How the ‘80% Rule’ Impacts Your Home Insurance: A Complete Guide to Avoiding Costly Mistakes

Key Takeaways:

• It’s important to understand the difference between ‘replacement value’ and ‘market value’ which can significantly impact your insurance coverage.
• Ensure your homeowner’s insurance coverage meets the 80% rule which provides adequate coverage and is required by most insurance carriers and mortgage lenders.
• Be informed about the possible penalties and consequences if your insurance coverage is too low and how to prevent problems as a homeowner.
• Review replacement cost assumptions every one to three years taking into account rising costs and changes to your insured property.

Have you heard about the ‘80% Rule’ as it relates to your homeowner’s insurance? Maybe you have heard it referred to as the ’80/20 Coinsurance Rule’?

Either way, the 80% Rule suggests that your homeowner’s insurance needs to cover at least 80% of the total replacement cost of your home’s current value. If it doesn’t, you could be subject to penalties for being underinsured or underreporting the value of your home.

In fact, some states, e.g., California, Connecticut, Florida, Louisiana, and others, have laws requiring homeowners to insure their homes for at least 80% of the home’s total replacement costs. Additionally, most (if not all) mortgage lenders require homeowners to adhere to the 80% rule at the least and may require increases in policy coverages when necessary.

As home values have soared in most communities within the last few years, now is a good time to provide a comprehensive guide to help you negotiate the complex landscape of home insurance and avoid costly mistakes. Here are some key explanations and timely tips to meet the 80% home insurance requirement and protect your home in the future.

Home Insurance and the 80% Rule Explained

The 80% Rule for homeowner’s insurance states that homeowners should maintain insurance coverage that meets or exceeds 80% of the home’s total replacement cost value. Replacement cost is the cost of building materials, labor, and all related expenses needed to rebuild the home to it’s current state, including upgrades, finishes, and personal property, e.g., appliances. This is not the same as Market Value.

Ensuring that your home is insured at 80% or better also provides protection should you incur partial damages. If you home is underinsured, your insurance carrier will apply a compliance penalty for partial damages that can significantly reduce your coverage and pass the financial burden on to you instead. Later in this article, we explain the penalties and provide examples of the financial burden they present.

Replacement Cost Value vs. Market Value

Defining replacement cost vs. market value is crucial when targeting precise coverage amounts. If you use the wrong value, you can end up overpaying for coverage or not protecting your home adequately.

Here is a breakdown of the differences between replacement cost value and market value:

Replacement Cost Value

• Replacement cost is the dollar amount it would cost to rebuild your home to its current condition using similar quality products or materials.
• The costs are calculated in terms of today’s prices and not on the original cost of the products used.
• Replacement cost does not include the value of the land since the land is not destroyed during an insurable event. It only focuses on the costs of rebuilding the home and any improvements.
• Replacement value includes the cost of many variable products that fluctuate constantly, including:
  • Construction materials, like concrete, wood, glass, and finishes, such as door handles and light fixtures.
  • Labor costs for contractors and skilled workers.
  • Current code requirements which may include additional costs due to updated building codes.

Market Value

• Market value is the price to buy the home, including all land, in a competitive real estate market.
• Market value includes the home and the land, as well as intangible factors, like the location, the neighborhood desirability, the school system, etc.
• Market value relies on trends:
  • Supply and demand within the local housing market
  • Location, location, location which can include proximity to amenities, appeal of the area, views, and other intangibles
  • Land value

Understanding the difference between replacement value and market value is important, e.g., a home in an ultra-desirable location could have a market value of $500,000, but the replacement cost to rebuild the house might be only $300,000. This will impact your insurance premiums.

Understanding the difference between replacement cost value and market value is important for three reasons:

1. Homeowner’s insurance typically covers replacement value (and not market value) since the intention is to rebuild your home in the event of a catastrophic loss.
2. Risk of Underinsuring Your Property – If you base your decisions on market value and the replacement costs are higher, you could suffer an expensive loss that would require significant out-of-pocket costs.
3. Risk of Overinsuring Your Property – If you base your coverage on an inflated market value, you could pay more than necessary for your homeowner’s insurance coverage.

How Home Replacement Value is Calculated

Calculating your home’s replacement value is crucial to understanding your obligations regarding coverage and the 80% Rule. For informational purposes, here is an outline of how home replacement value is calculated. Talk with your insurance agent about a specific review of your home’s costs associated with replacement and how it affects your premiums.

Step 1

Determine your home’s total living area square footage, including finished and unfinished spaces.

Step 2

Estimate local construction costs per square foot. These costs can vary depending on location, the types and quality of materials, and the labor market. Currently, construction costs can range from $100-$150 per square foot for basic construction, up to $250+ per square foot for high-end or custom construction. Contact a local contractor for a more accurate cost estimation that’s in line with the costs in your area.

