Actionable data plays an essential role as policyholders choose the right amount of coverage to protect their homes in the event of a disaster. In today's tumultuous housing market, current, reliable information is more invaluable than ever as property insurers work to alert policyholders to changing variables that could increase the likelihood that their properties are underinsured.
Certainly underinsurance is no new problem in the property insurance industry. In past years, insurers frequently encountered difficulties creating replacement-cost estimates that adequately addressed properties' probabilistic risk. Only within the past decade have we been able to harness the power of enormous amounts of data containing construction rates and detailed structural information for millions of U.S. properties. Advances in analytical tools also enable us to drill down to specific zip codes so we can view local trends for common building materials and labor necessary to rebuild a structure. Thanks to these tools, we are now able to create a component-based estimate for a building that is based on costs being paid for actual claims in the area and supported by detailed construction market research.
Despite all the advances we've made in technology, the home valuation process is still fraught with challenges. Recent trends in the housing market and construction industry have increased many properties' exposure to underinsurance, as some policyholders have reduced their insurance coverage to cope with the economic recession. This creates a precarious situation because affected policyholders could end up shouldering more risk if their property is destroyed in a disaster. Reconstruction cost data and analytical tools are invaluable resources that can help mitigate these issues. They provide policyholders with in-depth information about potential risks and with reliable insurance-to-value estimates that help them protect their investments.
Declining Home Market Values
Home market values have been on a steady decline ever since the housing bubble burst three years ago. The National Association of Realtors reports that the U.S. median sales price for a single-family home was $172,900 at the end of 2009, a 20.6-percent decrease from the median sales price of third quarter 2007. Many regions across the U.S. have suffered substantial losses since the fourth quarter of 2008. Ocala, Fla. experienced the steepest decline of 23.4 percent, followed by Las Vegas, N.V. with a decline of 23.3 percent. As houses across the nation continue to lose value, another trend is unfolding in the construction industry that puts many policyholders at increased risk of being underinsured, should disaster strike.
Rising Reconstruction Costs
While the value at which a home can be bought or sold imploded during the past three years, the cost to rebuild that same home with like-kind-and-quality materials has continued to increase. Analysis of thousands of field surveys and millions of actual claim files and construction rates in all 50 states and the District of Columbia reveals that nationwide reconstruction costs increased 0.96 percent in 2009. As shown in below in Figure 1, Vermont, Arkansas, Texas, Oklahoma, and North Carolina experienced the highest increases in the overall cost to rebuild. Only Florida and Rhode Island reported decreases in reconstruction costs.
This growth appears anemic when compared to a 3.95-percent increase in 2008 and a 4.18-percent increase in 2007, but research shows that reconstruction costs jumped 16.22 percent since the housing market first began to plummet. Figure 2 illustrates the tremendous disproportion that currently exists between the U.S. median sales price and reconstruction costs. This research also demonstrates the amount of probabilistic risk many policyholders now face, especially the high number of homeowners who have opted to buy less insurance to cut expenses.
Reducing Coverage in Tough Times
As the current financial crisis deepened in 2009, a high number of homeowners reduced their insurance coverage in a bid to save money. A recent study by the Insurance Information Institute, titled "January 2010 Insurance Pulse," found that 22 percent of surveyed homeowners admitted to buying less insurance last year. This is a particularly alarming statistic, considering the recent string of international disasters that have re-emphasized the importance of having adequate insurance coverage. The high number of people cutting back on insurance is also indicative of widespread misconceptions about how insurers calculate coverage.
Separating Fact from Fable
Property insurance professionals know the implications when reconstruction costs outstrip market value, but many property owners and commentators don't understand the distinction. Sales price is at the forefront of their minds, so it seems reasonable to them that the monthly premiums covering a home would drop in proportion to a decrease in market value. Some even see this as an ideal time to barter for lower insurance rates. For example, a recent edition of a leading consumer magazine contained a brief article advising homeowners to renegotiate their annual policy costs based on the value their homes have lost during the housing slump.
This ill-advised tip appears reasonable to many policyholders, but it's akin to assuming the cost to repair a car decreased just because the buyer negotiated a good price from a dealer with an overstocked inventory. In the same way, the current housing turmoil has driven down property values across the nation, and many banks and lenders have slashed prices just to sell homes and minimize their losses.
Under normal circumstances (an upward-trending economy), the market value of a property, including the land, is generally higher than the cost to reconstruct just the building. But market value and reconstruction costs are not tightly linked, and they do not have to move at the same speed or even in the same direction because they are affected by different factors. Reconstruction costs are influenced by the supply and demand of building materials and labor, while market value is influenced by the supply and demand of completed homes. In the current economy, land values and home values in some areas have deteriorated much more than construction costs. As a result, some homes' reconstruction costs are higher than their market value.
The following example provides a useful illustration: a four-bedroom, two-bath, 1,980-square-foot one-story home in Montpelier, Vt., is currently on sale for $224,000. According to an online replacement-cost estimator, however, it could cost as much as $323,400 to rebuild the structure. A homebuyer who decides to insure the structure at its sales price would have to pay as much as $99,000 out of his or her own pocket to rebuild, should a fire or storm destroy the structure.
While this example is not typical in every area of the U.S., it is certainly possible in areas that have experienced the greatest amount of market value depreciation. Reliable information found in comprehensive databases and analytical tools not only aids professionals who help policyholders choose the best coverage for their homes, but is also useful in promoting understanding about the valuation process and how insurers estimate replacement costs.
Raising Awareness about Risks
As the adage goes, knowledge is power. Policyholders who understand the variables that affect their properties' reconstruction costs and the risks they face are in a better position to select the appropriate amount of coverage necessary to protect their homes. Some insurance organizations recognize these benefits, and they are expanding efforts to promote awareness about these issues. For example, the Insurance Bureau of Canada has embarked on a public awareness campaign, using Web sites, brochures, and support materials to educate consumers about underinsurance risks and how insurers calculate replacement costs. Thoroughly researched and comprehensive cost data and high-powered analytics can also play an important role in efforts to alert policyholders to the dangers of underinsurance.
Current technology gives underwriters and claim professionals the ability to access localized, up-to-date cost information for labor and materials as well as analytical tools that track critical trends in the construction and insurance industries. These provide valuable resources to explain the difference between market value and reconstruction costs and show policyholders the appropriate amount of coverage their properties need. This also increases transparency because policyholders can view detailed component-based estimates -- in other words, where each stick of lumber, gallon of paint, or hour of labor is accounted for in detail -- to ensure they are protected against any unforeseen risks.
It is uncertain when the housing market will rebound. The economy has lost significant ground, and it may take several years of sustained growth before a recovery takes place. It is reasonable to assume the market must correct in those areas where home values are currently less than reconstruction costs -- whether it be an increase in market values, a decrease in construction costs, or some combination of the two -- before the construction industry begins to produce more inventory. Experts predict this will take time.
For instance, financial service provider Fiserv recently issued a report stating it expects home sales prices will continue to decline until the end of 2010 before they start to rise. Fiserv also expects that sales prices in areas most affected by the housing crisis (such as metropolitan areas in California, Florida, Arizona, and Nevada) may not return to peak levels until 2025.
Regardless of what happens in the housing market, there are a number of tools and strategies available as underwriters and claim professionals work to promote awareness about underinsurance risks and help policyholders select the right amount of coverage to give them peace of mind, knowing they have adequate protection if the day comes when they will need it most.