How Homeowners Insurance Works


Natural disasters are what many of us imagine of when we think of homeowners insurance, but it protects you in many other ways too. See more real estate pictures.

While rebuilding New Orleans and the Gulf Coast after the horrible devastation of hurricanes Katrina and Rita has relied in part on numerous volunteers, aid agencies and donations from the public, insurance agencies have also played an important role. The numbers involved in this disaster, the worst natural disaster the insurance industry has ever dealt with, are astounding: 1.7 million insurance claims were filed for $40.6 billion in damages. Approximately 682,000 insured vehicles were damaged or destroyed. Despite the terrible destruction and the long rebuilding process ahead, insurance companies have largely succeeded in their job. Reports indicate that only 2 percent of claims remain in some form of dispute [ref]. Though many people found themselves the victims of a poor FEMA response or lacked adequate insurance coverage, millions of others have been able to return to their lives because of the safety net provided by homeowners insurance.

Of course, homeowners insurance isn't just for victims of major disasters. From water damage to vandalism to someone accidentally injuring himself at your home, homeowners insurance has many applications. In this article, you'll find out why you need homeowners insurance, how it works and how to save money on the best policy for you.

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Why buy homeowners insurance?

Given all of the expenses that come with owning a home, it's reasonable to wonder if homeowners insurance is just another seemingly useless expense. The answer is no, it's not useless -- in fact, homeowners insurance is essential. Not only will a good policy save you money in the event that something happens to your home or belongings, an insurance company can also help you with other matters, like making your home more resistant to natural disasters. And though having homeowners insurance isn't required by law, most mortgage lenders require you to have homeowners insurance in order to borrow money from them. If you live in a condominium or co-op, you may also be required by your tenants' association to have homeowners insurance.

Even if you have a relatively new, well maintained house, homeowners insurance can help you in situations that may not be preventable. Say, for example, that you are having a dinner party at your house. A group of guests is gathered on the back patio, and one of the guests trips on a loose tile and breaks his ankle. You, as the homeowner, are potentially liable for the guest's injury. The right homeowners insurance policy should protect you against legal action and pay for the injured man's medical bills.

Now that you know why you need it, let's take a look at what it is you're buying.

Homeowners Insurance Policies

Homeowners insurance protects your house in case of theft, vandalism or natural disaster. Learn about the different types of policies.
Homeowners insurance protects your house in case of theft, vandalism or natural disaster. Learn about the different types of policies.
Photo used under Public Domain

Different policies exist for renters, owners of mobile homes, people seeking bare bones coverage and those living in homes that are very old, but most homeowners will purchase what is called an HO-3 policy. This insurance policy covers your home and its contents against damage and theft, as well as you, the owner, against personal liability if someone is injured while on your property. This coverage also includes damage caused by pets and most major disasters, though floods and earthquakes require separate policies. Homeowners insurance does not cover problems that result from poor maintenance or general wear and tear. A basic homeowners insurance policy should also cover other structures on your property and should provide for living expenses in case you are not able to live at home after a fire or other insured disaster. The amount of coverage provided for each of these items varies depending on the insurer and the type of policy.

Liability Limits

Photo courtesy MORGUEFILE ©2005-2006

One of the first things you need to know about your policy is the liability limit. The liability limit determines how much coverage you have should something happen to your home. These limits usually start at $100,000, but policies can be purchased with much higher limits. Most experts recommend that you have at least $300,000 to $500,000 of coverage, depending on the value of your home.

When someone talks about the amount of coverage they have, or their liability limit, they are probably referring to the coverage for their home -- that is, for the amount of money it would cost to rebuild their home given the price of materials and labor in the area. This amount is not the same as the purchase price of your home, which accounts for factors like the value of the land. A quick estimate of your rebuilding cost can be done by multiplying your home's total square footage by the building cost per square foot [ref].

While your liability limit is a reflection of the amount of coverage for your actual home, other structures on your property, such as a garage, are usually covered for 10 percent of that amount. Coverage for personal belongings usually falls somewhere between 50 percent and 70 percent of the amount of coverage on the structure of the home. And, as mentioned earlier, in case you have to live somewhere else because of damage to your home, most plans cover costs of living away from home -- hotel, restaurants/food, etc. -- up to 20 percent of your home's liability limit. Other policies may provide unlimited coverage for living expenses but only for a limited period of time.