Step 3

Determine any special or unique features that bring additional costs, such as:

• Architectural Details – Custom molding, specialized designs, vaulted ceilings
• Additions – Pools, patios, decks, outdoor kitchens, garages
• High-End Materials – Custom cabinetry, premium flooring and countertops, high-end appliances
• Unique Features – Historical designations, custom features
• Special Systems – HVAC systems, security systems, water filtration systems

Step 4

Factor in any labor and contractor costs, costs for shipping materials, and any costs for building code updates.

Step 5

Use a reliable appraisal tool, either from your insurance agent or a professional appraiser, to determine an accurate dollar amount. Keep any calculations, assumptions, and records to justify where you numbers are coming from.

Step 6

Repeat the process every one to three years to ensure that your homeowner’s insurance coverage is accurate.

Falling Short of the 80% Rule

Surprisingly, for something this important, there is relatively little discussion about it from mortgage lenders and insurance companies. When homeowners fall short of the 80% rule, they have significantly increased their financial risk and may find themselves in a devastating situation they didn’t know was possible.

Here are several situations that would find a homeowner in an avoidable situation:

• Failing to Review Coverage Every Few Years – Housing prices change which affects market value, but in terms of insurance and the 80% Rule, inflation and the rising costs associated with construction and hard goods and materials can be devastating to the replacement cost of your home. And don’t forget labor costs which can also impact your replacement costs.
• Failure to Reassess Following Renovations – So you finally have that gorgeous new kitchen with a new layout and the latest finishes. Don’t forget to ensure your homeowner’s insurance reflects the replacement costs associated with any new construction, additions, and renovations.
• Market Value vs. Replacement Value – As discussed previously, not understanding the difference can lead to over or under paying for homeowner’s insurance.
• Underestimating a Home’s Features – Whether it’s custom finishes, unique layouts, premier landscaping, historic materials, or high quality materials, be sure not to underestimate the replacement costs associated with these features at today’s prices.
• Inaccurate Valuations – Errors, rushed or low-ball estimates, and quick guesses can all lead to inaccurate valuations that would create coverage problems and possibly not comply with the 80% rule.

Penalties and Consequences for Non-Compliance

When you fail to comply with the 80% rule, it can result in significant financial penalties like reduced payouts when you file a claim. So, if you file a claim and your insurance carrier determines that you are not compliant with the 80% rule, they can apply a coinsurance penalty to your claim. This coinsurance penalty will reduce your reimbursement for partial losses.

The coinsurance penalty formula is:

Payout = (Actual Coverage/Required Coverage) X Damage Amount – Deductible

As an example:

• Replacement cost of a home is $400,000
• Required 80% coverage is $320,000
• Actual coverage is $240,000 (75% of the required amount)
• Partial damage claim is $50,000
• Payout calculation is:

($240,000/320,000) X $50,000 = $37,500, minus deductible

• This leaves a $12,500 shortfall, plus the deductible

Additional possible consequences for partial claims can include:

• Increased out-of-pocket expenses that must be paid by the homeowner to restore the home to its previous condition – something that mortgage lenders will insist upon.
• Small or partial damage, such as a roof repair or a kitchen fire, will be subject to the coinsurance penalty. So, an insurance claim for a partial loss can cost the homeowner thousands of dollars to repair simply because they didn’t meet the 80% rule.
• Rebuilding to your home’s original condition may require taking on an additional loan or dipping into savings to cover the difference. Choosing not to rebuild to the original condition may be in violation of your mortgage.
• Insurance carriers may cancel or refuse to renew your policy due to their increased risk exposure.

How to Avoid Penalties and Problems Relating to the 80% Rule

We encourage a proactive approach with respect to all insurance coverage. Whether it’s homeowner’s insurance or auto, health, or life insurance, get comfortable asking questions and being involved in the decision-making process to ensure your risk is well managed.

Here are some tips to help you avoid penalties with regard to your homeowner’s policy:

• Develop a strong relationship with your insurance agent. They work for you, so don’t hesitate to ask questions and get their support when making insurance decisions.
• Be sure to insure your home for at least 80% of the replacement cost value.
• Review your policy regularly, e.g., every one to three years, and re-calculate the replacement cost to ensure that your coverage is still within the 80% rule.
• Reevaluate your policy following any additions or upgrades to your home.
• Add an inflation endorsement. Most insurance companies offer an endorsement to automatically adjust your annual premium to comply with rising replacement costs. This keeps you in compliance and ensures you won’t have a surprise if you ever need to file a claim.

Final Thoughts

If you ever experience a major catastrophe with your home, having adequate homeowner’s insurance is the difference between landing on your feet and potential financial devastation.

While obtaining insurance seems like a one-and-done deal, it’s important to review your coverage, bundles, discounts, and costs for insurance annually to ensure that you have full coverage on the things that are most important to you and your family.

If you haven’t taken the time to review your homeowner’s policy and update the replacement costs, now is the time to make that happen. Complying with the 80% rule is a crucial element of a well-thought out financial plan and will protect your financial wellbeing in the event of an emergency.

Contact einsurance.com to learn more about homeowner’s insurance and find the best quote.