How Insurance Works & Homeowner's Insurance

appurtenant structures

(2) damage to other structures on the property—referred to as appurtenant structures.

coinsurance

A method by which the insured and the insurer share proportionately in the payment for a loss. For example, health insurance policies commonly require that the insured pay 20 percent of a loss and the insurer pay the remaining 80 percent. Substantial premium reductions can be realized through coinsurance, but you must be prepared to pay your share of losses.

condominium form (HO-6)

A named-perils policy protecting condominium owners from the three principal losses they face: losses to contents and personal property, losses due to the additional living expenses that may arise if one of the covered perils occurs, and liability losses. (The building itself is insured by the management of the condominium.) Two additional coverages are included in the HO-6 policy as necessary to meet the specific needs of the condominium unit owner. The first is protection against losses to the structural alterations and additions that condominium owners sometimes make when they remodel their units. The second is supplemental coverage for the dwelling unit to protect the condominium owner if the building is not sufficiently insured.

basic form (HO-1)

A named-perils policy that covers 11 property-damage causing perils and provides three areas of liability-related protection: personal liability, property damage liability, and medical payments. The most common perils that can cause property damage—fire and lightning, windstorm, theft, and smoke—are covered in the basic homeowner's policy. People who have finished basements (perhaps a TV room or spare bedroom) should purchase additional sewer backup coverage, as this possibility is not one of the 11 named perils.

renter's contents broad form (HO-4)

A named-perils policy that protects the insured from losses to the contents of a dwelling rather than the dwelling itself. It covers 17 perils and provides liability protection. HO-4 is ideal for renters because it provides protection from losses to dwelling contents and personal property and provides for additional living expenses if the dwelling is rendered uninhabitable by one of the covered perils. Although insurance is relatively inexpensive, only one-fourth of all renters carry HO-4 protection.

physical hazard

A particular characteristic of the insured person or property that increases the chance of loss.

morale hazard

A person is indifferent to a peril. For example, a morale hazard exists if the insured party, knowing that theft insurance will pay for the loss, becomes careless about locking doors and windows.

actual-cash-value (ACV) formula

ACV = P - [CA × (P ÷ LE)] where P = Purchase price of the property CA = Current age of the property in years LE = Life expectancy of the property in years

loss reduction

Action taken by the insured to lessen the severity of loss if a peril occurs. Smoke alarms and fire extinguishers in the home are examples of loss reduction efforts. These items will not prevent fires, but their use may lead to less severe damage. Many insurers offer reduced premiums to policyholders who practice loss reduction.

hazard reduction

Action taken by the insured to reduce the probability of a loss occurring. Insurance companies often offer reduced premiums to insureds who practice hazard reduction—for example, to nonsmokers.

deductible

An initial portion of any loss that must be paid before the insurance company will provide coverage. For example, automobile collision insurance often includes a $500 deductible and that means that the first $500 of loss to the car must be paid by the insured. The insurer then pays the remainder of the loss, up to the limits of the policy. You usually have a choice of deductible amounts, and the higher the deductible, the more you will save on your premium. This is because the insurance company will have fewer small losses to pay.

contents replacement-cost protection

An option sometimes available in homeowner's insurance policies that pays the full replacement cost of any personal property. The standard limitation that applies to contents (50 percent of insured value of the dwelling) remains in effect if contents replacement-cost protection is purchased. The overall limit on contents may need to be raised, as it is easy to reach the 50 percent figure when replacement-cost valuation is used.

hazard

Any condition that increases the probability that a peril will occur.

financial loss

Any decline in the value of income or assets in the present or future. Financial losses can be measured objectively in dollars and cents. When you become sick, you suffer as a result of the discomfort, inconvenience, lost wages, and medical bills. Insurance will cover only the lost wages and medical bills, however, because these losses—but not the others—can be objectively measured.

homeowner's general liability protection

Applies when you are legally liable for the losses of another person. Homeowners often wish to take responsibility for the losses of another person regardless of the legal liability. Consider, for example, a guest's child who suffers burns from touching a hot barbecue grill.

law of large numbers

As the number of members in a group increases, predictions about the group's behavior become increasingly more accurate. This greater accuracy decreases uncertainty and, therefore, risk.

personal losses

Can be directly suffered by specific individuals or organizations rather than society as a whole.

deductible and coinsurance reimbursement formula

Can be used to determine the amount of a loss that will be reimbursed when the policy includes a deductible and a coinsurance clause: R = (1 - CP)(L - D) where R = Reimbursement CP = Coinsurance percentage required of the insured L = Loss D = Deductible

homeowner's insurance

Combines the liability and property insurance coverages needed by homeowners and renters into a single-package policy. Four types of homeowner's insurance are available for people who own houses, another type for the owners of condominiums, and one other type for those who rent housing.

direct sellers

Companies that market their policies through salaried employees, mail-order promotions, newspapers, the Internet, and even vending machines. Any type of insurance can be sold directly.

all-risk (open-perils)

Cover losses caused by all perils other than those specifically excluded by the policy. All-risk policies provide broader coverage because hundreds of perils can cause property losses, but only a few would be excluded. Common exclusions are flood, earthquake, and mold unless caused by some non-excluded event such as burst water pipes. Coverage for excluded perils can often be purchased for an additional premium if desired. In coastal states or those prone to earthquakes, your policy may require a higher deductible if you suffer a loss due to these perils.

named-perils policies

Cover only those losses caused by perils that are specifically mentioned in the policy.

