How Does a Homeowner Insurance Policy Work and What's Covered?

family by the pool with good home insurance coverage
Understanding Home Insurance and How It Works. Westend61 / Getty Images

Homeowner insurance is a contract designed to protect you as a homeowner against sudden and accidental losses. The home insurance policy is a contract between the homeowner, also known as the insured, and the insurance company. 

The contract creates an agreement that for the premium paid by the home owner, the insurance company will compensate the homeowner for unexpected, sudden and/or accidental damage or disasters that occurs to the home, or contents of the home as agreed upon in the policy wording.

Homeowner insurance protects a homeowners assets and ensures that a covered loss, risk or disaster will not leave them in financial distress. Whether you are looking to buy insurance as a first time homeowner, referencing information to make sure you are getting the best value for your money, or looking for help to understand your policy, here are some basics about homeowner insurance that will help you understand how home insurance policies work.

How Does Homeowner Insurance Work?

Your insurance policy is a contract that agrees to cover you for specified risks or perils that may happen causing you financial loss.

In exchange for a premium (the amount of money you will pay for your contract) the insurance policy forms an agreement that the insurance company will compensate you for losses as described and detailed in your home insurance policy.

When you buy homeowner insurance, or a condo or renter insurance policy you have entered into a contract with an insurance company.

The contract is your insurance policy. 

All the terms and conditions of your policy dictate what is covered, how a claim will be paid, and what is excluded or limited. You can find the basic coverage information of your insurance contract on the Declaration Page of your insurance policy.

The insurance policy contract clearly outlines definitions and special limits to let you know what to expect as an insurance policy holder.

How Much Does Home Insurance Cost?

There are many factors that determine how much home insurance costs. Based on statistics, the average cost of homeowner insurance in the United States is $1,132 per year and the average renters insurance cost is $190 per year, according to the Insurance Information Institute. Those are just the averages. The cost varies by state, based on the Insurance Institute data, we have included a summary table of State by State average homeowner and renters insurance costs as an easy reference for you at the end of this article.

3 Main Factors on How Much You Can Expect to Pay for Home Insurance:

  • Your personal information including your age, occupation, if you have insurance history, your credit rating, if you belong to any organizations that have group insurance plans or discounts, your lifestyle and use of your home.
  • The Information related to the location of your home, the loss experience in the area where your home is located and anticipated risk factors about where your home is physically situation impact insurance rates.
  • The details about your home, including renovations, the year of construction and the materials used in building your home as well as any additional security you have at your home.

    Your personal insurance history and information usually allows for discounts to be added to a policy, so even if you compared the price of insurance for two identical houses right next to each other, the price might be different if the people who own those houses have different personal situations.

    Is Home Insurance Worth It?

    Home insurance provides people who own their home a valuable resource to protect their investment and financial stability if a situation comes up where there is sudden and accidental damage to your personal property or house itself. It also protects you by providing liability insurance that arises as a result of your home ownership, or even as a result of your actions and activity as an individual worldwide.

    How Much Home Insurance Do You Need?

    Your home insurance needs to have enough coverage to provide you with compensation for financial losses in 4 major categories.

    1. The value of your structure, or building. Also known as the dwelling insured value. This does not include the cost of the land.
    2. The value to replace your contents or personal property. The personal property are the things that are not part of the structure, the things you brought with you when you moved into the home.
    3. Cost of additional living expenses, these are expenses that you would incur as a result of a claim if you were unable to live in your home due to a covered loss or insured peril, while the insurance company repairs your home when it is unlivable. A home is unlivable when there is no running water or electricity, or when there is destruction that makes it impossible to live in the home during repairs. Each insurance company may define this differently or may assess the need to move out on a case by case basis.
    4. Liability coverage

    A home insurance policy is a package policy. The cost of the insurance is based on the value of your home, or insured dwelling value for home insurance.

    The cost of insurance is based on your contents value for renters insurance or condo policies.

    The additional living expenses are usually a percentage of the primary coverage, and the liability coverage comes as a base but can be increased depending on your personal needs.

    Other Home Insurance Coverages

    There are other coverages that can be included in home insurance policies, for example a homeowner policy will also include additional structures as a percentage of the building amount. As an overview, the above are the base sections of coverage that you would want to focus on in order to figure out how much home insurance coverage you need.

    Additional coverages can be added by endorsement if you need more coverage than is included in the home insurance package.

    One example is jewellery, home insurance policies usually have special limitations on certain items. After reviewing your policy special limitations, you may decide to add an insurance rider.

    Water Damage and Home Insurance

    Water damage is a tricky coverage when it comes to home insurance. Some water damage is covered, some coverages can be added by endorsement, such as sewer back up coverage; other water damage coverages are excluded. When choosing a home insurance policy be sure and ask about the different types of water damage that are included in your policy and find out which ones you can add coverage for by optional endorsement. Water damage is an increasing risk due to changing weather patterns and aging infrastructures.

    Who Is Covered on a Home Owner Policy?

    In your insurance policy there is a definition of the insured. Under this definition you will usually find the description of who is covered under your insurance policy. The policy usually will specify that the named insured and spouse or domestic partner (through common law or marriage) are considered insured under the policy. Along with this, the dependent children of the insured while living at home may also be included.

    Who Is Not Covered Under a Home Insurance Policy?

