Homeowners Insurance: What It Is and How It Works
Last Updated: April 27, 2020
Homeowners insurance has suffered from the unfortunate misconception that it is a luxury reserved for the rich. The truth is it’s a necessity that we should all make space for in our budget. Should your home be damaged, home insurance can restore it. If your possessions are stolen or destroyed, homeowners insurance may be able to replace or restore the items. Almost all mortgage companies require insurance coverage for the entire, or fair value (purchase price) of the property. In fact, without proof of insurance, the mortgage company will not engage in any sort of financing arrangement with you. Whether or not it’s required, having home insurance is a smart decision. As with any other insurance, you’ll want to make sure you select the right type of policy. That will be the one with the most appropriate coverage.
What Is Homeowners Insurance?
Homeowners insurance is a set of protections grouped as a single policy. The policy usually covers unforeseen damage and losses suffered from theft, vandalism, or catastrophic events (like severe weather). Relief from these threats takes the form of either cash or replacement of the lost items within, and including the home. Home insurance will also cover liability against claims from people who may be injured on your property and use of the home as well.
Basic Parts of a Homeowners Insurance Policy
What a home insurance policy covers depends on the terms of the agreement. They are not all created equally. Furthermore, you pay for what you get. If you spend the minimum, you get minimum coverage. Paying more means that you should receive better coverage with possibly higher limits. That being said, you shouldn’t pay for coverage that you don’t necessarily need.
Generally, a policy will have several discrete coverages, some of which are there by law, and others which are optional.
- Dwelling protection: protects against damage to the home and other attached structures on the property, like a garage.
- Other structures protection: coverage for stand-alone (non-attached) structures, like a fence or shed.
- Additional living expenses coverage: also known as loss of use. This pays part or all costs related to temporary relocation and basic living expenses, like meals. It’s used when you must leave your home in order to complete repairs.
- Personal property coverage: provides funds to repair or replace stolen or damaged property due to a covered loss.
- Liability coverage: protects against liabilities from other people’s injuries on your property, or while you are away from your home.
- Medical payments coverage: covers medical costs related to injuries incurred by your guests. It also provides coverage for you and your family if injured while away from home. This protection will be provided regardless of who is at fault.
Common Optional Coverages
- Water backup coverage: provides protection from damages due to damaged plumbing in the home. It only covers water that comes from the main and does not include flash floods. This coverage may or may not be automatically added by your insurer.
- Enhanced dwelling protection: this is additional coverage for your home structure. It’s often offered just in case your original limits are too low. This protection can also act as a buffer against a sharp increase in the cost of (re)constructing your home. Often, customers who have enhanced dwelling coverage appreciate this tool protecting their financial assets.
- Identity theft expense coverage: provides reimbursement for expenses incurred by activities related to recovering your stolen identity. Your insurer may include identity theft advisor assistance in your coverage. These advisors manage communications with creditors and bill collectors and possibly credit restoration.
- Scheduled personal property endorsement: provides coverage for high-dollar value items that exceed normal personal property limits. Fine art or jewelry would usually be covered under this endorsement.
The above are the most common coverages available for home insurance. Contact your insurance company for a comprehensive list of coverages they provide.
Types of Homeowners Insurance
There are several types of homeowners insurance policies that are standard (HO-1 through HO-8). Each standard gives different levels of protection based on the homeowner’s need, and the protected residence type.
- Basic Homeowners Policy (HO-1) covers 10 basic dangers, including fire, lightning, smoke, volcanic eruptions, explosions, and damages from aircraft.
- Broad Form Policy (HO-2) has the basic HO-1 benefits plus extra coverage, like injuries from artificially generated electricity. Personal liability, personal belongings, and the structures on the property are also covered.
- Special Form Policy (HO-3) gives all the protections of HO-2, and more. It covers your damage to other people and their property.
- Tenant’s Form (HO-4) is also known as renter’s insurance, and covers personal belongings and personal liability.
- Comprehensive Form (HO-5) provides the most homeowners insurance coverage than all the other policies. Like the Special Form policy, it may grant financial protection from every liability, save specific exceptions not covered in the policy.
