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After every natural disaster, too many people discover an awful truth: They don't have enough insurance to rebuild their homes.

Nationwide, more than two-thirds of homeowners are underinsured, according to a survey by insurance services firm MSB, by an average of 18%.

That means someone whose house cost $200,000 to replace would find herself short by $36,000.

Where homes and rebuilding costs are higher, the problem can be even more acute. A survey by United Policyholders, a consumer advocacy group, said 75% of California homeowners affected by the 2007 wildfires in San Bernardino and Riverside counties were underinsured by an average of $240,000.

Trying to figure out the right amounts of insurance coverage, however, is a tricky, frustrating process. Your insurance company or agent may be surprisingly little help and may even steer you wrong:

  • Many victims of Hurricane Katrina said their agents had told them they didn't need flood insurance when, clearly, they did. Courts ruled that insurers didn't have to pay for damage caused by flooding.
  • Likewise, many homeowners who lost property in the 2003 San Diego County wildfires complained that their agents had used a computer survey that vastly underestimated the cost of rebuilding their homes. The survey, called Quick Quote, was part of a larger software package sold to insurers to estimate replacement costs and was later removed.
    Homeowners often compound the problem by failing to report renovations to their insurers or by simply assuming their coverage is keeping up with inflation and replacement costs, which probably isn't true.

Liz Weston

Liz Weston

You might think insurers would err the other way, pushing folks to over-insure their homes. But that's generally not the case.

Lulled into complacency

Insurance analyst Brian Sullivan says the annual premiums paid on most policies are too small for insurers to spend much time doing a detailed assessment of customers' needs.

"If you ask most insurance companies what they're insuring -- how many hardwood floors, how many fireplaces -- they have no idea," said Sullivan, the editor of Risk Information, an industry newsletter. "It's only companies like Chubb that have (policies with) premiums in the thousands of dollars that will come out and appraise your home and everything in it."

Homeowners are often lulled into complacency because they have "guaranteed-replacement" or "extended-replacement" policies, which sound like they'll cover the rebuilding of a home regardless of the cost, said attorney Amy Bach of United Policyholders, the consumer advocacy group.

But true guaranteed-replacement policies are almost extinct, and virtually all insurers cap their payouts at 100% to 150% of the amount for which the home is insured.

How to ensure adequate coverage

Bach recommends consumers buy the highest cap they can afford and take the following steps:

Use Web tools to estimate replacement costs. Bach recommends AccuCoverage, an MSB site that charges $7.95 and walks you through a questionnaire that usually takes 20 to 30 minutes to complete. Another site, HomeSmart Reports, charges $6.95 and takes less time but offers less detail, Bach said. HomeSmart Reports gives low and high estimates of what it would cost to replace your home, plus a standard cost of construction in your area, but it doesn't account for custom features.

Compare the estimate with your policy limits. You'll find them on the declarations page of your policy. If your insurer can't explain discrepancies to your satisfaction, start shopping for another insurer.

Don't be cheap. Make it clear to your insurer or agent that you want the best coverage for your money, not the lowest possible premiums.

Decide on disaster coverage. Floods and earthquakes aren't covered by your homeowners insurance. If you're in an area considered at high risk for hurricanes, you may have to buy insurance from a special windstorm-coverage pool. Unless you're prepared to walk away from your home after a disaster, you need to consider such coverage.

Check your "loss of use." Homeowner policies typically provide money to pay your rent and related living expenses while your home is being rebuilt. Again, you should find this coverage on the declarations page. If the amount offered wouldn't cover you for two full years, Bach recommends asking for a higher limit or finding another insurer.

Get "replacement cost," not "actual cash value." It's not just rebuilding coverage that falls short. Many policies severely restrict how much money you'd get to replace your stuff and limit or even exclude some common household items from your policy. If you have a policy that pays out actual cash value on your home's contents, for example, you'd get a check for what your possessions were worth when they were destroyed, not what they would cost to replace.

It's much better to spring for replacement cost on your contents. You'd typically still get an initial check for the depreciated value of your items, but after you replaced them (and provided receipts to your insurer), you'd get another check to make you whole. The cost of this coverage is typically about 10% to 20% more than actual-cash-value coverage.

However, you still could be vulnerable. Some policies provide replacement-cost coverage for most items but make exceptions for others. Your policy might give you a check to buy a new couch, for example, but decide to depreciate your carpet and give you only a fraction of the replacement cost.