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Chapter 4

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FIN 512
Giulio Iacobelli

Chapter 4: Homeowners Insurance Three basic levels of coverage for home insurance: 1. Basic Coverage is a named perils policy- only those perils listed, such as fire, falling objects, and vandalism are covered. This is the cheapest and the most risky of the three. A Basic Policy is also called a Standard Policy. 2. Broad Coverage provides all-risks coverage on the buildings and named perils coverage on the contents 3. Comprehensive Coverage- covers the buildings and contents for all-risks that are not specifically excluded. It is the most expensive of the three and provides the most complete coverage. The Policy as a Contract: A homeowners policy is a contract & establishes the terms of the contract including: That it is an agreement between legally competent parties The consideration, that is, the amount of the premium The intent to do something that is legal The details of exactly what losses are covered and for how much they are covered; and The period of time covered by the contract - Losses covered are either: Direct Losses- damage to or destruction of the building and personal property, or loss of property if theft is also covered, or Indirect Losses- for example, loss of rental income from a tenant or the need to rent other living accommodations while the home is being repaired. - The policy covers the 4 principles of insurance covered earlier: 1. Indemnity- the insured is returned to the same financial position as before the loss, without making a profit. This financial position is defined using one of the following: a) Actual Cash Value of the market value. It provides compensation to replace what was there in the actual condition it was in at the time of the loss. It is replacement cost less any depreciation arising from its age, use, fair market value, and/or obsolescence. This can also be called its replacement value. b) Replacement Cost, which is the cost to replace what was there without deducting depreciation, that is, to replace it in new condition, and c) Guaranteed Replacement Cost, which is the same as replacement cost but payment is not limited to the amount of the insurance coverage. 2. Insurable Interest- only the homeowner(s) can insure the property. 3. Subrogation- the insurer will pay the insured the amount of the loss and is entitled to recover from a negligent third party who is not the insured, that is, the insurer pays the injured party and then has the right to recover this amount from the person who caused the loss. 4. Reasonable Expectations- the insured is covered for anything that he or she can reasonably expect to be covered for and any exclusion must be specified. - This contract also specifies anything excluded from the coverage, what property of other people is covered, what the insured is required to do in the event of a loss, as well any coinsurance requirements. Coinsurance: for a homeowners policy is the requirement that the property be insured for a minimum amount if the insured is to collect the full amount of the loss. - The insureds goal is to make sure that a home is not deliberately underinsured - Since a complete loss is unlikely to happen, the insured might be tempted to deliberately underinsure in order to reduce premiums - The insured value is the cost to clean up the site and rebuild the house, not its market value and not including the value of the land - Often the coinsurance requirement is that the home be insured for at least 80% of the replacement cost and, if the coinsurance requirement is met, the insurer will pay the full amount of the loss even if it is more than the amount of the coverage (which amounts to Guaranteed Replacement Cost) - The coinsurance requirement varies from 80% to 100% - If the coinsurance requirement is not met, the insurer will pay either the actual cash value or a percentage of the replacement cost Cost to Repair and Rebuild: - Homeowners policies specify two types of coverage although a few other types can also occur - The type of coverage is important because it spells out how much the insurer is obligated to pay should the homeowner incur a loss - Some by-laws prohibit the owner from re-building the structure if the damage is more than 75% of the assessed value- the homeowner must tear down the structure and build a new one - Homeowner policies pay the cost to repair or rebuild and generally do not pay more than the actual cash value if you do not repair or rebuild Guaranteed Replacement Cost: - This pays the full cost to repair or replace the home and contents with similar quality materials even if it is more than the policy limit (the amount of insurance required) as long as the home was properly insured meaning 100% insured at the last assessment - This coverage does not pay for upgrades such as better quality windows - If the home was not properly insured at the time of the loss, that is, it was insured for less than 100%, the homeowner usually receives the lesser of the amount of the loss and the limits of insurance (the amount of the coverage) to a maximum of the actual cash value (the replacement cost less any depreciation and obsolescence) - Replacement Coverage: pays the replacement cost without depreciation but only up to the limits of the policy while extended replacement coverage pays the cost to rebuild up to a stated percentage over the insured amount. Actual Cash Value: - Valuation pays the cost to put the home back to the condition it was in at the time of the loss- the replacement cost minus depreciation or wear and tear - The result is that a homeowner can replace 30-year-old windows only with similar 30-year-old windows - The homeowner buys new windows but the amount the insurer pays is less than the cost of the new windows since the old windows had been subjected to wear and tear for 30 years - The same goes for the roof, insulation, floors, walls, kitchen cupboards, and bathroom fixtures - The same distinction applies to the contents- actual cash value pays only the fair market value, which means the insured gets only enough to replace an old couch with another old couch Coinsurance Calculation: - If the homeowner has guaranteed replacement cost coverage but the coinsurance requirement is not met, the most frequently used formula for the amount collected using a 80% coinsurance requirement is: ( ) - Example 1: uses 80% coinsurance (page 116) With an 80% coinsurance requirement, without guaranteed replacement cost and with $300,000 of coverage, her insurer would pay her a maximum of $300,000 should her house be completely destroyed and the cost to rebuild is more than $300,000 - Example 2: uses 100% coinsurance (page 117) If Susans house is completely destroyed and she is fully insured, that is, she is 100% insured and has guaranteed replacement cost insurance, the insurer will pay the entire cost to rebuild it even if it costs more than $300,000 Conclusion: - Most insurance companies will not allow you to deliberately underinsure - When you first sign up with an insurance company, it will do drive-by inspections at a minimum and sometimes the insurer sends an inspector to do a full inspection- Insurers are not required by law to provide you with insurance, and most would pass up the opportunity to do business with you if you attempted to underinsure your house by a significant amount - Insurers also do not want houses over- insured- this would provide an incentive for arson (morale hazard) and would also violate the principle of indemnity - Most insurance companies automatically increase the coverage annually to reflect increases in construction costs - However, you can unwittingly find yourself underinsured if you do a major renovation and forget to call your insurer Health and Commercial Insurance: - In commercial insurance, the 80% co-insurance requirement usually means that, after the deductible which the insured pays, the cost is shared on a 80%/ 20% basis- the insurer pays 80% while the insured pays 20% (plus the deductible) - Dental coverage in a group policy at work, there may be 65% coverage on certain types of claims and 100% on other types - The premiums increase in order to get 90% or 100% coverage Calculating the Premium: - Many factors influence both your eligibility for insurance and the amount of the premium, including the following: Type of structure- brick or frame Detach
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