The impetus of this article is simple – we are asked multiple times a day by well-intentioned investors... More...
When it comes to determining how much value you should insure your property for, one issue that seems to continually cause confusion and misunderstanding is that of a property’s reconstruction amount, also commonly referred to as its replacement cost.
It is important to understand that the reconstruction cost (replacement value) is the amount that the insurance company estimates it will cost to completely rebuild the property from the ‘ground up’ with like-kind materials at the current labor rate and materials cost for the geographic area in which the property is located. This amount also includes often disregarded or forgotten ‘soft costs’ such as architectural fees, permitting fees, and the cost of demolishing and/or removing the damaged structure prior to rebuilding.
From a strictly insurance-based perspective, the reconstruction cost of a home has absolutely no relation whatsoever to the property’s purchase price, the mortgage loan amount, appraisal value, or market value. In other words, the reconstruction cost is a completely independent value with no correlation at all to any other property-related value. For example, you may have purchased a property that appraised at a market value of $230,000, but because of the seller’s personal situation you were able to negotiate terms and purchase it for $180,000. After providing a 20% down payment of $36,000, your mortgage loan balance is only $154,000. Although there are several different values associated with this property, none of them have anything at all to do with what it may actually cost to completely rebuild it after a loss.
How Reconstruction Costs are Determined
Another common area of misinformation for property owners is regarding how a property’s reconstruction cost is actually determined by the insurance carrier. As opposed to common belief, this is not simply a ‘blind guess’ as to the cost of replacing the property. This formula is a little complex and it may vary somewhat from company to company depending upon the data points used, but the process (which is simplified below) is generally the same.
Most companies in the United States pay an enormous amount of money each year in order to have full access to the Marshall & Swift/Boeck (MSB) construction database. This is an experienced and well-respected third-party company that maintains accurate construction costs (materials and labor) for every single zip code in every county in the United States. This database is updated every 90 days and it is usually very accurate.
When requesting a new quote for property insurance, you agent may ask you many questions regarding the property’s physical features, such as the square footage, number of stories, construction type, roof material, exterior walls material, what floor coverings are used, etc. The purpose of these questions is to understand exactly how your property is built so that this information can be input into the carrier’s reconstruction cost software. Once this data has been obtained and input into the system, the software works with the MSB database to compare labor and material costs for the area and determine a fairly accurate amount of what it is expected to cost to rebuild the property at current labor and material rates.
The reason that two different companies may have two completely different reconstruction costs even when using the same data has to do with how the company calculates its own internal cost estimate, not with the MSB database. For instance, company ‘A’ may develop a reconstruction cost of $100,000, but within their internal calculations, they may add an additional 20% for labor costs, 5% for ‘soft costs’, and 22% for materials while company ‘B’ uses only the hard costs provided by Marshall & Swift/Boeck.
The purpose of this is to err on the side of caution and attempt to include an additional margin in order to offset any unforeseen fluctuations in actual costs after a loss. Each company’s reconstruction cost formula is proprietary and agents have no idea exactly how each company calculates the end cost or what margins are included. All agents have access to is the final estimated cost of replacement.
Do All Companies Use the MSB Database?
While over 90% of ‘standard’ companies utilize the MSB database, there are still a few who do not. The primary reason for this is simply the cost of access. Some smaller or regional insurance companies simply cannot (or will not) pay the annual fee to access the MSB database and they, therefore, choose to utilize their own internal construction cost data. While they are well within their rights to do so, the danger to consumers is that these companies are not specialists in the construction field and their data is usually updated (inaccurately) only every few years rather than on a quarterly basis. This means that customers and property owners run the severe risk of being underinsured in the event of a fire or other loss due to changes in labor and materials. The insurer has little or no liability due to the fact that they may have actually insured your property at ‘full replacement cost’ as their policy may have indicated, but it may have been an inaccurate reconstruction cost from the beginning as determined by their own inaccurate internal system. Other companies, usually ‘non-standard’ insurers, have absolutely no reconstruction cost estimator whatsoever and they simply ask you, the customer, how much you want to insure your property for. This is nothing more than a dangerous wild guess on your part and without having an actual reconstruction estimate, you have no way of knowing whether or not the property is accurately insured.
