Homeowners rely on replacement cost endorsements to cover the full value of household items and home features. However, frequently and ever increasingly, they find that their coverage is not adequate to purchase identical items or restore unique facets of their homes.

Nearly 63% of insured homeowners say their coverage may not be adjusted for annual inflation, according to the American Property Casualty Insurance Association (APCIA), and as many as 67% said they may not have extended replacement cost coverage on their policies either. 

While homeowners face the problem of not carrying enough insurance, carriers have likewise encountered issues paying for the replacement cost of homes and their contents. In 2023, many homeowners and insurers find themselves in this dilemma.

Inflation in the U.S. clocked in at 4.9% in April 2023, according to the U.S. Bureau of Labor Statistics. While this figure is much lower than the 8% a year before, it continues to impact homeowners who have purchased goods or property that may now cost more to replace than when they were purchased.

Inflationary trends have had an impact on building costs. For example, the cost of plastic and copper plumbing in 2023 has risen 35% over the previous year, according to Chubb, while the price of drywall has increased 19%. Therefore, home repairs are more expensive—especially for high-end homes with ornate furnishings and features. To make things worse, the rising cost of copper fixtures has triggered a 540% increase in thefts from 2020 to 2022, according to APCIA.

The forces of supply and demand have also entered the equation. Even with rising interest rates for new homes and home equity loans impacting homebuying, multifamily dwelling construction reached a record high while home improvement pursuits continued at a rapid pace, according to APCIA. A shortage of about 2.2 million skilled construction workers has increased the cost of labor, according to Chubb, which boosts the price of building or rebuilding a home. 

Meanwhile, contents are trickier to underwrite than the framing costs of a 400-square-foot room, for instance. Home contents have a bearing on large insurance losses, since homeowners may not account for the type of upscale property in their homes. Appliances like smart refrigerators can now cost in the tens of thousands and replacing cutting-edge personal property in high-value homes adds significantly to the cost of claims.

At a time when inflation and demand for new homes have caused construction costs to spike upward, another contribution to loss ratios has appeared in the form of catastrophic nationwide claims occurrences. In 2022, the property & casualty insurance industry saw the third-highest number of billion-dollar disasters, according to Chubb, the largest of which was Hurricane Ian—the second-costliest global insurance loss on record. Losses between 2020 and 2022 amounted to $287 billion, according to APCIA, which was the highest number for any consecutive three-year period recorded by U.S. insurers.

All these variables are propelling higher replacement costs that may be inaccurate at the time of a claim. For example:

A low-cost replacement cost endorsement was added to a homeowner's policy. The home was purchased for $10 million with a current stated policy value of $10 million. After a fire, it cost $18 million to rebuild the home. The time from the last appraisal was just five years. Per the replacement cost endorsement, the insurer is obligated to reconstruct the home and its contents as they stood before the fire. Ultimately, the insurance carrier accepted a premium that has become too small to indemnify a risk that has doubled due to higher-than-expected inflation. This situation applies significant pressure to the bottom line of the insurer and leaves the homeowner in jeopardy of losing their coverage or not being able to fully rebuild after their loss.

Reconciling Unprofitable Loss Ratios

Unprofitable claims occurrences pave the way for insurance companies to terminate or drastically alter the practice of issuing replacement cost endorsements. Further, today's market dispels the theory that insurance value only equates to what a homeowner originally paid for a dwelling and its contents. This is especially true with upscale homes that include ornate custom-made features and rare collectibles that appreciate in value.

Additional reasons why current replacement cost endorsements are becoming less viable include:

• Updated local codes require greater expense.
• Environmental remediation requires expensive pursuits, such as ridding a property of underground oil tanks or other potential hazards.
• Most high-value homes include uncommon features or contents that are more difficult to replace.
• Owners fail to report upgrades or rare items to their insurers.
  

Sourcing, rebuilding and replacing features and one-of-a-kind items after a loss cost more than the original purchase price and, as a result, inadequate homeowners coverage and higher insurance carrier loss ratios are both exacerbated.

