By Robert J. Bruss
Tribune Media Services

What is the policy limit on your homeowner’s insurance policy?

If you’re like most homeowners, you insure your residence for the amount of your mortgage balance Û and your mortgage lender probably insists you do so.

But that makes no financial sense. What does your mortgage balance have to do with the amount of insurance you should carry on your home to rebuild if it burns to the ground? The correct answer is absolutely nothing.

If you insure your house for the amount of your mortgage balance, you could be wasting money by overinsuring. Or you could be incurring a high risk by underinsuring below the replacement cost to rebuild your home.

If you’re like many homeowners, your mortgage balance exceeds the reconstruction cost of your home because a major part of your residence property’s market value is in the nondestructible land value.

However, because it’s easy, many home mortgage lenders insist borrowers insure for at least their mortgage balance. And borrowers blindly comply.

I’ll never forget the morning I received a threatening phone call from a nasty employee of the bank that, at the time, held the mortgage on my home. She said my mortgage balance was about $100,000 more than the policy limit on my homeowner’s insurance policy, and I had to immediately increase my insurance limit.

I couldn’t convince her that if my house were to burn to the ground, my homeowner’s insurance policy limit would be for more than my home’s replacement cost. I finally gave up and asked my insurance agent to call to educate her about how replacement cost insurance works. That’s the last I heard from her about fire insurance.

Later, my insurance agent told me he often has to educate mortgage lenders that the correct amount for a homeowner’s insurance policy is the replacement cost to rebuild the house. He also told me overinsurance for more than the home’s replacement cost, in many states, violates state laws because it encourages arson.

Before the disastrous 1991 Oakland firestorm, which destroyed over 3,000 residences, insurance companies wrote guaranteed replacement cost homeowner insurance policies. But insurers lost millions of dollars paying claims to rebuild those houses to current, tougher building code standards. Back in 1991, guaranteed replacement cost homeowner insurance policies had no maximum limits.

Today, insurers are smarter. Now it is virtually impossible to buy a homeowner’s replacement cost insurance policy without a maximum limit. Most homeowner policies currently limit maximum reconstruction payments to 10 or 20 percent above the policy limit.

That means, for example, if you have a $200,000 homeowner’s replacement cost policy, the most your insurer must pay is $220,000 to rebuild if your home burns to the ground. In addition to your normal insurance premium, your insurer probably charges a slight additional premium to rebuild to current building code standards.

Most homeowner’s insurers, when the policy is renewed annually, automatically increase the policy limit (and the insurance premium) to compensate for the estimated increased cost of reconstruction.

Some homeowners, who either have no mortgage or a low mortgage balance, think they can outsmart their homeowner’s insurance company. Reasoning that most homeowner fires are not total losses, they decide they’ll buy, for example, only a $50,000 insurance policy.

Surprise! If the home is underinsured and a loss occurs, the insurer will then only pay a percentage of the loss, depending on the ratio of underinsurance to the correct amount that should have been insured. The homeowner then must pay for the uninsured part of the cost to rebuild. In other words, underinsurance can be an expensive mistake if a fire occurs.

The best way to be certain you have adequate replacement cost insurance is to contact at least two local agents representing two different insurance companies.

Each agent you interview should visit your residence, measure it, inspect it and photograph it. Then each agent should recommend a replacement cost insurance policy, based on the estimated reconstruction costs for your home and its type of construction.

Most insurance agents use a formula based on estimated construction costs per square foot. Be sure the agent measured your home correctly and the recommended policy guarantees your home will be rebuilt, including building code upgrades, even if the cost exceeds the policy limit. As explained earlier, however, most replacement cost policies now include a maximum payment, such as 10 to 20 percent above the policy limit.

Along with getting a homeowner’s insurance policy for your residence’s replacement cost, rather than your home’s mortgage balance amount, there are several additional ways to save on insurance premiums:

1) Raise your policy deductible amount from the customary $250 or $500 per insured loss to $1,000 or $2,000. Most insurers will then slash your policy premiums by 10 to 20 percent because higher deductibles eliminate costly small claims. Of course, raise your deductible only if you can afford to absorb the small losses, in return for policy premium savings.

2) Cut your homeowner and automobile liability insurance coverage and obtain better liability insurance by purchasing a $1 million or higher “umbrella liability policy.”

To illustrate, my insurance agent recommends I carry $300,000 liability insurance on my home and auto policies. In addition, I have a $2 million umbrella liability policy. If someone is negligently injured and I am liable, my homeowner or auto policy will pay up to the homeowner or auto policy limit. After that, my umbrella policy takes over, up to its policy limit. The result is I obtain better coverage at lower cost than if I had a higher liability limit on my home and auto policies.

3) To save approximately 20 percent on the personal property coverage of your homeowner’s insurance, instead of paying for replacement cost, select the actual cost replacement option. This controversial cost savings method means, in the event of a theft or fire loss to your furnishings, you will receive only the depreciated value, rather than the actual replacement cost. Discuss this alternative with your insurance agent before selecting it.

It can be expensive either to overinsure or underinsure your residence. The best alternative is to insure for your home’s actual replacement cost. Increasing the policy deductible amount to $1,000 or more can save additional premiums, provided you can afford to pay the small losses yourself.

Additional homeowner insurance savings are available by cutting your homeowner and automobile liability insurance limits and purchasing a $1 or $2 million umbrella liability policy. For full details, please consult your local insurance agent.

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