This article presents information on the function and coverage of homeowners insurance policies.
What is it about homeowners insurance?
Homeowners insurance indemnifies (compensates) the homeowner for money losses suffered by the homeowner when:
- the structure of his home is damaged;
- his personal property is damaged on or off of the property site; or
- he is liable for the injury of another person on his property.
Mortgage lenders require a buyer to obtain a homeowners insurance policy as a condition for funding a home loan. Homeowners are also required to maintain a current homeowners insurance policy for the duration of the mortgage. Upon full repayment of the loan, the homeowner can choose to cancel or maintain the homeowners insurance policy.
Protecting against the loss of valuable property by means of an insurance policy greatly benefits the homeowner, not just the mortgage lender.
Mortgage lenders require the buyer to not only furnish a homeowners policy but to prepay insurance premiums for the first month or two of the policy’s duration, if not the entire first year. These costs are often included in the dollar amount paid into a loan escrow account with the lender if the loan payments are to include deposits monthly for property taxes, insurance premiums and the like.
Lenders sometimes require additional specific types of coverage, including flood insurance or an endorsement for earthquake coverage. These coverage requirements are dependent on the region in which the property is located and whether or not the property is at high or low risk of damage from specific natural hazards.
Homeowners insurance policies differ in the type of coverage and extent of coverage they offer.
The base homeowners insurance coverage is set by a homeowner’s lender at the dollar amount of principal due under the loan. By this, the lender ensures it will suffer no loss if the property securing the loan is damaged or destroyed. Most insurance experts recommend homeowners insure their homes for the full replacement cost of the improvements. Some lenders require the same when the property is worth less than the cost of replacement.
A property’s replacement cost differs from its fair market value (FMV). FMV is determined by the state of the housing market and what sales price is attainable due to high or low buyer demand for housing in the area. FMV is constantly fluctuating and is essentially the realistic price of the real estate in the immediate location of the property.
Replacement cost varies by time and region, but to a lesser extent than FMV. The replacement cost of a home is calculated by multiplying the local construction cost (labor and materials) per square foot by the square footage of the home. Insurance companies use a service or reference guide to determine the replacement cost of improvements on a property, such as Marshall and Swift’s Residential Cost Handbook.
However, homeowners should not rely on their own amateur cost-of-replacement calculations when obtaining an insurance policy. A licensed appraiser or a local builder is the best source on the replacement cost of improvements, since they have specialized knowledge of the cost of labor/supplies and the reconstruction of specific architectural features.
On the annual renewal of the homeowner’s policy, homeowners need to assess the replacement cost of their home and adjust their insurance coverage accordingly if they are to maintain full coverage. Insurers with an eye on the premium amount are quick to note costs of replacements when they have risen, thus giving notice to the homeowner.
A homeowner’s risk under a policy is that they will only receive full payment for even partial damage to the property structure when the property is insured for a minimum 80% of the replacement cost of the property.
If the homeowner’s coverage is less than 80% of the replacement cost at the time of the loss, the insurance company will only partially pay for repairs to the property, regardless of the extent of the damage. For bullet-proof coverage, the cautious may consider obtaining a policy with guaranteed replacement cost of up to 120% the value of their home.
What homeowners insurance covers
Standard homeowners insurance policies cover the cost of damage suffered by the property’s structure. Generally, damage caused by any of the following is not covered by the homeowners insurance policy:
- water damage;
- collapse of the building;
- snow, ice or sleet;
- frozen plumbing; or
- the malfunction of household appliances.
However, these losses may be insured against by purchasing additional coverage through a separate hazard insurance policy or attached endorsements. Hazard insurance exclusively covers damage to the property structure and personal property due to natural hazards. This type of insurance is additional to homeowners insurance and is often purchased piecemeal — flood insurance, earthquake insurance, etc. If the property is located in a flood zone, or susceptible to other natural hazards, the lender will likely require the homeowner to obtain hazard insurance specific to the type of risk to which the property is exposed.
So, if that quaint, gurgling stream behind the house has a habit of swelling ominously in spring, homeowners should probably consider shelling out a little extra per month for flood insurance. In this case, the lender may even insist the homeowner be covered. Flood insurance is offered by many companies through the National Flood Insurance Program.
Likewise, earthquake insurance is regulated by a state agency with coverage provided by the California Earthquake Authority through local insurance companies. In the past, insurance companies were reluctant to offer coverage for this natural hazard. However, homeowners insurance companies are required to offer their clients earthquake coverage with their homeowners insurance policy. This offer must be repeated every other year and minimum standards for earthquake coverage provided if the client chooses to obtain the additional coverage. [Calif. Insurance Code §10081]
Standard homeowners insurance policies cover damage or loss of personal property, with limits on the dollar amount insured. The dollar amount policy ceiling may be increased with the purchase of additional personal property insurance.
Personal liability coverage is also included in homeowners insurance policies. Consider the possibility of an errant swing by the homeowner and the resulting hooked golf ball on a crowded course. A bystander is hit and injured as a result. It was an accident, but the homeowner is liable for the injuries.
Personal liability insurance covers medical expenses due to another’s injury for which the homeowner is liable. Also, standard liability coverage is $100,000 for the typical low- to mid-tier property owner. For a minimal cost, more extensive personal liability coverage can be obtained by purchasing an umbrella insurance policy.
Annual and monthly premiums vary for homeowners insurance policies, depending on the extent of coverage provided and the location of the property. Monthly premiums for a home in a low-risk region of California may be as low as $50 for mid-tier properties. However, premiums for additional flood or earthquake coverage can increase dramatically if the property insured is located on a fault line or in a high-risk flood region.
The California Department of Insurance annually conducts and publishes a survey of homeowners insurance premiums. Should a buyer’s agent be interested in the cost of premiums for a home, they may receive a rough estimate of annual premiums and deductibles by entering the age and location of the home, plus the desired amount of coverage. [Calif. Ins. C. §12959]
Homeowners living in areas at high-risk of flooding or other natural hazards are sometimes unable to obtain insurance from voluntary insurers for their property. The risk of loss for the homeowner is a risk of loss for the insurer.
However, California Fair Access to Insurance Requirements (FAIR), a private organization of which all California insurers are required to be members, offers homeowners insurance to any person regardless of their proximity to hazards. Homeowners insurance obtained through FAIR does not cover personal property or personal liability. [Calif. Ins. C. §10095(a)]
Homeowners insurance is not the end-all insurance policy for a homeowner. Those who expose their property to additional liability by leasing it to tenants or using it for their businesses should consider other types of insurance policies.
Property owners leasing property to tenants need to obtain a landlords insurance policy (which their lender will require). This is not the same as a homeowners insurance policy. Landlords insurance policies cover damage to the property structure and the personal liability of the landlord. They do not cover damage to personal property since the contents of the building are owned by the tenant, not the property owner.
To fully cover a rental property, the landlord must:
- obtain a landlords insurance policy; and
- require his tenant to obtain a renters insurance policy.
By requiring both types of insurance, the landlord protects against losses due to damage to the property structure, contents of the building and personal liability for both landlord and tenant.
Homeowners insurance is not business insurance, nor is it workers’ compensation insurance. Thus, homeowners insurance will not pay for your data entry employee’s carpal tunnel surgery or injuries during the construction of improvements on the property.
Homeowners who use their homes for multiple purposes, including meeting with clients for their professional business, must obtain additional coverage for business-related liabilities and damage to business property.
However, for the simple, single-use home, a homeowners insurance policy, with discretionary additional coverage for natural hazards, will provide adequate coverage for the property structure, personal property and personal liability of the homeowner.
It’s like a warm blanket. Financially speaking, a wraparound.