What Is Insurance to Value?

You probably hear a lot about how important it is to insure your home to its replacement cost. There’s an important reason this is stressed so heavily. If you’re underinsured by a certain amount, called the insurance to value ratio, your provider may not pay for all of your damage even if the amount is under your coverage limit. This difference in what you receive is called a coinsurance penalty.

Homeowners insurance companies use a concept called insurance to value to determine how much to pay for your claim, and this revolves around replacement cost and coinsurance. Let’s break it all down. 

Insurance to value (ITV) is a sort of rule insurance companies abide by. It’s a way for carriers to determine the appropriate premiums for the amount of risk they’re taking on when covering a property. ITV is present in many types of insurance, but we’re only going to focus on home insurance here.

Typically, insurers require you to cover your home for at least 80% of its replacement cost. This is so your policy covers close to the actual full value of your home in case it needs to be totally rebuilt. 

If you don’t reach the 80% threshold, your insurer may enact a coinsurance penalty. This means your carrier may not pay out the full desired amount of a claim if you incur a loss, even if the damage is below your policy limit. 

The reasoning is as follows: if you don’t cover your property for at least 80%, you’re not doing your job as a policyholder to adequately protect your home. Your insurance provider almost always encourages you to insure your home to its full value. If you don’t, your carrier isn’t fully responsible for you not maintaining enough coverage, so they enact a coinsurance penalty. With a coinsurance penalty, the provider signifies that you share some of the financial responsibility for the damage even if the claim is minor because you’re underinsured.

This allows the insurer to curtail its risk by holding you partially accountable for your property financially. When insurance companies are underwriting residential properties, they need an accurate assessment of ITV. 

Insurance companies calculate risk. No two policies are the same because each policyholder represents different risks based on their home, credit and claims history, and many more factors. An ITV assessment is a way to standardize the process just a little bit by having a fixed percentage to serve as one basis for rate valuation.

Insurers want to cover your home for its replacement cost so you can rebuild wholly after a disaster, but they also need to stay profitable as a business. Insurance to value helps them do both.

The insurance to value ratio varies by policy type. In homeowners insurance, it’s generally 80% of your home’s replacement cost.

To see if you fall above this 80%, divide the amount of dwelling coverage you have by your home’s replacement cost. If it’s over 80%, you’re good to go.

If your coverage falls below this 80% threshold, your insurance company will determine payouts by taking the number you get when you divide your dwelling coverage by your replacement cost and multiply that by the amount of damage you’ve sustained. Then, you subtract your deductible. This final number is the amount your provider will likely pay you. 

That’s hard to picture. So here’s an insurance to value example:

You got a homeowners policy 10 years ago with $300,000 of dwelling coverage. This was about the replacement cost of your home, so you were completely covered. Since then, you’ve made some upgrades to your house, like renovating your kitchen and adding a back deck. The replacement cost of your home is now $450,000. You don’t update your insurance policy to reflect these changes.

Now, you’re underinsured. Your $300,000 of coverage wouldn’t help you in case of a complete rebuild worth $450,000. And, you’re susceptible to a coinsurance penalty because you’re not insured to value. Your dwelling coverage ($300,000) is less than 80% of your replacement cost ($450,000). 

$300,000 / $450,000 = 67%

(80% coverage would be $450,000 x 0.8, which is $360,000 worth of coverage)

Now, let’s say a faulty outlet causes an electrical fire in the home, and you sustain $200,000 worth of damages. Even though this amount of damage is under your dwelling limit of $300,000, since you’re not insured to value, your carrier will likely only reimburse you for the percentage of the replacement cost you’re covered for (which is 67%). In this instance, the math to determine your payout looks like this:

$200,000 x ($300,000 / $450,000) = about $134,000

This is the meat of the formula. This gives you the payout for your damage relative to the percentage of replacement cost coverage you do have. 

To determine your final payout, though, you just need to subtract your deductible. This depends on what deductible you choose when you get your policy. Some common home insurance deductibles are $1,000, $2,000 and $5,000. Let’s say in this instance you have a $2,000 deductible. To determine your final payout, just subtract this from the number we got:

$134,000 – $2,000 = $132,000

In this case, you’ll only receive about $132,000 for your claim of $200,000 because you didn’t meet coinsurance requirements of at least 80% coverage, which was $360,000. The math to calculate your payout is what the coinsurance penalty looks like when applied.

In scenarios when you’re incurring a coinsurance penalty (when you don’t have 80% replacement cost coverage), your insurer will pay out the greater of two options: the ITV ratio percentage for your claim (like the number we calculated above) or the actual cash value of the claim. But, either way, you can expect a lower number than your coverage limit due to being underinsured.

Remember, a coinsurance clause or a coinsurance penalty will not affect you at all if you cover your property for its complete replacement cost, which is what carriers always recommend, anyways.

Getting a correct valuation for the replacement cost of your home is crucial. You can ask local builders, or look for replacement cost calculators online. As we’ve demonstrated, being covered up to your replacement cost is important for you and your insurance company. 

Following a catastrophic loss, if your home or property faces complete destruction, having a correct insurance to value figure identified by the insurance companies can be the difference between filing a claim that helps replace your home and not having a sufficient amount of coverage. 

While you might be concerned about keeping your insurance premiums as low as possible, being insured to value is well worth it, even if it means having to pay a little extra. 

Because they’re rather complicated, the ITV formulations that we discussed are commonly referred to as the 80/20 rule in home insurance. Simply put, the 80/20 rule states that if you’re above the 80% replacement cost coverage threshold of your home, your insurance company will likely reimburse you for the replacement cost of your home damage given that’s part of your policy.

In cases where you’re not insured to at least 80% of your house’s replacement cost, like in the example we went through earlier, you’ll either be paid the payout amount with the coinsurance penalty or the actual cash value amount of your claim.

Actual cash value is determined by subtracting depreciation from the replacement cost of whatever was damaged. Depreciation formulas vary by insurer but know that it’s always less than replacement cost. And, typically, the older an item is, the more it has depreciated. The more something depreciates, the less it’s worth.

You may see a coinsurance clause in homeowners insurance that outlines your duty or expectation to stay insured to value. To stay in agreement with the 80/20 home insurance rule and avoid coinsurance penalties, update your home insurance coverage every so often, especially after major renovations or local building code changes. 

Notify your insurer of any home repairs or upgrades you do, too, because it’s in your carriers’ interest to make sure you’re adequately insured also. 

If you keep the same amount of coverage on your home for close to or over a decade, you’re almost certainly underinsured even if you haven’t made any home upgrades. The cost of construction and materials rises, which raises your replacement cost. So, stay on top of your coverage amounts and communicate with your provider.