The Pros and Cons of 4 Types of Home Insurance

Inflation, high demand for housing and more frequent natural disasters are three pressures driving up building costs so rapidly in parts of the United States that your homeowners insurance may not fully cover you if you have a loss.

We asked two experts what this means for homeowners. “This issue of underinsurance is a huge deal,” says Kenton Brine, president of the NW Insurance Council, a nonprofit that represents property and casualty insurers. “In the last five years, it’s become an issue because the cost of construction has so far outpaced the limits of a homeowners policy in many cases,” he tells Money Talks News.

That’s why it is useful for homeowners to learn the basics about the four primary types of home insurance, says Janet Ruiz, spokesperson for the Insurance Information Institute, an industry organization. Understanding what you stand to get for your money can help you decide if your homeowners coverage is enough.

If it’s not, you could be forced to cover a sizable portion of your loss out of your own pocket. Or settle for being unable to replace your home as it was.

Read on to learn the basics of these four types of insurance. They vary mostly in how the policy reimburses you for a loss.

Actual cash value

What it is: This type of home insurance policy has a hard dollar limit — $300,000, for example — and payouts may be based on the depreciated value of a structure, not its value when new.

Pros: It’s entry-level home insurance at a more affordable price, allowing homeowners who aren’t wealthy to insure a home and to satisfy a mortgage company’s insurance requirements, Brine says. This policy type can be useful for purchasers of a newly built townhouse, condo or single family home since less robust coverage may seem a reasonable risk in the early years, when there’s typically less potential for problems, Brine adds.

Cons: Actual cash value policies may not cover the full cost of replacing or repairing a home. Here’s why:

• Your policy has a deductible. Actual cash value policies are subject to a deductible, meaning that you’ll have to pay a portion of the loss. If your home is a total loss, the most money you can recover (in this example) is the $300,000 limit minus a deductible — 20%, for instance — for a total of $240,000. If this is not enough money to rebuild, you’ll need to make up the difference out-of-pocket.
• Payouts can factor in depreciation. Suppose your home’s 15-year-old roof is damaged by hail, and now you need a new roof. Roofs have a life expectancy — let’s say 20 years in this case. If your policy includes depreciation, your payout won’t cover the full cost of a new roof. Instead, you’ll receive the roof’s depreciated value: what it’s worth now, in year 15. That’s unlikely to be enough to buy a new roof. As always, the details are in your insurance policy contract. But, typically, depreciation is applied to payouts for a roof or a home’s contents, Brine says.

Replacement value (or replacement cost)

What it is: Replacement cost — also called replacement value — coverage uses a different way to calculate reimbursement for a claim. It allows more coverage than actual cash value insurance, but it’s still possible that payouts will be less than the actual cost of rebuilding.

Pros: There’s no depreciation to worry about. If your policy amount is $300,000, your payout will be $300,000 if your claim is fully covered. A replacement value policy offers a better chance of rebuilding or replacing your home. It’s often used by homeowners who want to be able to rebuild and replace their home and belongings with a similar kind and quality, Ruiz tells Money Talks News.

Cons: Replacement policies are more expensive than actual cash value insurance. Even so, your payout may not be enough to rebuild or replace a home in today’s environment. That’s because your policy limit — $300,000 in our example — is the most you’ll receive. If inflation or newer, local building codes have pushed up costs, you may have to spend more to rebuild than your insurance coverage allows.

Extended replacement cost

What it is: Just as it sounds, extended replacement cost is a type of insurance that extends your compensation beyond a policy’s limit if necessary. Generally, it allows a payment of up to 120% or 125% of a policy limit if that’s what it takes to replace a damaged home, says Ruiz.

Pros: Extended replacement cost is especially valuable for homeowners living in areas where catastrophe risk — a wildfire, for example — is a possibility. In the rebuilding phase after a disaster, demand for building contractors and materials can surge beyond even ordinary inflation. In the last five years, the cost of construction has far outpaced the limits of insurance policies in many cases, Brine says.

Cons: Higher premiums are a drawback to this type of replacement cost insurance. What’s more, high costs of reconstruction could surge even beyond the extended limits of this policy, leaving you with a gap between your payout and the cost of replacing your home.

Guaranteed replacement cost

What it is: This deluxe homeowners policy covers the full cost, even over and above a policy’s limit or percentage extension, to repair or replace your damaged or destroyed home.

Pros: You can sleep like a baby at night, knowing that if you need it, there is no limit on the potential compensation from home insurance.

Cons: The downside of a policy with no percentage limits on what it repays is that, of course, it’s likely to be a good deal more costly than other homeowners insurance policies.