Your home is your castle—and whether it’s a manufactured home worth $30,000 in an unimproved mobile-home park, a $2 million dwelling in a posh gated community, or $50,000 of personal belongings in a high-rise apartment, your heartstrings are tied to it, and it’s an investment worth protecting.
Your castle, unfortunately, is subject to a partial or total loss from perils you can’t control. And to see your investment wiped out through no fault of your own can be devastating, emotionally and physically as well as financially.
So, having a homeowners’ insurance policy is critical. While insurance can’t prevent a major loss, it surely can make it more bearable.
How Homeowners’ Insurance Works
Homeowners’ insurance policies are based on the commonsense concept of redistributing risk. In any given time period, there will be a certain number of losses among participants in a group, but there’s no way to determine exactly who will incur the loss. So, using an actuarial model that estimates things like loss severity and frequency, each participant is charged a premium—and each hopes, of course, they won’t have to file a claim and receive the accumulated funds.
A quick history note: The first insurance company was started in England in 1681, a response to the Great Fire of London some 15 years earlier that destroyed an estimated 13,000 structures.
The idea was that, by collecting a premium from anyone who wanted to participate, a fund would be available to cover losses within the group. The concept caught on, and other companies sprang up. (Read more about the history of insurance here.)
Over time, homeowners’ policies have evolved into a few standard types we see today. The events or problems that would prompt an insurance claim are referred to in the insurance world as “perils.” They must be one-time, accidental, and/or unexpected events in order to be covered.
Policies are referred to in the industry as HO-1 to HO-8; the higher the number, the more extensive the coverage.
- Fire only. This policy (HO-1) provides coverage only for fire damage. It is rather obsolete nowadays, typically used only for older buildings when an insurer doesn’t want to take on additional risk due to the condition of the structure.
- Named Perils 1-9 Basic Form. This policy (HO-3) literally names the perils it covers: Fire or lightning, removal, windstorm or hail, explosion, riot or civil commotion, an aircraft falling on or vehicle running into the structure, smoke, vandalism, or malicious mischief. Some may include glass breakage or safety glazing.
- Named Perils 1-19 Broad Form: (Form 3). Yes, there are even more potential perils. This policy type (HO-5) includes the nine “basics” and ten broader categories that may include: Theft, breakage of glass, weight of ice, snow or sleet, collapse, accidental discharge or overflow of water or steam, cracking, burning, or bulging, falling objects, freezing of plumbing or HVAC system, and so on.
- Special Form (Form 4). This policy describes its scope by what it doesn’t cover, rather than what is covered. It might say, “We insure for direct physical loss to the property insured, except for any loss excluded below,”—and the exclusions are then itemized. Losses that aren’t excluded by any other policy provision are covered.
- Condominium (Form 5). This is a hybrid special form policy designed for condominium owners. It covers interior walls (from the drywall in), floor coverings, and other improvements to the owner’s indoor living space, along with personal belongings. Exterior walls and improvements are normally covered by the homeowners’ association.
All the policy types listed above include sections for premise medical and personal liability.
- Premise Medical. Premise medical is provided so some claims may be handled without having to prove negligence—i.e. a child hitting another child with a baseball bat while playing ball, a guest falling ill due to food poisoning, striking a golfing partner with an errant golf swing, a guest falling off an off-road dirt bike, etc.
- Personal Liability. This part of the policy covers the homeowner in the event that a loss involves negligence—i.e. any of the above examples, if they exceed the monetary limits under premise medical, or such issues as defamation of character, damage caused by a vicious dog, damage or injury to another’s property or personal injury while operating a boat, etc.
How Premiums are Determined
Since we’ve already established that no one can exactly predict losses, the premium you pay is an informed estimate based on calculating the potential risks in insuring the property. The insurer takes into account the age and overall condition of the structure and systems, the building materials, the local crime rate, and more. They’ll also look at your own credit rating and check for any past insurance claims on the property.
Do you have a trampoline or a swimming pool? Those could raise your premium. Having a home security system or smoke alarms and carbon monoxide detectors could lower it.
