About 64 percent of homeowners don’t have enough insurance, according to CoreLogic’s Residential Cost Handbook. Worse, their homes are underinsured by an average of 27 percent. But what does being underinsured really mean? After all, you should be protected if you have insurance, right?

Unlike someone who's uninsured, an underinsured homeowner has a policy, but the coverage is insufficient. This leaves them with bigger expenses if they ever file a claim. Many times, underinsured homeowners think they have adequate coverage only to find out in a disaster that they don’t.

What does underinsured mean?

Simply put, being underinsured means you have a policy that only covers a portion of your losses in a claim, often because of exclusions or coverage limits. For example, you might insure your home for $300,000, only to find out that rebuilding it after a total loss costs $400,000. Underinsured homeowners may have to pay tens of thousands – maybe even hundreds of thousands of dollars – out of their own pockets.

What happens if you are underinsured?

According to Brian Evans, CEO and founder of claims management firm Eastern Public, “Underinsuring property can be a life-changing mistake for homeowners. This is because homeowners insurance is often the only resource available to them to recover their home or to respond to a variety of other loss-related expenses.”

With such big costs at stake, each homeowner needs to fully understand the potential financial impact underinsurance has on their personal situation.

Why homeowners are underinsured

With more than half of US homes underinsured, you have to wonder why so many homeowners don’t get enough coverage. What are the biggest reasons for underinsurance in today’s market?

Unfortunately, there's no one cause. Underinsurance can be the result of any number of events, including:

• Undervaluing your property.
• Misunderstanding what’s covered and what’s not.
• Failing to account for construction costs.
• Failing to report upgrades to your insurer.
• Choosing to not increase sublimits.

Insurance companies can also make mistakes in underwriting or historical data collection that can cause a homeowner to be underinsured. Moreover, sometimes agent negligence is the root of the problem, such as an agent failing to ask the right questions or perform their due diligence.

7 underinsurance examples for homeowners

There are several ways in which your home can end up being underinsured. Perhaps the most common is when you assume it’s safe from catastrophes. Unfortunately, climate change is putting more homes at risk for major disasters. However, underinsurance can also be a problem if homeowners misjudge the value of their personal property or their chances of being sued after an accident. Below are just a few examples of how homeowners end up underinsured.

1. Underestimating your risk for catastrophe

Homeowners often assume they aren’t likely to suffer a catastrophic loss, so they’re better off skimping on insurance to save money. It’s hard to blame them, considering how home insurance premiums have risen steadily throughout the country. The most recent report from the National Association of Insurance Commissioners shows rates increased by 3.1 percent from 2017 to 2018.

These increased costs may have homeowners weighing the risk versus reward of paying more for insurance on the outside chance they have a catastrophic loss. But the reality is that we’re seeing more losses with bigger price tags, and that means homeowners who think they can cut back on coverage may be in for a world of trouble.

Underinsurance and natural disasters

Let’s start with wildfires. Veridesk’s Wildfire Analysis Report identifies 4.5 million U.S. homes as being in areas of high or extreme risk for wildfire, with over 2 million located in California. According to Insurance Business America, 80 percent of homes affected by 2018 California wildfires were underinsured. If we assume this percentage is the same for all the homes with high or extreme risk, then 3.6 million homes are underinsured for a wildfire and may not be able to rebuild after a catastrophic loss.

Of course, wildfires aren’t the only risk that homeowners may be underinsured for. Hail storms, floods, tornadoes, and hurricanes can all cause severe damage. The National Oceanic and Atmospheric Administration (NOAA) reports that the US saw 22 weather events where losses exceeded $1 billion in 2020. This beats the previous record of 16 (2011 and 2017) and is the sixth year in a row where the US sustained 10 or more billion-dollar weather events.

As the chart below shows, the average cost of billion-dollar disaster events (represented by the black line) has been climbing over the last 20 years. Also note that each of the colored lines, the ones that show the biggest jump in costs, represent recent years (i.e., 2005, 2011, 2012, 2017, 2018, and 2020).

Source: NOAA National Centers for Environmental Information (NCEI) U.S. Billion-Dollar Weather and Climate Disasters (2021). DOI: 10.25921/stkw-7w7

Since 1980, the year NOAA started tracking billion-dollar disasters, the US has suffered 285 of them, 41 percent of which occurred between 2010 and 2019. But perhaps the most important number is how many states have had at least one natural disaster that costs more than $1 billion: 50. The map below shows just how many areas were impacted by billion-dollar weather and climate disasters just in 2020.

Source: NOAA National Centers for Environmental Information (NCEI) U.S. Billion-Dollar Weather and Climate Disasters (2021). DOI: 10.25921/stkw-7w7

Storms don’t have to cause billions of dollars in damage to do great financial harm to homeowners, either. According to Evans, “Homeowners insurance policies will often exclude coverage entirely, include separate sub-limits of insurance, or impose higher deductibles for losses resulting from wildfire or hurricane. . . This presents difficult challenges for consumers to navigate when reviewing their policies to ensure they have adequate insurance coverage.”

Ultimately, it doesn’t matter whether you think the problem is man-made or natural, climate change is increasing your risk for a number of catastrophes. If you haven’t addressed this in your homeowners' insurance, then there’s a good chance that you’re underinsured.

Can underinsured homeowners rely on federal aid after a disaster?

Homeowners probably shouldn’t rely solely on funds from the Federal Emergency Management Agency (FEMA) disaster programs. Without a doubt, those funds are necessary after a disaster, but they aren’t always readily available, and you may receive a prorated amount based on the total assessed loss in your area.