What is Homeowners Insurance?

You may need an umbrella policy if you want coverage beyond a standard homeowners insurance policy.
You may need an umbrella policy if you want coverage beyond a standard homeowners insurance policy.

Another option you'll probably be asked to consider is replacement cost versus actual cash value. Here's where you'll really want to consider the contents of your home. Let's say, while you're not a complete luddite, by comparison to most current homeowners, the amount of electronic gadgets in your home is pretty small. You have a television that's almost as old as you are and you wouldn't miss it if it were gone. You also have an inexpensive stereo and the computer you use is an old loaner laptop from work. So which option is right for you? Going with actual cash value would mean that if these items were damaged, you'd get an amount of money equivalent to the current value of those items (accounting for depreciation). The laptop is covered through work; you won't need to replace that. And since you don't really care about the television, you could simply take the money you get and just get a new, cheap stereo. Meanwhile, your neighbor has everything a home theater should have - a plasma TV, a surround sound speaker system, DVD player, etc. in both her living room and the family room. With that kind of equipment, she'd definitely want to consider replacement cost coverage, which pays for a new version of the item that was lost or damaged - there's no accounting for depreciation. Obviously, in the case of electronics, which can depreciate in value rapidly over time, a replacement cost policy can be a big advantage. However, this isn’t the only scenario that calls for this option. Let’s go back to your household contents. There are other types of items to consider when making this decision. For example, what about the collection of signed prints you have? And there’s also the stamp collection and those original, signed Pearl S. Buck manuscripts. Original pieces of artwork or other costly collectibles can be just as, if not more, valuable than today’s pricey electronics. Replacement cost coverage is usually 10 percent more expensive than actual cash value coverage, but under the right circumstances, it's definitely worth the extra coverage.

Some homeowners may require a higher liability limit than what comes standard with their policy. Getting a higher limit can sometimes be as simple as paying a higher premium. However, in certain cases a special type of policy might be necessary. For example, an umbrella or excess liability policy is a separate policy that pays money to the policyholder after the liability limit on your regular homeowners insurance has been reached. Some umbrella policies defend against things like invasion of privacy, slander and libel. Generally, you have to have $300,000 in regular coverage before you can get an umbrella policy, and the more coverage you have in your regular policy, the cheaper your umbrella policy will be. An umbrella policy of $1 million in extra liability protection can cost $200 to $350 a year.

Other special policies include a special personal property floater/endorsement. This type of policy allows you to insure valuable items individually or together, has no deductible and charges a premium based on what the item is, its worth and where you live. An appraisal or a recent receipt determines the value of the item in question.

Remember that most standard policies do not cover earthquakes or floods. If live in an area prone to these disasters, you'll definitely want to consider special insurance policies that cover earthquakes and/or floods. Many policies do cover other natural disasters such as tornadoes and hurricanes, but it's always best to check with your carrier and, if your area experiences these disasters, consider getting a special policy.

Some homeowners insurance policies cover damage from blizzards and tornados, but it's best to check with your provider to see if you're covered. Some homeowners insurance policies cover damage from blizzards and tornados, but it's best to check with your provider to see if you're covered.
Some homeowners insurance policies cover damage from blizzards and tornados, but it's best to check with your provider to see if you're covered.
Photos courtesy stock.xchng © and MORGUEFILE ©2005-2006

Buying Homeowners Insurance

If you live in a hurricane prone area, investing in storm shutters could save you money and save your windows in a storm.
If you live in a hurricane prone area, investing in storm shutters could save you money and save your windows in a storm.

Now that you've decided you need homeowners insurance, or maybe you're looking for a new policy, it's time to consider an insurance provider. Dozens of carriers operate in every state, so making a choice can be difficult. Your state's insurance department can provide you with information about carriers, prices of policies and laws in your state.

