Focused on Risk

My home is only worth $250,000 in today’s market, so why does my insurance company want me to insure it for $350,000?  This is a common question people ask their insurance agents.  Market value and replacement cost are two different ways to value a home.  The replacement cost is the price it will take to rebuild the home.  This is not the home’s purchase price less the value of the land, the outstanding amount owed on the mortgage or the tax assessment amount.  Replacement cost is dependent upon the cost of labor and materials.  Market value is the price a property can realistically sell for.  It is based on supply and demand, and currently demand is down so we are able to buy more home for our money.  Market value can be affected by the surroundings such as a very desirable neighborhood, versus a depressed one.  For example:

The replacement cost is exactly the same for both of these homes.  There are many factors that can cause the replacement cost to be much higher than one would think.  Let’s assume a tornado has completely destroyed a home.  There will be debris cleanup of the existing structure whereas the original builder had an empty lot with which to start.  Rebuilding a home from the ground up is usually more expensive than building fresh.  An architect or engineer will have to look at the foundation to determine if it is salvageable along with redesigning the home plans, and the contractor will build using today’s prices for materials and labor.  In addition, building codes may have changed, and a builder will have to adhere to these new codes, even if they cost more.  Plus, this will be one home for the contractor to build, so there will be no economies of scale because he will only be buying one of everything this time around instead of buying hundreds of windows or 20 sets of cabinets all at once.  All these things lead to increased replacement costs.

The loss, or cost to put someone back into the position they were in before the tornado came through, is not calculated based on the market, but based on the actual cost of the goods or services needed to get the job done in a reasonable timeframe.  That’s why the price originally paid for a home, or the cost to buy a similar home down the street, may be very different than the cost to rebuild that same home following major damage.