    Domestic help, relatives not included in the definition of the insured, temporary house guests and roommates are not included or covered under a home insurance policy because these people do not fit into the definition of the insured.

    Insurance If You Rent Your Home

    If you rent your home and do not own it, whether it is a house, an apartment or a condo, then you need renters insurance.

    If You Rent Out Your Home

    Home insurance is intended to insure a home being used as a primary residence. If you rent out your home, then a homeowner policy is not the right policy for you and you may not be insured if you have a claim. 

    Home Business Activity and Home Insurance

    If you use your home for business, you should speak to your insurance company to find out if they can add a rider for home based business. Home insurance is not intended to cover business use, so using your home for business and not mentioning it to the insurance company could render your coverage null and void. Not reporting changes on a home policy or in your personal situation may cause the insurance company to cancel your policy.

    Learn more about reasons an insurance company could cancel your policy here.

    There are many endorsements or plans that might be better suited to you than a standard homeowner policy when you have business activity. Even situations where you are using your home for Airbnb hosting or home sharing could be a problem, but discussing your situation with your home insurance may provide you with solutions that will help you get the right coverage. 

    Home Insurance for Condo or Coop Owners

    If you own a condo or co-op, then you do not need homeowner insurance; you need condo or co-op insurance because condos and co-ops take into consideration many of the special circumstances that exist when you own only one unit of a building, or shares in a cooperative.

    For example, one coverage that is specific to a condo owner but would not be included in a homeowner policy is loss assessment, or contingent insurance.

    What’s Covered By a Home Insurance Policy

    When you buy a home insurance policy you have the option to choose what kind of coverage you want. There are two basic concepts of coverage in a home insurance policy:

    • Open Perils
    • Named Perils

    Understanding these two concepts helps show the difference in the level of coverage your different options in insurance policy can offer you since they have significant differences in coverage levels.

    • An Open Perils policy covers you for “all risks” unless they are excluded.
    • A Named Perils or Specified Perils policy covers you for very limited risks. The risks are usually limited to 16 core “disasters” that could happen to you, but then after that, anything else is not covered. Some policies may provide less coverage, such as the HO-1 form.

    Be sure and ask if the policy you are buying covers open perils on the insured dwelling structure and on the contents, or only on the insured dwelling. This makes a difference in what you get paid in a claim.

    How Does a Home Insurance Policy Pay Out in a Claim?

    The basis of claims settlement listed in your policy wording will tell you what you can expect in a claim as far as compensation goes. The two basic forms of compensation in a claim are:

    1. Actual Cash Value: this is the cost of replacement less the depreciation. This means that you will not get enough money to replace the home or items if the basis of claims settlement is Actual Cash Value. This is the least desirable form of claims settlement.
    2. Replacement Cost: Replacement cost provides you with compensation for replacement of the insured items in the loss. Find out if this applies to your building and contents. This allows you to replace what you have lost after a claim and get back to where you were at before the loss since you will get the money to replace. 

    It is important to read your policy wording about the basis of claims settlement when you get a home insurance policy to make sure you understand the provisions in the contract, exclusions and limitations. 

    What Is a Home Insurance “Policy Form”, What Does That Mean?

    When getting quotes for home insurance policies it is important to find out what policy form you are being quoted. A policy form describes the type of coverage in the insurance "package" you are purchasing. The key differences in the policy form would be in the basis of claims settlement, as well as in how many risks are covered. For example, an open perils or all risk policy form like an HO-3 will have far more coverage than an HO-2, but both are home insurance policies. It is the form that makes the difference is what you can expect to be covered for if you need to make a claim. 

    Examples of Some of the Different Types of Homeowner "Policy Forms"

    List of Home Policy Insurance Forms
    HO-1: Limited coverage policy
    HO-2: Basic policy covering only the listed risks
    HO-3: Provides more extensive coverage covering all risks unless excluded. 
    HO-8: Often used for older homes contains an actual cash value basis of claims settlement which means a depreciated value is paid in a claim - this is not enough to replace
    HO-4: Renter Insurance Policy
    H0-6: Condo Insurance Policy

     

    High Value Home and Specialty Home Insurance Policies

    High value homes, historic homes, and homes with special features may qualify for high end home insurance. If you have a home with high value, or above average construction and quality you may want to look into a specialty high value home insurer. High value home insurance offers the broadest coverage available, but comes at a premium cost.

    The benefits may include full replacement value, with no obligation to replace policies (cash-out options), bylaw coverage, greater allowances for additional living expenses and coverage for higher limits of jewelry, fine arts, antiques or items that can not be replaced due to their inherent nature. These kinds of items are not covered easily on a standard home policy due to limits and exclusions. 

    Do All Homeowners Have to Have a Home Insurance Policy?

    No. All homeowners do not have to have a home insurance policy, however if you have a loan or a mortgage and you do not fully own your home, the mortgage lender may require you to have home insurance because they want to protect the money they given you as part of the loan. They may require you to provide a binder of insurance before granting your mortgage or loan.

    Home Insurance Policy Guidelines: Always Check Your Own Policy Terms and Conditions

    It is always best to have a discussion with your insurance representative about how claims work with your insurance policy since conditions vary from insurer to insurer, concepts discussed in this article are the basic guidelines you need to help you ask the important questions about your coverage.

    You can compare home insurance or renter insurance costs for each state at the Insurance Information Institute.