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Anyone who’s bought a house or has shopped for one knows that homeowners insurance is a fact of life – some might call it a necessary evil; others peace of mind in times of crisis. And while most people are convinced or compelled by banks to purchase insurance on their homes, few people understand exactly who to trust, what their policy does, when to make policy changes, where to shop for it, why it is priced the way it is or – most importantly – how they can take control of the process.

This guide will help cut through the jargon and the blizzard of paperwork involved in home buying to explain exactly how homeowners insurance works. In these six main sections, you will:

What Insurance Does

A. Definition

To begin, homeowners insurance, sometimes referred to as “hazard insurance” or simply “home insurance,” is property insurance designed to cover private homes and their contents.

Homeowners insurance is a multi-line policy, meaning that the premiums, or regularly scheduled payments made to the insurer, cover both property and liability insurance. The premium is usually determined by the replacement cost of the home and its contents.

There are three major reasons to buy homeowners insurance:

To provide property coverage – Homeowners insurance covers the physical structure of your home and your personal property if it gets damaged or destroyed.
To provide liability coverage – If someone who isn’t covered under your policy is injured or killed, or their property is damaged or destroyed while they’re on your property, your homeowners policy will cover your personal legal responsibility. This coverage extends to cases where damage or injury happens adjacent to your property, such as when the limb of a tree on your property falls on a parked car on the street.
To satisfy your mortgage lender – To get a mortgage from a bank, most lenders insist you have insurance as long as you have a mortgage; you also have to list the lender as the mortgagee on the policy.

The premium is usually determined by the replacement cost of the home and its contents

Additionally, your policy generally covers such expenses as staying in a hotel or renting an apartment during the period when your home is being repaired following a disaster. In most cases, it requires that at least one of the individuals named on the policy actually live on the premises.

B. Why Mortgage Companies Require Insurance

If you have a mortgage, it’s likely that your lender will require you to purchase homeowners insurance. Often, its cost will be rolled into your monthly payment, along with property taxes. If you do not purchase homeowners insurance on your own, lenders may “force place” insurance on the property, often at an extremely high cost to you.

One of the justifications lenders give for the high cost of forced-place premiums is to protect their investments. After putting up the money you used to purchase your home, they don’t want something like a natural or manmade disaster to damage or destroy the property before they get a chance to collect that money back through premium payments. Because force-placed insurance is often considered “high risk” by private insurers, the premiums usually come at a higher price.

This policy, however, has come into question in recent years, and several state insurance departments are considering changes in regulation to ensure that the pricing becomes more competitive. (See this NAIC article for more details on the subject).

C. Why You Shouldn’t Do Without It

Of course, with the economy in its current state, it’s fairly normal to experience a case of sticker shock when that premium notice arrives in the mail, which could force you to actually consider “going bare“: an industry slang term for going without insurance. Most people shouldn’t even consider going without.

Sure, if you’re already independently wealthy and your home represents a small enough percentage of your net worth that it could easily be replaced, then by all means “go bare.” If you are affluent enough (and don’t have a mortgage), then you might consider opting for self-insurance, which involves setting aside a substantial sum each month toward future disaster losses and liability claims. Most “99 percenters” who have middle-class jobs, however, can’t afford the kind of funds that can replace an entire house.

Another thing to consider: If you drop your homeowners coverage now, insurance companies might not be willing to cover you in the future. They tend to assume that you either couldn’t meet your premiums in the past and will have trouble paying them now, or that you are only looking for coverage because you are anticipating a claim in the very near future. Either way, expect to pay substantially more for your coverage, if you can get it at all, according to Timothy Perr, managing principal of the consulting firm Perr & Knight, in this Bankrate.com article. Your credit could even be bruised, he adds, which could severely impact your financial standing for years to come.

Basic Homeowners Insurance Terms

Insurance can sometimes seem like a foreign language unto itself. Here is a glossary of definitions for some common terms used in this guide to make sure you know what your agents and adjusters are talking about.

