(MoneyWatch) If you ask people who lost their homes in the recent Colorado wildfires if they expect their insurance to cover rebuilding costs, don't be surprised if the answer is a resounding "no."
It's not that most folks are burdened with lousy policies from bad insurers -- it's that they don't have enough insurance. Nearly 6 of 10 American houses are underinsured, with most homeowners having only enough insurance to pay about 80 percent of the costs to replace or rebuild their homes, according to property data provider MSB.
Most people have insurance that provides what is known as "extended replacement coverage." That means if their home is damaged or destroyed as a result of some covered calamity, their policy will pay out no more that up to 120 percent of the so-called dwelling limits in the policy, and not a penny more. The problem is that it could cost a lot more to rebuild or replace your home, and if your policy limits are insufficient you will end up paying the difference.
For example, say you own a home with a market value of $200,000, but the dwelling limit in your policy is $180,000. If you suffer a total loss on your home, then your policy would pay up to $216,000 toward rebuilding it. But the rebuilding costs could be far in excess of what the policy will pay, leaving many underinsured for a variety of reasons.
Why so many homes are underinsured
Most people buy and set the limits on their insurance when they buy their home. The amount of dwelling coverage is typically an estimate of the market price at any given time, which may or may not be a good starting point.
The mistake many people make is that once they buy home insurance, the only thing they keep up with is paying the premiums. They don't closely review their policy, including comparing the coverage limits to current reconstruction costs to determine if their policy limits are adequate. This "set it and forget it" thinking is what leaves so many homeowners underinsured. And unfortunately, most policy holders only discover their inadequate coverage when they experience a loss, by which point it's too late to take out more insurance.
So what should you do? Start by completing an estimate of the reconstruction cost of your home, and set your policy dwelling limit to this amount. Also review the amount of coverage on your home every few years. Remember, you can't increase your coverage when danger is imminent. Insurers generally place a moratorium on coverage changes in areas that are in the path of an incoming wildfire or storm, typically several days before a disaster is expected to strike.
In addition, contact your insurance agent to update your coverage when you remodel and improve your home. Even if you don't make improvements, you can be sure that it will cost more to replace it today compared with when you bought it. The reason: The surging price of building materials, energy and labor, all which have increased replacement costs up by more than 7 percent a year since 2001. (As a result, many policies offer a rider that automatically adjusts coverage every year by an indexed amount or a set percentage.)
Higher costs in tornado alley
If your home is located in an area prone to severe weather, such as tornadoes or hurricanes, then your rebuilding costs could also be pushed higher because of new building codes that require shutters, foundation supports, and other features designed to protect against wind damage or floods.
If you have a home insurance policy that costs $2,000 per year and are still underinsured, you could be wasting your money. Instead, increase your dwelling limits and increase your deductible. The savings from the higher deductible often offsets the cost of increasing the coverage.
The upshot: It is the homeowner who is responsible for selecting the proper policy coverage limits. In other words, if you find out after a loss that you are underinsured, don't expect the insurance company to take responsibility and make up the difference. According to the laws in many states, it's not their responsibility to advise you on the limits to set in your policy.
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