Long story short? That means you’re competing with your neighbor for assistance grants that may or may not be available by the time FEMA gets to you. Look at Hurricane Katrina as an example. More than a decade later, New Orleans and outlying neighborhoods are still trying to rebuild and get the pre-hurricane population back.

2. Not checking construction costs

You should always look to insure your home for the amount it will take to rebuild it. However, rising construction costs can cause you to be underinsured if you simply renew your coverage for the same amount every year. Fluctuating costs for materials and labor could mean you don’t have enough coverage, especially if you’ve insured your home for its actual cash value. The depreciated value of your home will be even further away from the amount you’ll need to spend to replace it.

Construction costs have been climbing fairly steadily for a few years and don’t show any signs of slowing down. The most recent data from the National Association of Home Builders shows the average cost of building a single-family home is $296,652, or $114 per square foot. Compare that to the average cost in previous years:

• 2011: $80 per square foot.
• 2013: $95 per square foot.
• 2015: $103 per square foot.
• 2017: $86 per square foot.

According to JLL’s latest H1 2021 Construction Outlook, costs will continue to rise, increasing between 3.5 and 5.5 percent.

3. Undervaluing your personal property

While homeowners are usually most concerned about rebuilding their homes after a claim, they can also face significant costs if they fail to fully insure their personal property (i.e., all the stuff inside your home). Imagine a total loss on a home where the homeowner insured all of their personal property for $20,000. At a minimum, that $20,000 has to pay for:

• Kitchen appliances.
• Furniture for every room.
• Electronics.

That list doesn’t even take into consideration clothing, dishes, cookware, and other home goods that may need replacing.

Many insurance companies set a default coverage amount for personal property, Coverage C on your declarations page, which is a percentage of the building replacement value found in Coverage A. This default coverage can be anywhere between 10 percent to 75 percent of the building replacement value, depending on your insurer.

However, you’re not stuck with the default amount. You can request personal property coverage of up to 100 percent or more of your home’s replacement value. Doing so can help you get back to normal after a major loss.

4. Underinsuring for Liability

Liability claims are where a homeowner is responsible for someone else’s bodily injury or property damage. This type of claim typically covers events like:

• Your dog biting the mail carrier.
• Your tree falling on the neighbor’s property.
• Swimming pool accidents.

Between 2014 and 2018, liability claims accounted for 1.9 to 4.0 percent of all homeowners' claims and averaged $26,872 according to a report created by Verisk Analytics and cited by the Insurance Information Institute (III). The III also reports that the average dog bite claim in 2019 paid out $44,760 with some claims costing hundreds of thousands of dollars. While these averages are covered by the standard $100,000 in personal liability found in most homeowners insurance policies, any outlier claim over this leaves homeowners exposed to additional costs.

5. Insuring your home’s actual cash value

When it comes to property coverage, you can insure your property’s actual cash value or its replacement cost. These are two very different ways to insure a home that can dramatically affect the cost and the coverage.

Actual cash value insures your property based on its depreciated value. Let’s say you insure your home on an actual cash value basis, and you suffer a total loss. Your insurance company is going to look at the value of your home, subtract an amount for depreciation, and pay you that, up to your policy limits. So if your home’s depreciated value is $100,000, but rebuilding it costs $150,000, you’re going to come up short in a claim.

Instead, homeowners should insure homes for the replacement cost, which is the amount it costs to repair or replace the property without subtracting from depreciation. Insuring for your home’s replacement cost is usually more expensive, but it keeps you from being underinsured.

6. Ignoring sub-limits

Home insurance policies can have sub-limits or a set coverage amount for a specific type of loss. For example, a homeowners policy might cap payouts for damaged computer equipment at $1,500, firearms at $2,000, and jewelry at $3,000. If any of these items are damaged in a covered claim, then your insurers only pay up to the sub-limit.

As Evans points out, failing to take notice of sub-limits can cause homeowners to be underinsured because the total limit of insurance isn’t available in all scenarios. He uses the example of a frozen pipe causing water damage and mold in a $400,000 home. According to Evans, “The insurance policy for the home may provide insurance coverage up to $400,000, but a separate much smaller limit for mold-related expenses often exists.”

So while the insurance policy covers the home for the full value, it’s actually underinsured for the claim in question. Understanding this before claims arise empowers you to ask more questions about your policy’s sub-limits so you can be more fully protected.

7. Relying on your condo’s master policy

Condominium owners sometimes make the mistake of assuming they have sufficient coverage because part of their fees goes to what’s known as a master policy. This is essentially insurance purchased by the condo association to cover its liability and property damage to the building’s main structure and common areas.

So let’s say a pipe bursts in your multi-unit building, causing damage in your condo and the building’s entryway. The condo association’s master policy covers damage to the entryway, but pays nothing for your damage, leaving you underinsured.

How to avoid being underinsured

Most homeowners fulfill their mortgage company’s insurance requirement and are done with their policy until it’s time to renew. While your bank may be satisfied, you’re probably better off taking the time to dig a little deeper into your policy. You want to understand what’s covered, what exclusions or limitations exist, and how one policy works to fill gaps of another (i.e., pairing a homeowners policy with a flood insurance policy).

You’ve already taken the first step by researching what happens when you’re underinsured. The next is to have an honest conversation with your insurance provider. This means asking what a standard policy covers and how you can fill any gaps. It may also mean making sure your provider knows that your home is on the Gulf Coast or that it’s over 100 years old. These details might cause your premium to go up, but getting the right coverage for your situation typically saves you money in the long run.