In 1999, Dick Silva's house in Billerica, Massachusetts, burned to the ground, gutted by an electrical fire. Fortunately, no one was hurt in the blaze. But Silva — brother and business partner of This Old House general contractor Tom Silva — was certain that his troubles were just beginning when he looked at his insurance policy. Like most people, he had purchased homeowner's insurance when he bought the house in 1967 and had paid little attention to it since then. While the cost to replace his house had gone up significantly due to increases in construction costs and materials, his homeowner's policy showed he was insured for only $140,000.

"I just assumed that as the years had gone by, my insurance increased automatically to keep up with higher costs," Silva says. "I thought I was going to have a huge problem, because I couldn't rebuild my house for less than a million."

What Silva didn't know was that a few years earlier, his insurer had updated his policy to cover full replacement at any cost, a special bonus for some local residents who had put in few claims over the years. It was a lifesaver. Within a year, he was able to build a four-bedroom Victorian on his two-acre lot, with a synthetic slate roof, custom-milled oak and southern pine floors, and, this time, smoke alarms tied to automatic fire sprinklers. "I know we got lucky," he says.

Unfortunately, few people can say the same thing. As many as 58 percent of U.S. homeowners are carrying insurance policies that don't cover replacement cost if a fire or storm levels their house, according to a study released in 2006 by Wisconsin construction-data firm MSB (formerly Marshall & Swift/Boeckh). To make matters worse, those policies are undervalued by more than 21 percent in many cases.

The epidemic of underinsurance is relatively new. Until the mid-1990s, most standard homeowner's policies guaranteed full replacement for the building and at least 50 percent coverage for its basic contents, such as furniture, electronics, and clothing, no matter the extent of the damage or the value of the policy. In recent years, however, faced with large and unexpected losses from wildfires, hurricanes, and mold, most insurers have abandoned this approach. Now only a few companies provide full-replacement policies, at much higher premiums. Instead, the typical policy pays out a maximum of 120 percent of the home's assessed value and includes an inflation guard that hikes coverage about 3 percent annually—not enough to keep pace with construction costs. According to MSB, the average cost of materials used in building construction rose by more than 6% in 2005 and 2006 after an 8% increase in 2004.

The boom in remodeling is also bringing insurance policies up short. Americans spent about $150 billion on renovations in 2002. Yet an estimated 60 to 75 percent of homeowners failed to increase their insurance coverage to reflect the improvements, according to the Independent Insurance Agents and Brokers of America. "In many cases, rising construction costs and renovations have added fifty to one hundred percent to the replacement cost of a home since it was purchased," says Robert Hartwig, chief economist at the Insurance Information Institute. "Yet often the only time people think about their homeowner's insurance is when they first get a mortgage. That's like playing Russian roulette."

Here's how to make sure you have adequate coverage and at the same time keep insurance premiums to a minimum.

(This article has been updated with new information, October 2007)
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