent based in Washington. His column appears every other Friday in the Observer-Reporter.