Insureds generally do not read their homeowner's policy. This is a mistake. In most states the insurance policy is enforced as it is written whether or not the insured has read it. Most insurance policies sold to consumers have been simplified so that they are generally understandable. There are sections, particularly dealing with the measurement of loss that are complicated but even they can be understood provided one goes through the examples with a pencil and paper.
A homeowner's policy contains two general categories of coverage, first party coverages and third party coverages. "First party" and "third party" refer to the person who is paid insurance benefit in the event of a loss.
- A first party coveage means the insurance money for a loss is paid to the insured, the first party, as reimbursement. If, for example there is a fire loss to the home, the insurance money is paid the insured.
- A third party coverage is different because the payment is made to a person other than the insured who is injured, oftentimes because of the negligence of the insured. If a person falls and breaks their arm because there was a defect in the sidewalk the insured should have repaired, then the injured party collects the insurance money. This third party coverage is called "liability coverage."
The homeowner's insurance policy is a package policy of several coverages, some of which are first party coverages and at least one of which is a third party coverage. The policy is designed to pay for losses to home and contents. It is prudent to buy "all risk" coverage for house and contents as compared to a specified risk policy which only pays for those losses that are specified on the face of the policy itself. "All risk" coverage is more expensive but not excessively so and avoids issues of interpretation in the event of a loss.
The limits of the policy are stated on the declarations sheet of the policy. It is usually first page and it often contains the cost of the policy, which is intentional. The insurance company wants you to read this page. Although a policy is not sent yearly, the declarations page is sent each year at renewal. It contains a general description of the coverages with the limits. The limit is the most the insurance company is obliged to pay for the loss. A separate limit is expressed for the house as compared to the contents, the amount of which is often automatically assigned as a percentage of the value of the house. Generally a house can be valued in two different and very distinct ways.
- The first is actual cash value. Actual cash value deducts depreciation in its valuation of what it will pay. The actual cash value policy is less expensive and sometimes all that can be purchased.
- The second is replacement value. Replacement value means the insurance company will pay for the replacement of the house with the same quality materials. This is a reimbursement policy meaning the property must be replaced in order to qualify for payment.
Contents coverage is subject to special limits for valuable items. Jewelry and furs have relatively low assigned limits and if the insured has special possessions that exceed the basic coverage amounts, an appraisal has to be done and the items must be "scheduled" meaning they are individually listed. An additional premium is required for scheduled items.
The liablity limit is important because it is what the insurance company will pay to a third pary who is injured on account of the insured's negligence. There are other types of policies that have liability limits such as auto insurance but it is limited to the specific risk of auto operation. The homeowners coverage provides broader coverage, but not for auto, situations, so it is important that the insured is satisfied that he/she has a high enough limit.
Consider insurance a risk transfer device. For the premium paid by the insured, the insurance company accepts the risk that would ordinarily be borne by the insured. The risk that is transferred and the amount that is transferred is contained in the policy documents and it is wise to make sure you know what you have received.