policy limits

Every policy includes policy limits which specify the maximum dollar amounts that will be paid under the policy. As a result, insurance purchasers must carefully select policy limits sufficient to cover their potential losses.

fortuitous losses

Fortuitous losses are unexpected in terms of both their timing and their magnitude. A loss caused by a lightning strike and fire to your home is fortuitous; a loss caused by a decline in the market value of your home is not because it is reasonable to expect home values to rise and fall over time.

actual cash value

Historically, property insurance policies paid only the actual cash value of an item of personal property, which represents the purchase price of the property less depreciation.

replacement-cost requirement

Homeowner's insurance policies usually contain a replacement-cost requirement that stipulates that a home must be insured for 80 percent of its replacement value (some companies require 100 percent). Thus, a home with a replacement value of $200,000 would need to be insured for $160,000 (or perhaps $200,000), and this amount would be the maximum that the insurance company would be obligated to pay for a total loss (after payment of the deductible by the policyholder). If you fail to meet your replacement-cost requirement, you will not be considered fully insured and must co-insure partial losses as well.

inflation guard protection

However, you will also want to increase your limits each year to keep up with inflation in housing construction costs. To do so, you can sign up for inflation guard protection to have your insurance company increase your coverage automatically each year.

independent insurance agents

Independent businesspeople who act as third-party links between insurers and insureds. Such agents earn commissions from the companies they represent and will place each insurance customer with the company that they believe best meets that customer's particular needs.

premium

Insurance protects each individual in the group by replacing an uncertain—and possibly large—financial loss with a certain but comparatively small fee. This fee, called the premium, has four components: 1. The individual's share of the group's losses 2. Insurance company reserves set aside to pay future losses 3. A proportional share of the expenses of administering the insurance plan 4. An allowance for profit (when the plan is administered by a profit-seeking company)

personal property inventory

Making a personal property inventory of, and placing a value on, all the contents of your home are time-consuming but important tasks. Table 10-3 shows the inventory and valuation for the contents of and personal property in a typical living room. You should conduct such an inventory for each room, the basement, garage, shed, and yard possessions. When totaled, these values will enable you to select proper policy coverage limits. Most homeowner's policies are designed to automatically cover contents and personal property for up to 50 percent of the coverage on the home. For example, if your home is insured for $240,000, you would have $120,000 in personal property insurance. If you need more coverage, simply notify your agent.

insurance

Mechanism for transferring and reducing pure risk through which a large number of individuals share in the financial losses suffered by members of the group as a whole.

special form (HO-3)

Provides open-perils protection for four types of property losses: losses to the dwelling, losses to other structures, landscaping losses, and losses generating additional living expenses. Contents and personal property are covered on a named-perils basis for 17 of the 18 common homeowner's perils (the exception is glass breakage). In terms of liability protection and in all other respects, the coverage under HO-3 is the same as under HO-2.

class of insureds

Rates represent the average cost of providing coverage to various classes of insureds; these classes consist of insureds who share similar characteristics. For example, automobile insurance policyholders may be classified by age, gender, marital status, and driving record, as well as by the make and model of vehicle that they drive.

exclusive insurance agents

Represent only one insurance company for a specific type of insurance. They are employees of the insurance company they represent. Life insurance, for example, is often sold through exclusive insurance agents.

insurance agents

Sellers of insurance, called insurance agents, represent one or more insurance companies. They have the power to enter into, change, and cancel insurance policies on behalf of these companies. Two types of insurance agents exist: independent agents and exclusive agents.

principle of indemnity

States that insurance will pay no more than the actual financial loss suffered. For example, an automobile insurance policy will pay only the actual cash value of a stolen automobile. This principle prevents a person from gaining financially from a loss (certainly a moral hazard). The principle of indemnity does not guarantee that insured losses will be totally reimbursed.

replacement-cost-requirement formula

The amount of reimbursement for partial losses will be calculated using the replacement-cost-requirement formula: R = (L - D) × [I ÷ (RV × 0.80 or 1.00)] where R = Reimbursement payable L = Amount of loss D = Deductible, if any I = Amount of insurance actually carried RV = Replacement value of the dwelling

broad form (HO-2)

The broad form (HO-2) is a named-perils policy that covers 18 property-damage-causing perils and provides protection from the three liability-related exposures.

insurance policy

The insurance policy is the contract between the person buying insurance (the insured) and the insurance company (the insurer). It contains language that describes the rights and responsibilities of both parties.

binder

The insurer typically issues a temporary insurance contract, called a binder, which is replaced at a later date with a written policy.

underwriting

The insurer's procedure for deciding which insurance applicants to accept.

insurance rate

The price charged for each unit of insurance coverage.

older home form (HO-8)

The replacement value of an older home may be much higher than its market or actual cash value. The older home form (HO-8) is a named-perils policy that provides actual-cash-value protection on the dwelling. It does not provide that the dwelling be rebuilt to the same standards of style and quality, as those standards may be prohibitively expensive today. Instead, the policy provides that the dwelling be rebuilt to make it serviceable.

moral hazard

When an insured person wants a peril to occur so that he or she can collect on an insurance policy.

homeowner's no-fault medical payments protection

Will pay for bodily injury losses suffered by visitors regardless of who was at fault. In the preceding example, such coverage would help pay for the medical treatment of the visitor's burns.

homeowner's no-fault property damage protection

Will pay for property losses suffered by visitors to your home. An example of such a loss might be damage to a friend's leather coat that was chewed by your dog.