What is the 80/20 Rule in Homeowners Insurance?

Some homeowner's insurance policies include inflation guard coverage, which helps cover the rising cost of construction supplies and labor. If you haven't made any improvements to your home since purchasing your policy, the insurance guard coverage may be sufficient to maintain your coverage amount.

However, suppose you've done any construction that has increased the value of your home since purchasing the insurance. In that case, the inflation adjustment will not be applied to your property's new (higher) replacement value. When you receive policy renewal letters, some agents or insurers may remind you to adjust your coverage to reflect home improvements, but many do not (or many homeowners ignore them). It is advisable to be proactive and inform your insurance carrier of any big home improvements. The "penalty" for being underinsured is that your insurer may not pay the full amount of a claim you file.

Consider a hypothetical instance. Holly and Greg purchased a $300,000 home a few years ago and insured it for its replacement value with an insurance policy that included inflation protection coverage.

Holly and Greg have improved their kitchen, constructed a new front porch, and renovated all of their bathrooms over the past several years. Even after adjusting for inflation, the policy's replacement cost will not reflect the changes; the cost to rebuild the house is now $500,000.

The house was devastated by fire one day. Holly and Greg escaped safely, so don't be concerned. The fire resulted in about $200,000 worth of damage. Holly and Greg exhale a sigh of relief because the amount of their home's insurance coverage exceeds the value of the damages. However, instead of covering the total cost of the reconstruction, their insurance company handed them a $149,000 payment.

The majority of insurance companies require you to insure your home for at minimum 80 percent of its replacement value. (100% coverage is preferable. However, most insurance companies will pay a complete claim with 80% coverage.) If you do not, your claims will be reduced by the proportion of the replacement cost for which you have coverage minus your deductible.

Remember that homeowner's insurance aims to reduce your risk of financial loss due to property damage, but you are not effectively managing these risks unless you have enough coverage. In the example, in order to boost their coverage from $300,000 to the greater replacement value of their home, Greg and Holly's homeowner's insurance premiums likely would have risen slightly. However, the difference in rates would not have been as great as the $50,000 they paid out of pocket to compensate for the damages that were not covered by insurance.