- Condominium Unit Owners Form (HO-6) was created for owners and occupants of condos. HO-6 covers your personal property, walls, ceilings, and floors against damage. It extends protection against damages from any additions and/or alterations that the condo owner may create, up to coverage limits. Alteration coverages usually apply after the condominium association’s own policy has been exhausted.
- Mobile Home Form (HO-7) is also similar to the Special Form Policy but designed for mobile homes, which differ in coverage to regular homes.
- Older Home Form (HO-8) was designed for older homes, where market value is far exceeded by the cost to rebuild. Coverages are similar to those of HO-1.
- Dwelling Fire Form is a limited policy that provides very few specific protections. Personal liability, personal property, and medical payment coverages are not available. It is a popular choice for vacation homeowners. Mortgage lenders may also purchase this coverage if you allow your home insurance policy to lapse.
A note about townhouses. These can be insured either through an individual homeowner policy or homeowner’s association (group) policy. Consult with your insurance agent to determine the benefits of each policy and identify the best fit for you.
What Does Homeowners Insurance Cover?
The most common policies are HO-2 (Broad Form) and HO-3 (Special Form). HO-2 is a less comprehensive, “named-peril” policy, so it only covers the specific protections listed below:
- Fire or lightning,
- Volcanic eruptions
- Falling objects
- Damage due to the weight of ice, sleet, and snow
- Freeze damage
- Water damage or overflow
- Hail and windstorms
- Sudden bulging, tearing or cracking of the home
- Damage from artificially generated electricity
- Damage from aircraft
- Damage from vehicles.
If you need more protection, you should get an HO-3 policy. These are called “open-peril” policies because they cover everything except what is explicitly excluded. Personal property is still protected under named-peril coverage.
For even more protection, consider an HO-5 policy, which protects your dwelling and personal property against everything except named exclusions.
No matter how comprehensive your policy is, there are dangers that will not be covered. These include damages from:
- Nuclear hazard
- Wear and tear
- Government actions
If needed, you can purchase flood insurance and earthquake policies separately. Some states offer windstorm insurance. Your insurer can provide more accurate recommendations for weather-related dangers or other risks not in a standard policy. These are called endorsements and will cost extra in addition to your current policy. Your insurer should be able to recommend where to purchase flood, earthquake and windstorm insurance.
How Much Coverage Do I Need?
The best way to answer this is to first understand the difference between replacement costs and actual costs.
- Actual cash value (ACV). ACV provides the reimbursement, considering depreciation due to age and wear and tear over the years. ACV is often lower than the market value of the covered item. Because of this, you can expect to pay lower premiums for a policy with ACV.
- Replacement cost value (RCV). RCV doesn’t consider depreciation, so your possessions would be replaced at the current market value. The current market value may be higher than the actual value of the item. As a result, premiums for a policy with RCV tend to be about 10% higher than a policy with ACV. If you choose a policy with RCV, make sure that the coverage includes the entire RCV value of your home.
Your home’s market value includes the price of your property’s land and is dependent on your local real estate market. Should the dwelling coverage fall below 80% of RCV, your insurer may lower how much they’ll pay for the claim.
When generating a quote, you may be asked for some basic information about the insured property, like:
- The location
- Size/square footage
- Construction year
- Type of construction
- Roof type and age
- Number of floors, bedrooms, and bathrooms
- If it has a garage, and what type
- Method of foundation (for example, poured concrete)
- Present security systems and smoke alarms
- Type of heating and cooling systems.
Information provided for quotes should be consistent. Ensure all quotes are received in writing, and they provide the same levels of coverage and limits. This will allow a better comparison between offers.
While gathering quotes, you may want to assess other parts of the insurance experience, like the insurer’s customer service. It’s also important to ask about, and observe, how they handle problems. Review your state’s insurance department “complaint index”, which measures how many grievances have been lodged against the insurer. The complaints are normalized to the company’s size, so you can compare the insurer’s responses on the same scale.
