How Much Insurance Coverage Should You Purchase?

Buy a dwelling limit equal to what it would cost to rebuild the rental at current construction prices. Do not use the market value or the purchase price, because both include land, and land is not covered. Under the standard DP-3 form, insuring below 80% of full replacement cost can reduce building repair payments. For older buildings, add ordinance or law coverage, which pays to bring the rebuilt structure up to current building codes.

Why market value and purchase price are the wrong numbers

The NAIC tells consumers that coverage should equal the full replacement cost of the home, and that replacement cost and market value are not the same. Market value includes the land and moves with the real estate market. The standard dwelling form (DP-3) says plainly that it does not cover land, including the land under the building.

The gap can run in either direction:

• Expensive land. A small rental on a valuable lot may sell for far more than it costs to rebuild. Insuring the sale price means paying premium on value the policy will never pay out.
• Older or custom construction. Plaster walls, brick, or older trim can cost more to rebuild than the building would sell for. Insuring the sale price leaves you short.

How to estimate the cost to rebuild

Your agent can run a replacement cost estimate from the building's square footage, construction type, roof, and features. The NAIC suggests a contractor as a second source. California's required disclosure encourages owners to get a current estimate of rebuild cost because insuring for less "may result in your having to pay thousands of dollars" after a total loss.

Include debris removal in the dwelling limit because the DP-3 pays debris removal out of the limit on the damaged property, not on top of it. A detached garage falls under other structures coverage. The DP-3 lets you apply up to 10% of the dwelling limit to other structures. If your detached buildings cost more than 10% of the dwelling limit to replace, buy a higher other-structures limit.

Ask the insurer to show the estimate it used, and correct the inputs (square footage, number of bathrooms, roof type) if they are wrong.

The 80% rule: how underinsuring cuts a claim

The DP-3's 80% threshold applies to building replacement-cost settlements, using the building's full replacement cost right before the loss. Below 80%, the insurer pays the larger of two amounts: the damaged part's actual cash value (its value after depreciation) or a reduced share of the repair cost, subject to the building limit. A loss can still reach that limit without an additional proportional reduction. The NAIC gives consumers the same warning.

Example: suppose a duplex costs $440,000 to rebuild, so the 80% threshold is $352,000. You insured it for $300,000. A kitchen fire causes $60,000 of damage, and your deductible is $1,000.

• Repair cost after the deductible: $60,000 - $1,000 = $59,000.
• Your share of the required insurance: $300,000 / $352,000 = about 85.2%.
• Payment: $59,000 x ($300,000 / $352,000) = about $50,284, unless the depreciated value of the damaged part is higher.

At a $352,000 limit or more, the same claim would pay $59,000.

Replacement cost vs. actual cash value settlements

Replacement cost pays to repair or rebuild with materials of like kind and quality, with no deduction for depreciation. Actual cash value (ACV) subtracts depreciation for age and wear, so it often does not pay enough to finish the repair. Even with a replacement cost policy, three DP-3 rules shrink or delay payment:

1. ACV until you rebuild. The insurer pays only ACV until the repair or replacement is complete, then pays the rest. The exception is a loss under both 5% of the dwelling limit and $2,500, which is settled at full cost right away. You can take the ACV payment first and still claim the difference later if you notify the insurer within 180 days of the loss.
2. Some items are always ACV. Your personal property, carpeting, household appliances, awnings, and outdoor equipment are settled at actual cash value, even when the building is insured at replacement cost.
3. Code upgrades are excluded from replacement cost unless you have ordinance or law coverage (below).

Flood claims follow different rules. The NFIP pays replacement cost only on a single-family home that is the owner's principal residence, so a flood claim on a rental house is paid at actual cash value.

Extended and guaranteed replacement cost

If construction prices jump after a regional disaster, a limit that was accurate at renewal can fall short. California's disclosure law describes two add-ons:

• Extended replacement cost pays above the dwelling limit, up to a stated percentage or dollar amount. A 25% extension on a $440,000 limit would pay up to $550,000.
• Guaranteed replacement cost pays the full cost to rebuild regardless of the limit on the declarations page. Ask whether your insurer sells it for rental dwellings.

An inflation guard endorsement, which the NAIC describes, raises the dwelling limit each year in line with inflation. Even with one, recheck the estimate after any renovation. If you are financing upgrades, see how home renovation loans work, and tell your insurer when the work is done.

Ordinance or law coverage for code upgrades

When a damaged building is rebuilt, the local building department can require the new work to meet the building codes and zoning laws in effect today. Standard replacement cost covers putting back what was there, not those upgrades.

Ordinance or law coverage pays the added cost of:

• Rebuilding the damaged part to current code.
• Demolishing and rebuilding the undamaged part when the code requires the whole building to come down.
• Remodeling undamaged parts when needed to finish the code-required repair, plus the related debris removal.

The DP-3 includes ordinance or law coverage equal to 10% of the dwelling limit, paid in addition to that limit. On a $440,000 policy that is $44,000. The coverage does not pay for the building's lost value or for testing and cleanup of pollutants. If the building predates current codes for wiring, plumbing, or fire separation, ask a contractor to estimate the code work, compare it with the 10%, and ask what higher percentages your insurer sells. Also confirm your policy form includes the coverage at all, since it is often sold as an endorsement.

For flood damage, the NFIP's Increased Cost of Compliance (ICC) coverage can pay up to $30,000 to raise, relocate, or demolish a covered building to meet state or local floodplain rules. Floodproofing is covered only for nonresidential buildings and residential basements meeting FEMA standards. Building and ICC payments together cannot exceed the maximum allowed by federal law; if the building payment exhausts that maximum, no ICC payment remains.

Eligibility requires either flood repair costs of at least 50% of the building's market value, with a state or local substantial-damage provision enforced against the building, or qualifying repeated losses. The repeated-loss route requires two floods within ten years, repair costs averaging at least 25% of the building's market value at each flood, a previous qualifying NFIP payment, and enforcement of a state or local cumulative substantial-damage or repetitive-loss provision against the building. See what a landlord policy covers after floods and other disasters.

Next steps

1. Get a written rebuild estimate from your agent and compare it with a contractor's per-square-foot figure.
2. Set the dwelling limit at or above that figure, with debris removal included.
3. Price extended replacement cost and a higher ordinance or law percentage, especially for an older building.
4. Recheck the limit at every renewal and after renovations.

For what else belongs on a landlord policy, start with whether you need landlord insurance and what it covers. To compare quotes once your limits are set, see how to choose your insurance.