Problem: Ricardo Juarez is purchasing a homeowners insurance policy. He is very concerned about inflation and wants to make a determination about purchasing the optional inflation protection rider. He has identified several scenarios and wants to know how often he needs to revisit his coverage to maintain at least 80% of replacement cost. Base all calculations on an initial home value of $ 250,000 and initial coverage of 100% on the dwelling and contents.
Required:
a. He believes that current housing prices will increase at 4% per year. How long will his coverage meet the 80% rule if he does not buy inflation protection? How long would he be covered if he purchases an inflation protection rider that offers annual compound increases of 3%?
b. Given the recent declines in housing values, he believes a recovery is coming and that housing prices will increase at 7% per year for the next five years before slowing to a permanent 4% annual appreciation rate. How long will his coverage meet the 80% rule? First assume that Ricardo does not purchase an inflation protection rider, and then assume that he purchases an inflation protection rider that offers annually compounded increases of 3%.
c. Ricardo believes that housing prices still have a ways to fall before any meaningful recovery. He believes that future housing prices will decrease at an annual rate of 4% for the next three years before the long-term trend of 5% annual increases resumes. Assuming that he does not purchase an inflation protection rider, how long will his coverage meet the 80% rule?
d. He believes that future price increases will be very unstable. With this uncertainty, he wants to have the inflation rider protection of 3% compounded annually. Assume actual housing price changes for the next five years are 3%, -7%, -2%, 8%, and 12%. Will his coverage meet the 80% rule at the end of this five-year period? What if he does not purchase the optional rider?
e. Based on the results from above, what can be said about how frequently insurance coverage needs to be reevaluated?