You don't want your home to be underinsured

John Perry is an assistant professor of economics at Centre College in Danville.
John Perry is an assistant professor of economics at Centre College in Danville.

Question: I'm in the market for home insurance and am finding it difficult to understand everything.

I'm paying $213,000 for my home and want to make sure it's well-covered in case of a catastrophe. I'm wondering whether I should insure it for more because I doubt I could build a home like this — all brick, hardwood floors, etc., on a one-acre lot — for $213,000 today. What's a good measuring stick for how much I should insure it for?

Also, while I want it to be insured well, I also have no real desire to have a very high insurance bill. I've talked with quite a few of my friends and colleagues and have found only one person who has ever had a claim on their home insurance (a new roof after a hail storm). How high of a deductible should I seek to ensure low premiums? What kinds of things should I consider in the trade-off there?

Answer: I imagine most people would rather spend time with their mother-in-law than think about home insurance (for the record, my mother-in-law is great). But home insurance, or homeowners insurance, is not much different than any other insurance product in that respect: Very few people like thinking about the insurance in spite of its importance.

First things first: Who should have homeowners insurance? Anyone who owns a home. The only exception would be if the complete loss of the home would be insignificant to your net worth. So Warren Buffett is exempt. The rest of us should have coverage.

What coverage? This is where things start to get confusing. A typical home insurance policy has five areas of coverage:

■ Dwelling: insurance on the house structure.

■ Other structures: insurance for buildings not attached to the home.

■ Personal property: coverage for your possessions, such as furniture, clothing, computers, etc.

Loss of use: coverage that provides living expenses should you not be able to use your home.

■ Personal liability: coverage for your negligent acts.

Within each category, each policy has specific details. The dwelling coverage amount is probably the most important for a couple of reasons. First, the coverage amounts for other structures, personal property and loss of use generally will be some percent of the dwelling number. For example, my personal property coverage is set at 75 percent of the dwelling coverage. Personal liability, meanwhile, is its own creature.

Second, the dwelling coverage amount is the specific amount for which the home is insured. If that number is too low and something bad happens, you will be underinsured, and the insurance company will not have to cover the full cost of rebuilding/repairing.

So you want to make sure you get the dwelling coverage right. With a new policy, the insurer will develop an estimate of what it would take to rebuild the house using recent construction cost data. However, this estimate could be higher or lower than the actual amount it would take for your house. If your home has special features that would make it more costly than average to rebuild, you will want to bring up the topic in the process.

The real danger is over time. After even five years, it might cost far more to rebuild, and if you have not updated your policy amounts, you risk being underinsured. The good news is that as long as you have insured your home for 80 percent of the cost it will take to rebuild, you are treated as having been insured fully. But you should review your coverage regularly. That goes for all insurances.

After selecting coverage amounts, an important consideration is the deductible, which is the amount of money you must come up with before the insurer pays anything. Technically, deductibles are meant to discourage small claims. Home insurance is a must, but it is something you do not want to use unless you must. That might seem odd, but even a single claim can increase your premium. Two claims in the same year could result in you being dropped. Three claims nearly assures it and means you will pay through the nose for coverage, if you can even get it, elsewhere.

That means your deductible should be high enough to remove the temptation to use your insurance for small issues but low enough that you will not be in a bind should you need it. In addition, as the deductible increases, premiums tend to fall. Choosing a deductible is a balance, but a $1,000 deductible is a nice level.