What's the Difference Between a Home's Market Value and Its Insurable Replacement Cost?

In today’s economy, many people are looking at ways to reduce their household expenses, including their insurance costs. Insureds are seeing the values of their homes, and of those homes around them, decrease, so if the values are decreasing, why is the home insured for more than it can sell for, or for its market value? Conversely, when the economy is booming and the housing market is at its peak just the opposite is occurring. A home can be sold for more than what it is insured. If that’s the case, then shouldn’t the insurance match the value that it could be sold for or its market value? To understand this concept or practice, we must go in depth into what constitutes both alternatives.  

Market value

This is what the house will sell for on the open market. Also included in the sale price of the home is the land once which it sits. Since land is never included in the amount of insurance coverage on a home, we see the first important difference. The home could be a little 1,000 square foot salt-box-style that sells for $500,000. The driving factor for the price of the home is that it sits on an acre of land on a coast, with full ocean view. Now, when you are insuring your home you are not insuring the view; you are insuring the physical structure.

 

Replacement cost

As the name implies, this is the cost that will be incurred to replace the home or building should it suffer a total loss. This is where we will see the differences between the two. Factors that are included in replacement cost:

 

  • Demolition/excavation. If the home suffers a total loss, before any construction can begin, the old house “skeleton” (the remains) must be removed. In order to do this, heavy equipment must be brought in, any remaining structure must be collapsed, dug out and removed. What also could be included here is the basement which most people do not think about. When there is a fire, the heat generated may dry out the concrete and cement to the extent that the integrity of the basement/foundation will be jeopardized and the entire foundation may need to be excavated. Once that is dug out, the land will then need to be re-graded—again with the heavy equipment that may have to be rented by the contractor.
  • Original building-type construction. Depending on when the home was built, the homeowner may want to have it rebuilt using the same type of construction materials. If it was an older home, it may have been built using plaster and wood lathe instead of the drywall that is currently used. Using these different types of materials will add to the ultimate cost. The cost for custom woodwork or cabinetry is significantly higher today than it was 10-20 years ago.
  • Architectural/engineering. There is a cost involved in contracting with an architect in order to have the plans for the new building drawn up and get them passed/approved by the building inspector. These costs also are included in the calculations for the replacement cost.
  • Economies of scale. Chances are when the original home was built, a contractor built it, along with several others, in the same vicinity. At that time, the contractor was able to negotiate purchasing the materials based upon the fact that several homes were being built; when items are purchased in quantities you are able to get a better price for them. Also, the use of heavy equipment trucks, cranes and dozers is minimized when several homes are being built at once, at one basic location. Now, the contractor has to build a single home without the luxury of having several projects happening concurrently. When in a development of homes, a contractor can have all of the homes framed at the same time, then bring in the plumbers, electricians, drywallers, etc., on an assembly line-type process. Therefore with a single home, it will cost more to build it entirely at one time.
  • Ordinance or law. What this involves is that since the time the first home was built until the time the second or replacement occurs; there could have been regulation, code or law changes that directly affect how the home is to be built. These changes could dictate specific materials are to be used and certain square footage requirements among other issues are adhered to.

So, when it all comes down to it, in order to have the most coverage for yourself and your home, you should always insure to replacement cost (and include additional coverages to adhere to, or be consistent with current building codes). There is a lot more involved than meets the eye.

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