The New York Times has an interesting article about insufficient homeowner's insurance.
My take is that people are really missing the point of homeowners insurance. It is to make you (and the mortgage company) whole from the loss of your house. It is not intended to fund the rebuilding of your house (probably with customizations) in place.
A major problem is the lack of available contractors and a rise in building material costs when an area has been devastated (such as Hurricane Charley and the California fires). However, arbitrage will normally control the materials issue. But the biggest problem is outlook.
My current house is the second house I've lived in where the projected cost to rebuild is greater than the cost of the house. This seems extraordinary because the land costs (the lot presumably does not lose value if the house is destroyed) are included in the house purchase price but not the insurance coverage. So the insurance company is making it quite clear that it would cost $50K-100K more to rebuild than the house is currently worth. But if you live in an older house, or in a declining neighborhood, it makes sense. House prices are determined by supply and demand with a supply floor at the construction cost of a new house. House values will not rise significantly above construction cost until land of equal desirability is not available. But there is nothing to stop them from falling if there are bad schools, neighbor's houses in disrepair, or even due to natural wear and tear as the house ages. What is not intuitive is that all houses should be valued below reconstruction costs. All of the external factors that cause house values to rise (neighborhood, schools) influence the value of the lot, not the house. And internal factors such as remodeling can only reverse the effects of depreciation to bring the house closer to reconstruction cost. The problem is exacerbated if the house has special features such as moldings or plaster work. My houses were unusual only to the extent that the land price was insufficient to offset the cost gap between the "as-is" house and a reconstructed house, thus causing the reconstruction cost to exceed the purchase price.
My house has problems -- uneven floors, ancient telephone wiring, aging windows, rotting trim (hey, its from 1865). A new house built to identical specifications would not have these problems and would thus be worth more. And I would probably want other modifications. Which would quickly put me in the realm of custom houses which have significantly higher construction costs (due to intrusive customer involvement and nonstandard requests). Building a house under a microscope is an expensive proposition since it is easier to accept existing compromises that were made decades before (and may well be invisible) than to allow them in a new custom home.
The Carrolls' in the NYT story purchased their house for $172,500. The lot value was about $50K. State Farm is paying $220K (everything on lot destroyed). This is entirely reasonable, valuing the house and personal goods at nearly $270K. The replacement cost is supposedly $400K. This could well be a reasonable estimate -- but the purpose of the insurance is so you can walk away, not hit the jackpot.
They should sell the lot, which will be snapped up by a builder or an investor who can rebuild a house on their own schedule, with a few corners cut, without people breathing down their neck. Then take the money and buy a new house with a new set of compromises which make it affordable. Sure, you can't buy in the same neighborhood (high demand, most houses destroyed). But there are other neighborhoods.
On a personal basis, its a tragedy that most people are forced to leave their neighborhood after a castastrophe. But if you couldn't afford a new custom home prior to the catastrophe, its unclear why the insurance company should provide one as a consequence. People who really want this extraordinary result should be prepared to pay a significant amount for this privilege. This isn't a story of big bad insurance companies -- rather it's a story of the nonobvious and personally painful consequences of a reasonable and economically rational level of insurance.