Adjuster – A person who is trained to investigate losses and seeks to determine the extent of an insurer’s liability for that loss when a claim is submitted. Adjusters can represent specific insurance companies or can be a “public adjuster” hired by the claimant to work independently.
Appraisal – An evaluation of a home insurance property claim by an authorized person, usually an adjuster, to determine property value or damaged property value. Many policies require this appraisal process to resolve claim disputes.
Cancellation – The termination of a homeowners policy before its agreed-upon expiration date, most often for nonpayment of the premium.
Claim – A homeowner’s request for reimbursement under the terms of the policy.
Deductible – The amount that a policyholder must pay out of their own pocket before coverage kicks in – even when a claim is accepted.
Depreciation – The estimated decrease in value of property over time due to wear, tear, aging, and other factors.
Endorsement – A provision, document, or clause added to a homeowners policy that modifies the original coverage offered by the policy.
Exclusion – Items, conditions or circumstances that are specifically noted in a homeowners policy as not being covered.
Exclusive agent – An insurance agent who only sell the products of one insurance company.
Group policy – A policy sold through an employment-based group, an association or a special group insurance trust in which all participating members are included under one master policy. Each receives an individual certificate of coverage from the group policy.
Independent agent – An insurance agent who represents more than one company.
Individual policy – A policy sold directly to an individual.
Lapse – An interruption in coverage caused by non-payment of the premium.
Liability coverage – Covers losses for bodily injury or property damage to others that occur on the homeowner’s property, as well as medical and legal expenses that may arise from lawsuits. Both losses are covered up to a specific dollar limit.
Market value – The current worth of your home, including the land on which it is built.
Nonrenewal – When an insurance company declines to renew a policy at the end of its current term.
Peril – A specific risk or reason for a loss.
Personal property – Portable items, such as furniture, electronics and clothing, that are not permanently attached to the home.
Policy – A written contract between an insurer and customer specifying coverage for loss or damage to property.
Premium – The price charged by an insurance company the varies depending on the level of coverage purchased.
Property coverage – Protection for land or personal property against loss or damage.
Underwriting – The process that insurance companies use to determine eligibility and premiums for coverage.

Understanding Your Policy

The first rule of understanding property insurance is that not all homeowners policies are the same. This is often one of the most common misperceptions about insurance. In a 2010 survey by the Independent Insurance Agents & Brokers of America, more than a third of the respondents said they didn’t have, or didn’t know if they had, adequate homeowners insurance coverage, and 62 percent had never discussed a complete disaster preparedness plan with an insurance agent.

Not knowing what’s in your policy can have serious financial consequences. In 2005, after Hurricane Katrina flooded the city of New Orleans, and again in 2012, when Superstorm Sandy paralyzed countless communities in New York and New Jersey, thousands of desperate survivors got a rude shock when they found their basic homeowners’ policies did not cover flood damage.

more than a third of the respondents said they didn’t have, or didn’t know if they had, adequate homeowners insurance coverage

A. What’s Covered

Your coverage will not kick in unless you experience a loss that is caused by a specific peril, or reason for loss, that your policy covers. For most policies, according the NAIC’s “Consumer’s Guide to Home Insurance,” the list of covered perils includes:

Fire, smoke, wind, hail, lightning, explosions, or civil unrest
Theft or vandalism
Trees and other falling objects
Weight of ice, snow, sleet and freezing rain
Rupturing and sudden overflowing of a plumbing, heating, air-conditioning appliance or sprinkler system

B. What’s Not

Some common perils occur with such frequency and predictability in certain areas that they are subject to exclusion from basic coverage. The most notable excluded perils include:

Floods or sewers that back up into the home
Land movement, including earthquakes, landslides and mudflows
Acts of war, or overthrow of the government
Damage from pets, birds, rodents or insects
Pollution damage
Deliberate damage to the home
Normal wear and tear

Most of these are fairly clear-cut perils, but many people get confused by the types of water damage perils, as defined by insurance companies. They make a clear distinction between sudden water damage caused by a ruptured pipe (covered) and gradual water damage caused by rising floodwaters that seep into a home (not covered).

