If Your Home Is Insured Based On Market Value, You May Be At Risk

By Richard A. McGrath, CIC, LIA

Many victims of the tornado that recently hit the Sturbridge area learned the meaning of “replacement costs” the hard way.

In today’s housing market, with the price of housing having fallen, many homeowners have reduced their insurance coverage, based on falling market values.  But a home’s market value is not the same as its replacement cost.

As market values have fallen, it is increasingly common for insurance agents who estimate replacement costs for their clients to recommend coverage that exceeds the market value of their home.

Not insuring your home for its full replacement value – even if it exceeds the current market value – can be risky.  Homeowners need to have a complete understanding of replacement costs, so that they can make an informed decision.

Market Value vs. Replacement Costs

Market value is determined by supply and demand.  It is the price at which a home can be bought or sold at a specific time, based on its location, condition and other factors.  It includes not only the home, but the land on which it is built, landscaping, fencing, detached garages, sheds, swimming pools or other related structures.

Replacement cost is based on an estimate of what it would cost to rebuild a similar structure on the same site with the same kind and quality of materials.  Estimates of replacement costs do not include the value of land, and may or may not include detached structures on the property.  Rather than being based on the price the home would bring in today’s market, it is based on the cost of building materials and labor, and the use of equipment.

Because the supply of homes for sale has far exceeded the demand in recent years, market values have fallen significantly.  The cost of reconstruction may have also fallen somewhat, but not as much as the price of already constructed houses.  As a result, the cost of replacement may be higher than the market value of a house, even though replacement does not include land and detached buildings.

Given the poor real estate market nationwide, replacement costs exceed market values in many markets.  Based on a study using its replacement-cost estimation tool and sales prices reported by the National Association of Realtors, Xactware found that the differences between market value and replacement-cost estimates are often significant.

In Ft. Myers, Fla., the most extreme example included in the study, the median replacement-cost estimate was 160 percent higher than the median home sale price in the first quarter of 2011.  In other words, you can buy two houses currently on the market for well under the cost of reconstructing one house in Ft. Myers.

In the Phoenix, Ariz., area, the price of reconstruction was 62.3 percent higher than the market price of a home; it was 56.9 percent higher in the Las Vegas, Nev., area, and 43.4 percent higher in the Sacramento, Calif., area.

While the study did not include Sturbridge, let’s assume that the difference between market value and replacement cost is the same here as it is in Ft. Myers.  The current market value of your home might be $200,000, but, based on the 160 percent difference, the replacement cost would be $520,000.

In such a case, if your home were destroyed by a tornado and insured for market value, you would have to come up with $320,000 out of pocket to replace your home.

Consider a less extreme example, based on conditions similar to Sacramento.  Assuming again that the current market value of your home is $200,000, the cost of replacing your existing home would be $286,800.  You would still have to come up with $86,800 out of pocket to replace your home.

These examples assume a complete loss, but being underinsured would also have a dramatic impact if you were to suffer a partial loss.

In today’s economy, it is important to do whatever you can to save money.  But insuring your home based on market value can end up costing you a great deal of money.

When insuring your home, your most valued possession, be sure to have your agent estimate the cost of coverage based on replacement costs, not market value.

Richard A. McGrath, CIC, LIA is President and CEO of McGrath Insurance Group, Inc. of Sturbridge, Mass.  He can be reached at rmcgrath@mcgrathinsurance.com.

This article is written for informational purposes only and should not be construed as providing legal advice.