Can Two Properties Built Exactly Alike Have Different Reconstruction Costs?
Absolutely! Labor and material costs can vary a great deal from one geographic area to another. For example, here in Texas a home in El Paso may have a reconstruction or replacement cost of $150,000; however, that same house with the exact same size and physical features, may have a reconstruction or replacement cost of $210,000 in Houston. The reason for this, as has already been mentioned, is due to the local building codes, labor rates, materials costs, and other such issues.
Why Reconstruction Costs for Newer Properties are More Than the Builder’s Sales Price
One common point of disagreement between an insured property owner and his or her insurance company is that of the reconstruction cost of a property being a great deal more than the actual purchase price of a new home that was only recently built. From the customer’s perspective, he or she may have only paid $200,000 for the property, which includes the builder’s construction cost as well as the equity, land and everything else involved, but the insurance company determines that the replacement cost is actually $225,000. The customer often can’t understand why the reconstruction cost for the insurance company is so much more than for the builder and he or she often argues that the property is being over insured. This is a logical point of view; however, it is simply not the case.
When a tract builder constructs a new home, their cost of construction is far less than that of a custom builder. The reason for this is simple. When a tract builder constructs a new home, he or she is usually building a great many more at the same time and in the same subdivision or geographic area. This means that the builder is often purchasing millions, if not tens of millions of dollars, of supplies and materials in bulk. This allows the builder to obtain huge volume discounts on pricing which greatly reduces his or her construction overhead.
In addition, the builder may use the same labor crews for framing, concrete work, and all other phases of construction. Because the builder is supplying a steady flow of repeatable work to his subcontractors and these subcontractors are working for extended periods of time in the same areas, the labor rate is also greatly reduced.
This is not the case with regard to custom builders. Rebuilding a property is always more expensive than first-time new construction.
If your two-year home that you purchased from the original builder for $200,000 is destroyed in a fire, the contractor or builder that you hire to rebuild the home will not have the same deep discounts on his labor and material costs. In addition, he will have the added expense of obtaining new blueprints, architectural and permitting fees, debris removal, etc. which the original builder either did not have or which was also greatly reduced. This means that your $200,000 home may cost $250,000 to rebuild.
Why Older Properties Often Cost more to Rebuild
It is also important to understand that older properties may cost even more to rebuild. In addition to all of the other aspects already described, older properties may have unique architectural features that are difficult to replicate with today’s codes and materials and some of this work may require craftsman specializing in such things as tin ceilings, ornate molding, and similar work; all of which increases the construction cost.
Are Reconstruction Costs Automatically Updated When My Policy Renews?
Yes and no, it depends upon the company issuing the policy. Most standard companies automatically re-process the reconstruction cost when a policy renews using the information previously provided. This is why property owners may see both their premiums and reconstruction costs increase on an annual basis.
However, if there have been any improvements or alterations made to the property, such as room additions, elevation changes, interior remodels, or other such changes, the reconstruction or replacement cost listed on the policy will be inaccurate as it does not include these new modifications unless the insurance company is notified and this new data is included. This is why you should always contact your agent any time you make changes to your home or property that may affect what it ultimately costs to rebuild.
In summary, there is much more to properly insuring your property for its actual replacement value than simply pulling a number out of the air. There is a methodical and well-established process for determining actual costs that may be incurred and there is little or no relationship between the reconstruction cost of a property and the loan amount, appraisal, taxed, or market value. These numbers are all completely independent of one another and it is your responsibility, the property owner and insured customer, to make certain that your policy contains enough coverage to completely indemnify you (make whole financially) or replace the property in the event of a loss.