C. Types of Policies

The reimbursement you can get for damage also depends on the kind of policy you buy. The most common form of homeowners insurance will cover all perils except for those that are specifically excluded in the policy language. Here are a few other kinds of policies that differ slightly depending on the type of dwelling being covered:

Modified Coverage Form is for older homes, where the cost to rebuild is greater than the market value. It covers the same set of perils as the standard homeowners policy.
Condominium Unit Owners Form is for owner-occupants of condominium units. It insures your personal property and your walls, floors and ceiling against all of the perils, and also extends coverage for damage to additions and/or alterations that the unit owner may have made, up to specified limits. Usually, this coverage for alterations kicks in only after any insurance limits are reached by policies (if any) that are purchased by the condominium association.
Dwelling Fire Form only covers your dwelling, and only for a few specific perils. It does not cover your personal property, personal liability or medical payments. This coverage is a popular option for vacation homes. It’s also the kind of limited policy your mortgage lender will purchase for you if you let your homeowners policy lapse.

If you own a townhouse, you may insure it through an individual homeowners policy or an association policy – sometimes referred to as a group policy. Interestingly, people living in a mobile home with wheels that don’t rest on blocks or a permanent foundation can be covered through automobile insurance, although it offers far less coverage than homeowners policies.

D. Optional Insurance and Endorsements

Many catastrophic events are not part of the standard homeowners policy, but they are still insurable; they just require additional levels of insurance or, in some cases, entirely different policies, which are often several times more expensive than typical homeowners premiums. Some homes are located in high risk areas like flood zones or earthquake zones, which makes purchasing additional insurance a high priority for these homeowners.

Flood Insurance – If your home is located in a known flood zone, you may want to consider taking part in the National Flood Insurance Program, part of the Federal Emergency Management Agency (FEMA), which writes most flood insurance policies. Premiums for this coverage can vary widely, depending on the history of flooding in your area. According to claims processing firm National Flood Service, as quoted in The New York Times, the average annual flood premium is $615, but it can go as high as $1,200 to $3,000 per year in some places.
Earthquake Insurance – If you live in a seismically active zone, some insurance companies will sell earthquake insurance either as a separate policy or as an endorsement to your homeowners policy. Premiums vary depending on your region and the type of home you’re insuring; wood frames are cheaper (roughly 50 cents to $3 per $1,000 of coverage) than more fragile brick buildings (60 cents to $15 per $1,000 of coverage).

California is one of the highest-risk states in the country, with annual earthquake premiums averaging just over $700 per year as of 2010, says the California Earthquake Authority (CEA). (Those in the California area who are interested in specific premium costs and various discounts can use CEA’s handy calculator app.)

Many catastrophic events are not part of the standard homeowners policy, but they are still insurable

Deductibles for earthquake insurance are also a major cost hurdle. They are often expressed as percentages, rather than dollar figures, and can range anywhere from 2 percent to 20 percent of a property’s replacement value, depending on the activity of the nearby fault.

Weather Hazards – In states where homes are regularly exposed to specific hazards, a homeowners policy may not have sufficient coverage, forcing people to pay their insurer top dollar for the necessary endorsements. For example, some insurers that offer policies in storm-heavy coastal areas of the U.S. will exclude coverage of windstorm and hail damage, and only offer separate, more expensive policies for those two common perils.