Before you begin to look for a carrier, get acquainted with your house and the area where you live. Do you live in an area that gets a lot of storms? Is your house in a floodplain? Does your neighborhood suffer from a high level of crime or vandalism? Does your house have a history of water damage? Asking these sorts of questions will not only give you a better idea of your home and where you live -- it will allow you to make a more informed decision when choosing an insurance carrier. This can also be a great time to get a home inspection done. A professional home inspection can uncover lurking problems in your home and show you where your home may need retrofitting or improvements, all of which will help lower your premiums.

Once you're confident that your house is in good shape, it's time to start looking. Talk to your friends and neighbors about the insurance carriers they use. If you are moving into a new home, ask the sellers or your realtor for recommendations. It's important to choose a carrier that is reputable and licensed to operate in your state. If you are unsure of how a certain insurance company stacks up against the competition, many Web sites have ratings of insurance companies' financial strength. Here are a few:

Shop around for the right plan -- don't just look at the companies you know best. Some insurance companies sell through their own agents or through independent agents, while others sell directly to customers on the Internet or over the phone, so there are many different places for you to look.

How to Save Money on Homeowners Insurance A $1 million homeowners insurance policy can cost a few hundred dollars a year in some cases. In calculating this cost, an insurance company considers many different factors:

  • Propensity for disasters in the area
  • Building materials used in the home
  • Building costs (including labor)
  • Neighborhood crime levels
  • Size of house and special amenities
  • Condition of home
  • Distance to nearest fire hydrant and fire station

The presence of a volunteer instead of a professional fire department in your community can also affect the price of your policy.

Many of these things are beyond your control, but having a good knowledge of some of them can help you in shopping for a better premium. For example, if your area occasionally experiences severe hail storms, investing in storm shutters and shatterproof glass will make your home less at risk and possibly decrease insurance premiums. In general, taking measures to make your home disaster resistant, whether it's retrofitting the foundation or reinforcing the roof, will keep your home safer and help in getting a favorable insurance policy.

While the above factors can affect the price of your policy initially, other issues can result in an increase in premiums or in a reduction in availability of coverage. These include:

  • A decline in the stock market
  • Several major catastrophes in a given year
  • Increase in number and severity of claims filed with a company
  • Jump in price of building materials and local labor

It's important to do more than just keep your house in good physical condition. Installing a burglar alarm and other home security devices can help to lower premiums and prevent theft. Maintaining a good credit record, bundling services (i.e. getting auto and home insurance from the same carrier), obtaining group coverage through an employer and staying with the same insurance carrier for many years can help to keep rates down. Consider also raising your deductible -- the minimum amount of money you can file a claim for -- and balancing that higher deductible against a lower premium. If you're on a government plan, look for a private insurance carrier as they will often be cheaper and provide more options. Some insurance companies also give discounts (up to 10 percent in some cases) to people who are retired, with the belief that retired people have more time to maintain their homes.

Regular repairs, such as fixing an old roof, can lower your premiums. Regular repairs, such as fixing an old roof, can lower your premiums.
Regular repairs, such as fixing an old roof, can lower your premiums.
Photo courtesy MORGUEFILE ©2005-2006 (Photographer: Jeff Williams)

Above all, it's important to know when to use your insurance. Insurance companies will often raise your premium or consider dropping you from the policy if you make too many claims. Even if you have a clean record, decide whether making a claim on your insurance is worth the potential increase in premiums. Insurance companies have become swamped with claims about mold and water damage, and unfortunately even one claim can leave a bad mark on your record. Of course, if you need to make a claim, go ahead and do so. That's why you have insurance. But if you can afford to pay for a $1,000 repair rather than going to your insurance company, it may be in your best interest to do so.

Once you have your policy, your work isn't over. You should continue to keep an eye on your house and your policy. Maintain your home, and make any necessary, minor repairs. And, if possible, review your policy every year, and continue to update the inventory of your house, reappraising valuable items. Some insurers allow for an inflation guard policy, which, when you renew your policy, automatically adjusts your coverage to account for inflation.

Homeowners Insurance Challenges

Sometimes insurance companies make it very difficult to find coverage, but there are other options out there.
Sometimes insurance companies make it very difficult to find coverage, but there are other options out there.

Sometimes there are more challenges to getting insurance than just finding the best rate. At times, it can be difficult to get insured at all.

