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Chapter 11.docx

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FIN 502
Joan Lobo

Chapter 11: Property, Home, and Automobile Insurance 11/10/2012 11:54:00 AM One buys insurance to transfer most of the risk to an insurance company in return for paying a premium. The required premium depends on both the statistical probability of the loss (or expenses) and the expected amount of the loss (not the same as insured face value since property is rarely totally destroyed) Property Insurance: insures your physical properties – your home, clothing, furniture, appliances, jewelry and so on – against damage or destruction Home insurance and automobile insurance – the two major areas in which the average Canadian family is exposed to potentially large and catastrophic losses. HOME INSURANCE Def’n: Protects the family against the risk of loss, damage, or destruction of the home, its related outbuildings(garage), and its contents (clothing, furniture, appliances) Also covers third parties for injuries suffered on the property o Two question that are important before buying Home Insurance  What are the risks that are covered?  How much home insurance do I need? o List of typical risks/damage/destruction:  Fire, lightning  Falling objects  Riots  Windstorm, hail  Explosion  Vandalism  Theft and break-in  Glass breakage, window breakage  Freezing  Water, flood  Weight of ice, snow, sleet  Collapse of building  Smoke  Aircraft or other vehicles  Faulty electrical wiring  How much insurance do you need? o How much insurance do you need (Contents of the Home)? st  1 way: estimate the value of the contents as some percent (usually 20%) of the value of the structure (which is the home excluding the land) o Example: for a home valued at 100,000 one would buy 20,000 insurance coverage for the contents  2 ndway: estimate the insurance coverage for the contents is to list and value every item o recommended by companies and agents. List must be kept separately in a safety deposit or other location. o How do you value the contents of the home? o Two forms of home insurance policy  Depreciated Value: value of replacement or repair for the item to the condition it was in when lost or damaged. Standard insurance policy usually pays the depreciated value. Calculated by subtracting from the price of a new item an allowance for depreciation based on the age of the item that is to be insured.  Replacement value: value of a damaged or lost item is the cost of buying a new item of the same quality.  Depreciated value is less than the replacement value, replacement value requires a higher premium  Damaged or Lost items: Lost/Destroyed: Must be replaced with new ones of comparable quality, if the insured chooses not to replace, the claim will be settled at the depreciated value only. Damaged items: repairs must be made to return the items back to the best possible condition, if one chooses not to make the repair, one will be paid the depreciated value only. (replacement cost policy) o Replacement Value of a Home  Not the current market value/fair market value as it includes the value of the land and foundation—this is b/c in most cases, the land and foundation of a home cannot be destroyed by typical disasters.  Insure the replacement value of the home – what it would cost to replace the home’s structure if the home were totally destroyed.  More practical to pay for an appraisal of the home indicating the appraiser it is for buying home insurance. Give you both the depreciated value and replacement value of home’s structure.  Some insurance companies automatically set the amount of the home insurance equal to the amount of the mortgage on the house. Some banks/loan companies require this insurance amount to be in place before they will grant you a mortgage. – protects the lender’s interest only , not the owner’s interest in the structure o The 80% Rule  Most insurance companies will not pay the full loss on partial damage unless the insured has bought insurance to cover at least 80% of the home’s replacement value.  If the insured buys less than that, the insurance company will only make payments proportional to the percentage of required minimum coverage taken. o Example: replacement value: 100,000 and bought home insurance for 70,000 (less than 80%). Their home suffered a loss equal to 30,000 o Insurance company will pay (70000/80000 x 30 000) = 26 250.  Sometimes replacement value increases over time and you have to check your policy periodically to ensure that you have the minimum coverage. o Example: bought a house 5 years ago with replacement value of 150,000. Bought insurance coverage of 125,000. Current replacement value is 180 000. Fire damage of 10,000. Their insurance company will pay:  180 000 x 80% = 144, 000  144000/125000 x 10,000 = 8681  The insurance company will only pay $8,681 o Inflation Protection Provision  If your policy does not take inflation into account, then the real value of coverage may decline over time  IPP: automatically increases the coverage amount each year in accordance with the increase in some inflation index such as Consumer Price Index (CPI) – might have to pay additional premium for this provision  If you live in an area where housing costs are expected to rise faster than the average rate of inflation (represented by CPI) then IPP may not provide adequate coverage and additional coverage may be provided by insurer for extra premium o Deductible  Part of a claim that you must pay first before the insurance company will pay anything. o Example: you have 2000 insurable loss with 500 deductible, you first have to pay the 500 for the insurer to pay the 1500.  The higher the amount of the deductible, the lower the premium that you have to pay. Three reasons why premiums will be lower if deductibles are higher o Since you have to share part of the damages/loss, insurer doesn’t have to pay as much on claims o The insured will try harder to avoid damages, losses and accidents against which he is insuring valuable property if there is a significantly large deductible o There is a fixed cost of admin for settling any claim that is largely independent of the size of the claim. The insurance company would rather avoid numerous small claims, and will charge a high premium on policies with low deductibles to encourage customers to deal with their own smaller losses. o High deductible policies make more economic sense than low deductible policies. By buying a policy with a large deductible, you are spending your insurance money to cover large losses, reducing the premium cost per dollar of insurance and can therefore afford a higher total coverage. o Rule of Thumb: many financial experts recommend a deductible equal to 3% of your net worth. For example, if one’s net worth is 50,000, one should seek an insurance policy with a deductible equal to $1,500. Third Party Liability Insurance o Protects you from the liability to other people for injuries suffered on your property or by anything attached or related to your property. o You are required to ensure that your property does not pose sa danger to a reasonable person. o However, there
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