Higher rates can only do so much to balance the financial interests of homeowners and insurance companies. It raises the question: How can the replacement form be changed to achieve this objective?

One solution may be a modified replacement value coverage, which focuses on replacing unique features of older high-end homes with materials available in the current marketplace. To illustrate, stained glass in a 130-year-old home is impossible to source in 2023. Modified replacement value coverage would allow the insurance carrier to pay for materials and installation of modern stained glass that is available today, while the rest of the expense would be picked up by the homeowner.

Addressing Replacement Cost Issues

Agents and brokers can endeavor to educate their clients. They can be proactive in reviewing and explaining replacement cost endorsements so that policyholders have realistic expectations after a loss.

Here are four best practices agents and brokers can adopt to mitigate the problem:

1) Be a trusted adviser. When you operate in the capacity of a trusted adviser, high net-worth customers will rest easier knowing that you have a solid grip on how home values appreciate and how unique items should be scheduled on a policy. When an agent or broker takes a proactive stance on carefully interpreting policy endorsements and monitoring increasing home values, it's a lot easier to prevent coverage gaps.

One challenge in an inflationary environment is how frequently values change in the high-end homeowners market. Annual policy reviews may have been customary in past years, but it's important for you and your clients to understand that coverage may need to be updated monthly or even weekly in certain markets. Therefore, communication between you and the policyholder must be constant to reduce the chance of their home being underinsured. 

2) Revise your approach at renewal time. Agents and brokers can't expect clients to report every upgrade or addition to their home and contents. By the same token, you also can't depend on the nominal inflation guards used by carriers to keep pace with the rising value of a dwelling and personal property. A simple review of the replacement cost endorsement, coupled with a detailed questionnaire, might help uncover some of the critical data that warrants a coverage increase.

Consumers today are no strangers to inflation. Therefore, during each annual renewal review, it's imperative to help homeowners understand how rising prices impact their coverage needs. Using a visual aid that conveys the current price of lumber, doors and windows, roofing materials and fixtures will help drive the point home.

It may be difficult to recommend strategies that increase policy premiums, so emphasize how protection is being secured for pennies on the dollar.

3) Help clients distinguish between replacement and purchase value. Historically, the burden of grasping increasing insurance values had rested upon the shoulders of the homeowner. But, while the homeowner may not think about it, you'd want them to tell you if they had Brazilian cherry wood floors installed in their home. Such a move could boost the replacement value of a $1 million home to $1.1 million. Brokers and agents understand how upgrades and purchases affect replacement value. So, it must be you who assumes the responsibility of calculating replacement value by supplanting sporadic home inspections with probing questions.

Explaining the concept in its simplest form may be beneficial: Replacement cost is intended to make the customer whole by restoring a property to the same condition before a loss. The accuracy of that cost has been muddied in recent years with high rates of inflation impacting building materials and household goods. Client homes may be significantly undervalued, but you can be the agent of change to remedy the issue of underinsurance.

4) Set the tone on the status of replacement cost endorsements. With rising inflation, escalating construction costs and accumulating losses, the status of the replacement cost endorsement is tenuous. There may be two eventual outcomes. These policy provisions may be eliminated entirely from new and renewal business or the endorsements will become much more expensive for policyholders to acquire or maintain. In either case, educating clients helps them understand the situation and sets them up to make appropriate coverage decisions.

Other potential viable endorsements can help fill gaps within traditional insurance policies. Do your research to find out if the following options are applicable to any of your clients: 

• Ordinance and law coverage. Ensures rebuilds comply with new local laws levied by municipalities to address new building codes.
• Extended replacement cost coverage. Pays for repairs during “demand surges" in areas affected by natural disasters.
• Additional living expense endorsements. Covers food and lodging if a rebuild runs beyond a projected deadline.

Navigating the replacement cost landscape requires copious amounts of education, communication and cooperation. As changing economic circumstances force insurance carriers' hands, it's critical to keep high net-worth homeowners in the loop about the dynamic nature of policy values that help protect their financial interests. When you do this, you'll be seen as a true partner and trusted adviser—and that is the ultimate goal.

Robb Lanham is chief sales officer at Hub International.