If you live in an area considered "high risk," such as one with severe weather conditions or an urban area with lots of crime and theft, insurance companies may decline to cover you. A home with old plumbing, heating or electrical systems may also be denied coverage, though these problems can generally be fixed through repairs.

If a company refuses to insure you, it's probably because they consider your home in some way to be too much of a risk. In that case, find out if there are any improvements you can make. If you are in a new home, ask a realtor for companies that insure in the area, or if you just purchased your home, find out from the previous owners who insured their home.

If you live in an unusually high-risk area, consider the Fair Access to Insurance Requirements (FAIR) Plans. Information about FAIR plans is available from the Insurance Information Institute. This program, created in the 1960s, allows people living in very high risk areas to become insured. The plans differ depending on the state, but all of them cover losses due to fire, vandalism, riot and windstorm. Still, please note that they aren't available in every state.

Similarly, residents in seven Atlantic and Gulf states may be eligible for the Beach and Windstorm Plan. This program provides residents in some areas with coverage against hurricanes and other storms.

Homeowners insurance money has allowed many Gulf state residents to rebuild following hurricanes Katrina and Rita. Homeowners insurance money has allowed many Gulf state residents to rebuild following hurricanes Katrina and Rita.
Homeowners insurance money has allowed many Gulf state residents to rebuild following hurricanes Katrina and Rita.

If you are having difficulty obtaining insurance, you can contact the Institute for Business & Home Safety, a nonprofit agency that advises businesses and individuals on how to minimize property losses from natural disasters and other events. While they don't work directly on behalf of consumers' in obtaining insurance, the expertise IBHS provides can help to improve the condition and safety of your home, which in turn can boost your chances of finding an insurer. Check out their Maintenance Matters section for suggestions on projects that will keep your home safe and prevent headaches in the future.

Homeowners Insurance: A Short History

When broken down into simple terms, insurance can be considered a method for distributing risk among a group of people so that no single person feels the full effects of a loss. Defined that way, insurance has a long history. In ancient China, farmers’ crops were taken to market via water, rather than land. If a ship sank, obviously it meant great financial loss. Eventually, farmers distributed their crops across a group of ships so that the sinking of one ship wouldn't ruin one lone farmer. Other ancient societies had similar systems of safe-guarding individual investments. In the 13th century, European merchants began insuring their ships by signing contracts with wealthy benefactors that provided compensation in case a ship was lost at sea [ref].

In a then anonymous letter to The Pennsylvania Gazette on February 4, 1735, Benjamin Franklin coined the famous phrase "an ounce of prevention is worth a pound of cure" when talking about the need for a better fire fighting service in the city of Philadelphia [ref]. In December 1736, a fire fighting service was formed in Philadelphia, and in 1752, Franklin's Union Fire Company, along with members of other fire fighting groups, formed the Philadelphia Contributionship, the first insurance company in the American colonies. Today, Franklin's proverb remains as valuable as ever. As shown in this article, a little bit of prevention, in the form of regular home maintenance and a good insurance policy, can go a long way towards preventing future losses.

For more information on homeowners insurance and related topics, check out the links on the next page.

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Sources

  • "Benjamin Franklin - Citizen Ben - Insurance Ben-efactor." 2002. PBS. http://www.pbs.org/benfranklin/l3_citizen_insurance.html
  • "History of Insurance." Financial Web. http://www.finweb.com/insurance/history-of-insurance.html
  • "III - Home Insurance Information." Insurance Information Institute. http://www.iii.org/individuals/homei/
  • "III - Hurricane Katrina: One Year Later." Insurance Information Institute. http://www.iii.org/media/hottopics/additional/katrina1year/
  • Lind, K. Michelle. "The Homeowner's Insurance Crisis." 3/2006. Arizona Association of Realtors. http://www.aaronline.com/documents/ins_crisis.aspx
  • Orman, Suze. "Test Your Homeowners Insurance Smarts." 10/23/2006. Yahoo! Finance. http://finance.yahoo.com/columnist/article/moneymatters/11166
  • Weston, Liz Pulliam. "Insurers Keep a Secret History of Your Home." MSN Money. http://articles.moneycentral.msn.com/Insurance/InsureYourHome/InsurersKeepASecretHistoryOfYourHome.aspx?page=1