In all homeowners insurance policies, an amount is deducted from payments for claims. You may receive a deductible for each type of claim by default. Alternatively, you may also choose an all-peril deductible to cover multiple types of damages. Your insurer will subtract the deductible from the claims check that they send you. For example, let’s say you file a roof repair that will cost $10,000. If you have a $1,000 deductible, the insurance company will issue a cheque for $9,000. You will be responsible for providing the remaining $1,000.
Some insurers require a separate deductible for wind and hail. In general, deductibles do not apply to liability claims.
How High Should You Set Your Deductible?
Usually, an insurance deductible falls within $500 and $1,000. High deductible amounts will result in lower premiums, but you will have a larger financial burden if damages occur. Lower deductibles will mean higher premiums, but your insurer will cover more of the claim.
How Much Does Homeowners Insurance Cost?
According to ValuePenguin, home insurance premiums average about $1,083 per year. However, where your home is located can skew your policy cost higher or lower. Live in Hawaii, and your policy may be as low as $337; in Florida, it may be as much as $3,575 (Insurance.com).
The factors which influence your home’s insurance cost include:
- The cost to rebuild your home
- The age of the home
- How far away your home is from the nearest water source
- Your city’s fire protection rating
- Your claims’ history and that of your neighborhood
- The selected coverages, limits and deductible
- Major injury risk recreational items, like pools or trampolines.
Cost-Cutting Insurance Tips
- Purchasing and/or maintaining your security system. You can lower your annual homeowners insurance premiums by owning a burglar alarm. The alarm must be monitored by a third party or local police. The discount could be 5% or more.
- Smoke alarms, CO2 detectors, deadbolts, and sprinklers are devices that insurance companies love. Most recently built homes may come standard with these devices, but older homes may not. Installing smoke alarms can result in a 10% discount. Contact your home insurer for more information.
- Raise your deductible. As mentioned earlier, higher deductibles mean lower premiums. Unfortunately, smaller claims like a broken window repair costing a few hundred dollars will not meet the deductible. This must be paid exclusively out-of-pocket by the homeowner.
- Look for multiple policy discounts. You may be eligible to receive a multi-policy discount of 10% or more. All you have to do is have two or more policies with the same issuer. Bundle your home and car insurance and enjoy the savings.
- Plan ahead for construction. If you’re looking to build an addition or a new structure on your property, consider the materials used. Wood-framed structures are more flammable and are more expensive to insure. Cement or steel frames are less expensive because they are more robust against fire and bad weather.
- Don’t forget about the swimming pool, trampoline, and other risky items. These things can increase your policy cost by 10% or more.
- Pay off your mortgage. Insurers believe that if the house is 100% owned by the insured, he or she will take better care of it.
- Make regular policy reviews and comparisons. Take the time to see what else is available. Consider quotes directly from insurance companies, but also look into offers that come through memberships. Your credit union, employer, trade union, or another social club may have group discounts that can lower your premium. Once per year, review your policy and compare them to similar offers from the competition.
The goal is to do two things:
- look for opportunities to lower your premium; and
- get the best rate for the coverage you need.
If you have made changes that can lower your costs, you will want to gather your evidence and notify your insurer. Evidence can include photos, receipts, and bills.
- Some companies love loyal customers and may offer lower premiums for the long-standing insured. Contact your insurance company to see if you qualify.
- Assess your most valuable possessions regularly to ensure you have enough coverage.
- Pay attention to what’s changing in the neighborhood, especially near to your home. The installation of a new fire hydrant can positively affect your premiums if it occurs within 100 feet of your home. Similarly, a new fire substation erected nearby can do the same.
Homeowners insurance is a living document, that must be reviewed with time. Your insurance needs change, which means that your policy could be insufficient or excessive, depending on your current situation. The best way to adapt is to carefully read your policy and to know what’s available. Shop around for quotations and to ensure you’re working with the right agent. You may want to keep an inventory of your possessions so that you can determine what coverages should be selected. The goal is to ensure that you, your home, your possessions and your guests are protected, no matter what happens.