Some other popular endorsements and extra policies include:

Guaranteed Replacement Cost Coverage – A policy that pays to rebuild your home completely, even if the cost is above your policy limits. You can expect to pay $400 to $1,000 more in premiums per year for this endorsement
Inflation Guard – An endorsement that automatically raises your dwelling coverage limit annually in line with inflation, so that your limits are at least 80 percent of its value. Incremental premium increases in relation to the limit are usually charged when the policy is renewed.
Personal Umbrella Liability Insurance – So called because it tends to broadly cover assets, this insurance increases your liability coverage above the limits available in any of your “primary” policies, including homeowners, auto and boat insurance. Umbrella coverage can extend to other excluded coverages, such as false arrest, slander, libel and invasion of privacy, which can kick in once your primary coverage is exhausted. Premiums for this coverage tends to begin at around $150 to $300 per year for $1 million in coverage, an additional $75 for $2 million, and $50 extra per year for each additional $1 million in coverage, according to the Insurance Information Institute.
Scheduled Personal Property – An endorsement that covers high-value objects such as jewelry, furs, stamps, coins, guns, computers, antiques and other items that could exceed the limits in your homeowners policy. Sometimes referred to as a “personal article floater.”

E. Limits of Coverage

Even if you suffer a loss that is included as a covered peril, there are limits to the amount of reimbursement you can receive

Even if you suffer a loss that is included as a covered peril, there are limits to the amount of reimbursement you can receive. Typically, your insurance agent will help you decide how much dwelling, personal liability and medical payments coverage to buy when you first get homeowners insurance, based on the value of your home.

The limits of your coverage for other structures on your property (including separate garages, studios, storage sheds, etc.), for personal property and for loss of use of your home are expressed as percentages of your dwelling limit. The coverage is usually a set as a percentage of the agreed-upon dwelling coverage limit.

Say your dwelling coverage limit is $200,000 and your coverage for personal property is limited to 50 percent of your dwelling coverage, while loss of use is pegged at 20 percent of the dwelling limit and other structures is pegged at 10 percent. In that case, your coverage for personal property would be $100,000, loss of use would be $40,000 and other structures would be $20,000.

F. Deductibles

Before reimbursements can be made, policyholders must also pass one more obstacle: the deductible. In order to cut down on trivial claims that would otherwise be filed against the insurer, the deductible is the amount the money you have to pay out-of-pocket on a claim before the policy pays the loss. This deductible is meant to be low enough to be reasonably affordable by most homeowners and applies to coverage for the home and personal property.

The amount of the deductible can vary depending on how much you want to save on your monthly premiums. For instance, a policy with a $1,000 deductible will come with a premium that is roughly 25 percent lower than the same policy with a $500 deductible. So, while you pay less each month for a $1,000 deductible, you must pay the first $1,000 of any claim you make before the coverage becomes active.

In most locations, there are also catastrophe deductibles for other, more expensive policies such as earthquake and flood insurance, which are expressed as a percentage of the value of the property instead of a dollar amount. (See Optional Coverage and Endorsements section above.)

How to Shop for Homeowners Insurance

As discussed earlier, insurance policies come in many different shapes and sizes. The same is true for insurance companies and agents, which can charge wildly different rates for essentially the same coverage. Bigger is not always better, and small, local insurers don’t necessarily have the best customer service. So it’s always in your best interest to shop around for the best deals and to ask the right questions in an effort to know what you’re actually getting.

The NAIC came up with a list of good questions to ask an agent while you’re shopping around for quotes. Use this handy checklist the next time you chat with an agent about shopping for a homeowners policy:

What is the claims history of the home I am considering?
If I submit a claim, how will it affect my premium when I renew the policy? Could it end up costing me overall?
How will my credit history affect my premium?
What does the policy cover? What doesn’t it cover? What are the limits to the coverages?
How much coverage do I need for my personal property?
How much liability coverage should I buy?
Should I buy flood insurance or earthquake coverage? Can an agent help me determine how much risk my home is at?
What types of water damage are not covered? Is mold damage covered?

Check with your state insurance department or consumer agency to see if it publishes premium comparison guides for homeowners insurance. To make sure all prospective insurance companies are financially sound, check their health by using evaluations from independent ratings agencies such as Standard & Poor’s, A.M. Best and Moody’s.

A. Stick with the Professionals

With the dizzying amount of choice available for finding insurance agents, some people just go with recommendations from friends, neighbors and relatives. However, you should always beware of referrals from non-professionals. Your brother-in-law may have gotten a great quote from his agent, but that’s no guarantee you’ll get the same treatment.

beware of referrals from non-professionals

Insurance companies generally use one of three methods to sell their products.