One of the biggest ways to influence your premium cost is the deductible you choose. How much could you afford to pay out-of-pocket if a loss occurs? The higher your deductible, the lower the premium.
Some Common Misconceptions
Maintenance perils: Some perils are considered “maintenance perils”—i.e. normal wear and tear, deterioration, excessive buildup of ice and snow, vermin damage, etc.—and are not covered by homeowners’ insurance. The insurer expects its policyholders to show a certain amount of care and responsibility for their personal property. And deliberate acts that result in damage or loss could be cause for termination of all coverage.
Premium payments: Another misconception some folks have is that the homeowners’ insurance premium they pay each year is equivalent to depositing it in a bank, where it accumulates until there’s a loss to be covered. They assume those accumulated funds are then used to offset some of the loss. And if they ever decide to cancel their policy, they assume they’ll get a refund of the premiums they’ve paid over time. That is not the case. The premium collected each year is calculated to cover the actuarial possibility of loss in that year. If the insurance company doesn’t pay out as much in claims as it takes in, the balance is simply added to the company reserves.
Dual ownership: If you have a partner or co-owner, that person is not automatically protected as an insured under your homeowners’ policy unless their name appears on the declaration page as a “named insured” or by endorsement. As an example, let’s look at the dual ownership of a boat. Both owners need to cover their own liability exposure under their own homeowners’ insurance policy and have a clear understanding where hull coverage will be provided.
What’s not covered: One of the biggest frustrations is assuming your policy will cover a loss, only to find it doesn’t. Some perils most likely to not be covered include water damage, earth movement, neglect, war, power, heating or cooling failure, depreciation, decay, deterioration, change in temperature or humidity, loss of market, ordinance or law, nuclear hazard, and weather conditions. In some cases, separate structures on your property—a shed, barn, garage, etc.—might require separate coverage.
Floods and earthquakes: Special insurance coverage is available for homes located on a flood plain or in areas prone to hurricanes or earthquakes—in these situations, your mortgage company might even require it. It may be a separate policy, or a rider on your existing policy.
How Claims are Paid
There are several ways to settle an insurance claim. Your policy can specify which method may be used.
Actual Cash Value: In this method, an item’s replacement value is determined, then depreciation and your deductible are applied to come up with a settlement amount. This method requires good record-keeping on your part to be able to prove purchase dates and values, and proof of the amount of wear and tear for depreciation purposes. When the settlement is made, you can spend the money however you want—the policy doesn’t require you to replace the lost item.
Replacement Cost Value: Coverage for personal belongings only requires application of a deductible, proof of loss, and the actual replacement of those belongings. Usually, the insurer will make an actual cash value settlement and then, upon proof that you replaced the items, will adjust the settlement to reflect your replacement cost. If you decide not to replace the items, depreciation is applied, and a cash settlement is made.
For a structure, one requirement is that, at the beginning of the policy period, the building’s value must be at least 80% of its present replacement value. If it’s a partial loss, the deductible is applied without using depreciation. If the building is a total loss, its replacement cost can’t exceed the amount the structure is insured for. This settlement method is generally preferred, both by insurers and homeowners, because it’s straightforward—no record-keeping requirements or differences of opinion about the value of lost items.
Guaranteed Replacement Cost Value: The policy language allows a certain percentage over the declared replacement cost, if inflation has made the actual replacement higher than the declaration sheet reflects. However, it’s usually capped at 125% and applies only to inflation value, not increases from additions or improvements to the building. It also requires initial agreement that the building is insured at 100% of replacement value at the beginning of the policy period. Considering the volatility of building costs in today’s market, this isn’t a bad option.
Do Your Homework
Most people have a long list of things they’d rather do than read a homeowners’ insurance policy. Understood! But you will sleep better in an approaching storm if you know you have the coverage that’s right for you.
It’s especially important to get multiple quotes. Check out the insurance companies online; ask neighbors or relatives to share their own experiences and recommendations.
Bring a list of questions to your agent, and make sure they’re answered to your satisfaction. After all, it’s your castle that you’re protecting.