CA fire laws: How homeowners can recover and how advisors can help

The Los Angeles wildfires have renewed interest in a specific California insurance regulation

When a homeowner applies for or renews a homeowner’s policy, Section 2695.183 requires residential property insurers to provide them with a replacement cost estimate. This is the company’s own calculation of the actual cost to rebuild the home in its entirety.

“The regulation is very specific about how that number has to be calculated,” said Kya Coletta, associate of the Insurance Recovery Group at Reed Smith, a global law firm.

The estimate needs to reflect the costs of labor, materials, overhead, and profit, as well as demolition and debris removal, permits, and the architect’s plans. In addition, it must be tailored to the actual structure being insured: its square footage, age, foundation type, framing, roofing, number of stories, and so on.

It can’t be based on the value of the land, an outstanding loan balance, or a depreciation deduction. A generic number pulled from a tract-home model is unacceptable as well.

“What people often miss is that this isn’t a one-time disclosure. It’s an obligation the insurer must perform for each newly insured home, and then annually in advance of a renewal,” Coletta explained.

The regulation requires the insurer to take reasonable steps to verify that the estimate is accurate and reflects current construction costs for that specific location.

Essentially, per the regulation, the initial burden of making sure the coverage limit is adequate rests with the insurer, not the homeowner.

Why the regulation is gaining traction

Until now, Section 2695.183 hasn’t received much attention.

In fact, Reed Smith’s review of California court filings identified 56 lawsuits, filed in state and federal courts over the past eight years, that specifically cite the regulation. That number is likely to climb as LA wildfire claims move out of the loss-documentation phase and into the rebuilding phase, where the gap between what the policy pays and what it actually costs to rebuild becomes impossible to ignore.

Homeowners may be faced with sticker shock when they realize the actual costs of rebuilding exceed what they thought would be adequate replacement cost coverage.

“Construction costs are up substantially, and reconstruction bottlenecks, such as permitting delays, contractor demand, and material shortages, are forcing that gap into the open,” Coletta said.

Many of these homes may have been grossly underinsured, but Section 2695.183 gives policyholders and their counsel a concrete regulatory yardstick to measure that against.

“It turns a vague sense of ‘my insurer let me down’ into a specific, provable finding of a misleading statement that could support a bad faith claim,” Coletta added.

The true definition of replacement cost coverage

The most common misconception is that “replacement cost coverage” means a home will be replaced to its original condition. However, it’s not that simple.

Instead, it states the insurance company will repair or replace the residence with new materials of like kind and quality up to the policy limit, and there is no deduction for depreciation.

In the past, guaranteed replacement cost coverage meant the carrier would cover the full cost of rebuilding the home, regardless of the amount, but that type of coverage is rarely offered today.

“These days, many insurers offer ‘extended replacement cost' coverage,’ which adds a buffer on top of the dwelling limit, often 20% to 50%, and is intended to cover unexpected rebuilding costs,” said Keith Meyer, partner of the Insurance Recovery Group at Reed Smith.

However, if there is a major disaster that causes widespread damage, local labor and material costs can skyrocket, and even the ‘extended’ replacement cost cushion may not be enough to cover the full cost of rebuilding.

Another potential issue involves sublimits.

Even with replacement coverage, many policies impose sublimits on specific types of work required for a rebuild.

For example, a policy might include a sublimit for building code upgrade work. If building codes have changed since the house was originally built, the replacement dwelling will have to comply with current standards, and a sublimit in the policy operates as a cap on such costs.

“Some policies may permit the homeowner to apply the 20% to 50% ‘extension’ toward building code upgrade costs, but many do not,” Meyer explained.

The moral of the story is that homeowners should check to be sure that “extended” replacement cost coverage can be used toward work that would otherwise be subject to a policy’s sublimits.

Where advisors come into play

When a homeowner is evaluating whether their coverage is adequate, they can’t just picture their stove catching fire and burning down their own house in isolation.

“Homeowners should plan for a mass event: wind-driven fire moving through an entire neighborhood, leading to thousands of homes lost at once,” Coletta said.

In that scenario, they’re not just insuring their house. They’re insuring their house in a world where their neighbors’ houses burned down too, and in the aftermath, everyone is bidding on the same contractor, the same lumber, and the same architects at once, and those costs could soar.

“It would be prudent for a homeowner to take the insurer’s rebuilding estimate and consider whether that amount would be sufficient in a mass disaster event or whether they should increase the limits to account for the demand surge that would follow a widespread loss,” Coletta added.

Though advisors aren’t typically the ones calculating replacement costs, they can play an important role as a reminder.

Ideally, they’d ask questions such as, “Have you received an updated replacement cost estimate from your insurer this year?” and "Based on that number, would you actually have enough to rebuild?”

In addition, advisors should stay informed about California laws, regardless of where their clients are located. That’s because California has been a bellwether for insurance regulation and tends to write the playbook other states end up borrowing.

“If this doctrine proves effective for policyholders here, we wouldn’t be surprised to see other wildfire- and disaster-prone states look at similar disclosure and annual-update requirements,” Coletta said.

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Anna Baluch is a finance reporter and writer with more than a decade of experience. Contact her at [email protected]