Opinion: Most buildings, homes currently underinsured

Richard Ollis

As all of us continue pushing through this inflationary environment, the increased cost of construction is significantly impacting the insurance marketplace. Insurance industry sources estimate that the current property limits could not replace over 75% of buildings and homes insured. Even more concerning, most policies have a penalty, i.e. coinsurance, for being underinsured, making even a partial loss problematic.

Most property insurance policies are written on a replacement cost basis, which essentially means the policy will repair or replace covered damage to a commercial building or home. It is even sometimes referred to as “new for old,” meaning a 50-year-old structure is replaced or repaired without deducting anything from the age of the building.

In order to qualify for replacement cost coverage, you must agree to insure the building for the replacement value of the building or home. In our current inflationary environment, many are not meeting this obligation.

Most all property insurance policies have coinsurance provisions. These require a building/homeowner to insure to some level of replacement cost, typically 80%-90%. Coinsurance penalties also are applied on partial losses. Let’s examine how this works on an 80% coinsurance policy. Say the building or home’s 100% replacement value is $1,000,000. The policy has an 80% coinsurance provision. The building/home is actually insured for $500,000. In order for a partial loss to be paid in full – subject to the total limit – the structure must be insured for 80% or $800,000.

In a coinsurance rate formula, one would divide the amount insured ($500,000) by the amount that should have been insured ($800,000) and multiply it by the amount of loss ($1 million, if total). That calculates to a $625,000 payout. However, the structure was only insured for $500,000. It is normally a good idea to insure for 100% replacement, or in this example, $1 million.

Over the past five years, construction costs have soared. Most underestimate what it would cost to reconstruct a building or home.

Another mistake we often encounter is confusing market value with replacement cost. Market value is the estimated cost of the property based on the sales price of other similar properties. The market value of a home or building is not relevant or applicable to a replacement cost insurance policy.

Although virtually all property insurance policies are on a replacement-cost basis, there are other types of policies available for specific circumstances.

Actual cash value policies are available, and losses are calculated on repair or replacement minus depreciation, or fair market value. This type of coverage is typically used for older buildings or houses that would not be replaced. Repairs for damages are often not covered in full based on the deductions for the age and/or condition of the property.

Another method of insuring buildings that can be employed is functional replacement cost. This is typically used when the structure would not be replaced with a similar building. An example may be an obsolete, older structure that would be replaced with a small, more modern one.

If multiple commercial buildings are being insured, a blanket limit may be applicable. This essentially adds the buildings together, creating a total, or blanket, limit. This can also be used for contents, and it’s especially valuable for contents or stock that may be moved from one building to another. Because the total blanket limit can be used to replace a building, most policies require the structures to be insured to full replacement value.

Guaranteed replacement cost can be an option on some homeowners’ policies, guaranteeing the structure will be replaced. A full replacement value is required for this option to be used.

One may want to consider adding an agreed-value endorsement to the policy. This suspends the coinsurance penalty and requires a statement of property values to be signed by an insured. Again, full replacement values are normally required for this option.

The real takeaway is that 75% of buildings and homeowners are underinsured. Inflation, coupled with increased material and labor costs, has increased significantly over the past several years.

Conservatively estimating replacement value annually and properly structuring your property insurance policy will ensure a property loss will be paid in full. Work with a professional insurance agent to assist in exploring the various options. Don’t be caught short in these inflationary times.

Richard Ollis is CEO of Ollis/Akers/Arney, an employee-owned, independent insurance agency. He can be reached at richard.ollis@ollisaa.com.