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home-insurance-valueWhen you buy a home insurance policy, your goal should be to have enough coverage to replace your dwelling and its contents if they are damaged or destroyed. You do notneed to be insured for an amount equal to your dwelling’s value on the real estate market. The idea is to have enough money to rebuild your house, not to buy another home.

Location will always be a key factor in determining your home’s real estate market value. The land beneath your home will not lose its market value if the structure is damaged in a flood, fire, earthquake or hurricane. In beachfront communities, for example, it is not uncommon to find small, inexpensive bungalows built on ocean view lots that may be worth millions of dollars. If the modest homes are destroyed, the value of the land is not diminished.

Your home insurance coverage should be based on the construction cost to rebuild your home.

“Replacement is what you insure, not market value,” says J. Robert Hunter, director of insurance for the Consumer Federation of America. “If you have a fire, your land does not burn down. Frequently you don’t even lose the foundation. You really want to insure what you could lose. Replacement costs may vary, based on the cost of labor and materials. Sometimes there are spikes in that, but normally repair costs do not change as rapidly as market values.”

Hunter recommends that you talk to a builder before you buy home insurance to establish accurate replacement costs. Your insurance agent should also be able to provide guidance.

When insurance and real estate values don’t agree

Home prices run in cycles in volatile markets like Southern California. During the recent housing boom and bust, some neighborhoods saw prices double between 2000 and 2005, only to fall sharply when the recession hit. By comparison, construction costs were relatively stable, giving homeowners little reason to change their level of home insurance coverage even in a roller-coaster real estate market.

Katie Kimball, a spokesperson for the American Insurance Association, recommends that you monitor the costs of construction materials and labor periodically.

Recently, building costs have increased, despite the ongoing slump in home prices, says Peter Moraga, a spokesperson for the Insurance Information Network of California. “Even though we are in a recession now, the materials for construction — wood nails, metal and concrete — are rising.”

The “ups” of construction costs and the “downs” of the real estate market have led to some surprising results: Many homeowners are discovering that their houses are insured for far more than what they could sell for.

“There may be homes out there whose market value is less than the cost to rebuild,” Moraga says.

In such cases, financially strapped homeowners may be tempted to destroy their homes to get the insurance money.

“If the home is worth more in terms of reconstruction value, you have more of a propensity for fraud,” says Moraga. This is especially true when home prices drop and owners owe more on their mortgages than dwellings are worth on the real estate market.

While some homeowners may entertain these thoughts on bad days, people generally have an emotional attachment to their homes. Hunter says that it is rare for homeowners to destroy their dwellings simply to collect insurance money.

“Most people do not burn down their own homes,” Hunter says. “It is where you live.”