Back to the Basics: The Key Components of Your Home Insurance Policy
Knowing how to read and understand a homeowners insurance policy will help you purchase the right one for your needs.
You’ve finally saved enough to make a down payment on a home and your bid has just been accepted (renting instead of buying? See these 6 Reasons You Need Renter's Insurance). You'll need homeowners insurance but you might not know a whole lot about it. This article will bring you up to speed by explaining some basic home insurance terminology and some of its fundamental concepts. With this information, you'll be able to read and understand a policy and know what the essentials are before buying one.
A Few Essential Terms
In your insurance policy, there will be a section entitled "definitions." Here are a few of the key terms you'll find there.
Insured: a person who buys insurance (in this case, you!)
Insurer: an insurance company that sells insurance (protect your investment by learning How to Choose an Insurance Company that Won't Go Out of Business).
Coverage: a dollar amount of protection provided by an insurance policy.
Liability Coverages: coverage for injuries to another person or damage to another person’s property caused by you or another person covered under your homeowner’s policy (such as a minor child living with you).
Optional Coverages: coverages that you can choose to buy, as opposed to property and liability coverages, which are mandatory and found in every homeowner’s policy.
Actual Cash Value: If your property is damaged, the insurer will usually pay actual cash value up to the limit of insurance purchased. To determine actual cash value, the insurer will take into account the cost of replacement less depreciation among other things.
Business: regular pursuit done for financial gain. Note that business property is not usually covered under a homeowner’s policy even if the business property is kept in your home.
Flood: water damage from any body of water, whether natural or man-made, whether wind-driven or not (for more details, see 5 Water Damage Home Insurance Scenarios: Are You Covered?). Note that while "other water damage" (such as damage from a water pipe bursting) is covered, floods are usually not covered unless you specifically pay for such coverage or buy it from the National Flood Insurance Program (NFIP). In some high-risk, flood-prone areas you might be required to purchase flood coverage—and even if you are not required to purchase it, you might want to (especially considering these 5 Ways Climate Chance Can Affect Your Home Insurance Policy).
What You Need
If you, like the vast majority of homeowners, are taking out a loan to buy your home (a mortgage), the lender will require that you have an insurance policy in place before you close on the house (and even if you don’t have a mortgage, you will want insurance). The real estate agent you are working with to find your home can recommend an insurance agent or broker who will help you find the best policy for your needs (see Insurance Agents: What's the Point? to find out whether you should work with one).
At the top of the list of key components are the property coverages. For example, if your home burns down in a fire—whether caused by an internal problem in the house (an electrical short, a dropped cigarette) or from an external source such as a wildfire—you are covered (learn more in Does Homeowners Insurance Cover Natural Disasters?).
Note that damage to electronic equipment cause by power surges is usually not covered, and that some insurers will not sell insurance to you if you live in an area that is prone to wildfires.
Some key things to look out for with respect to property coverages:
- If you have outbuildings on the property, such as a tool shed, a studio or workspace of any kind, a small rental unit, or a garage that is not connected to the house, be sure to tell your insurance agent or broker about these structures when you discuss your needs with them. These might or might not be covered under the standard policy. If they are not, you can add them to the policy with a small increase in premium. And of course, if you add such a structure to the property after you buy, call your agent before you build it and find out if the structure will be covered.
- If you have a swimming pool on the property, whether it's an in-ground concrete pool or one made of synthetic material that stands above ground, be sure, again, to tell your agent or broker about these structures. And, again, if you add them after you buy, call your agent before they are built or installed to see whether they'll be covered.
- If you are storing items of unusually high value, such as an old, classic car; rare artwork; fine jewelry; or expensive firearms, on the property—whether in the house, in an outbuilding, or outside—ask your agent or broker whether they are covered and, if they are not, what it would cost to add them to the policy (see An Intro to Insurance Sublimits to learn about the limited coverage for luxury items).
As with property coverages, liability is always included in a homeowner’s policy. This is a broad form of coverage and applies to all kinds of situations.
Your dog attacks one of the neighborhood children or a postal worker and injures them severely. Your 10-year-old son gets into a rock-throwing fight in the neighborhood, throws a rock that strikes another child in the eye and blinds him. A guest trips and falls on a stairway and is seriously injured. In all three of these cases, you could be sued. The liability portion not only covers any judgment or settlement, but also covers the fees of the lawyer who represents you in the suit (see Insurance and Lawsuits: What Happens When Your Are Sued?).
It is highly recommended that, regardless of the value of your home, you have a minimum of $1 million in liability coverage. If an agent or broker tries to tell you that you only need an amount equal to the value of your home, and your home is worth less than $1 million, insist on at least $1 million anyway.
Depending on your needs, you might want to include certain optional coverages. If you have a home business, you can insure the business property (as noted above in the terminology section, this is usually not covered under a homeowner’s policy). Also, if you travel with business property such as tools or a computer, you can add "business property temporarily away" to your policy. You can also add loss or earnings coverage. This would protect you if, for example, your business was temporarily halted due to loss of equipment in a fire. Last but not least, liability coverage for the business would be highly recommended.
If you are a hunter or anyone else who stores large quantities of meat in a freezer, you can purchase coverage for loss of frozen food due to a power or mechanical failure.
Many insurers offer identity theft coverage. It includes losses such as funds lost due to credit card forgery, legal costs to restore your identity or to defend you in actions brought by merchants who were defrauded by the person who stole your identity, lost wages due to time away from work to deal with the issue, and more (but see Identity Theft Coverage: Is it Worth the Price? before purchasing this coverage).
If you have a separate rental unit or rent space in your home, you will want to discuss coverage related to this with your agent or broker.
When you sit down with an agent or broker to discuss your needs, ask them to explain the various optional coverages that are available to ensure that you get what is appropriate (see What Is an Insurance Broker? to find out how they can help).
With respect to all of your coverages, review everything once a year, on the policy anniversary date. Has the value of your home increased significantly since you set the property coverage limits? Has a child moved out of the house? Has an elderly parent moved into the house? Are you renting some space that you didn’t rent before? Have you acquired some expensive artwork? Any new circumstances should be reported to your agent or broker so that you can discuss any necessary changes in coverage that you might need.
Don't Cancel Your Policy Unless You Sell Your Home
Last but not least, a vignette. When I was working in the first of the two law offices I worked at, a friend of one of the partners was being sued and brought his case into the office. Seems that since he had paid off the mortgage on his home and thus he was no longer required to have a homeowner's insurance policy (required, of course, by lenders), he cancelled it! If he had still had a policy in force, the particular suit against him would have been covered under the liability portion of the policy. So never ever cancel your homeowner’s policy until after you sell the home.