Independent agents who represent several companies and can give you several quotes at once;
Exclusive agents who only sell the products of one insurance company; and
Direct market sales that are done over the Internet, by mail or by phone.

Note: As helpful as independent agents can be, make sure you take the time to look up their credentials via your state insurance department and to make sure they are fully licensed. Some unscrupulous adjusters without licenses print up false business cards and claim to be legitimate, but may not follow through after you have paid them.

Doing business with an unlicensed agent may jeopardize your chances of having your claims paid or refunds sent in the event of a cancellation, which can leave you responsible for all replacement costs in the event of a major property loss. It really pays to do your homework and make sure independent agents are the real deal.

Make sure [agents] are fully licensed. Some unscrupulous adjusters without licenses print up false business cards and claim to be legitimate, but may not follow through after you have paid them

B. How Insurers Determine Your Premium

Many factors affect the underwriting process, which determines the premiums you pay. Different insurance companies charge different premiums for similar coverage. Decisions you make about how much insurance coverage to buy also affect your premium. Some of the other things that are likely to affect your premium include:

The cost to rebuild your home; this is not the same as the purchase price, which includes the cost of the land. Your insurance agent might help you estimate replacement cost using information about your home and its contents.
Whether your home is made of brick or wood; the premium is usually lower for homes that are primarily brick or masonry than for wood frame homes
The proximity of your home to resources and services, such as a water source or fire department and the quality of your community’s fire protection services
The age and condition of your home;the premium is often higher for older homes and homes in poor condition than for newer homes and homes in good condition.
The claims history of your neighborhood and community, particularly the homes immediately next to your address
A wood furnace or wood stove in the home
Owning high-risk outdoor amenities, such as a swimming pool, a trampoline or playground equipment that could cause injuries
The types of pets you have. Some insurers won’t insure you if you own certain breeds of dogs that are known to be aggressive, such as, but not exclusive to:
Akitas
Alaskan malamutes
Presa Canarios
Chow chows
Doberman pinschers
German shepherds
Pit bull terriers
Rottweilers
Siberian huskies

Other companies do not exclude specific breeds, choosing instead to consider individual animals on a case-by-case basis. In some cases, the presence of exotic pets in the home, such as snakes, lizards, birds and horses, may also drive up rates.

C. Getting Premium Quotes

Today, new apps have made quote-gathering online faster and easier than ever before. Rather than calling each insurance company individually or searching endless web pages for quote information, these online services allow you to quickly pull up a broad comparison of different companies’ prices.

Insurance companies such as Esurance (offered by Allstate), Progressive Insurance, Liberty Mutual and many others have sophisticated search algorithms that allow you to plug in some basic information about your home’s location and size, plus the type and amount of coverage you want, and receive an instant preliminary quote.

To expand the reach to several insurers at once, online insurance shopping services, such as NetQuote, InsWeb and Affordable-Home-Insurance.org, offer similar search services that calculate the lowest available premium quotes from their networks of thousands of agents across the country, working for dozens of insurance companies.

Also, most state insurance departments are now providing services that show you average premium price ranges (though not specific premium quotes) based on a property’s value, type of construction, mitigation features, various deductible levels and other criteria. For instance, check out the CHOICES page on the Florida Office of Insurance Regulation site, or the Homeowners Premium Survey page from the California Department of Insurance.

But first you should decide what coverages and policy limits you need. This is where the importance of replacement costs vs. actual costs comes into play:

Actual cash value (ACV) – This method would reimburse you for your lost or damaged possessions only after accounting for the age of each item and discounting for the wear and tear – or the depreciation – that has occurred over the years to lessen its value. Usually, the ACV is lower than the market value, but premiums tend to be cheaper.
Replacement cost value (RCV) – This would replace your possessions with similar items at their current market value, so it does not factor into depreciation. The downside is that the annual premiums for RCV policies tend to be about 10 percent higher that ACV ones.