Climate change and insurance affordability

Climate change and insurance affordability

By October 28, 2019Climate Risk, News

The issue of the availability and affordability of property insurance in Northern Australia has been the subject of government inquiries and generated considerable media attention. In this blog we consider this issue’s relevance to what may be on the horizon due to climate change.

The push to price more accurately

Australia is exposed to large natural disasters, which we estimate to comprise 40% to 50% of long-term home insurance losses. Insurance companies have gradually recognised the importance of accurate natural perils pricing and introduced more sophisticated methods over the years, particularly in high resolution address level rating. This has led to fewer cross subsidies, much higher premiums for high risk properties and increased incentives for mitigation.

The rise of affordability concerns

In 2014 the Productivity Commission released a paper that looked into the Natural Disaster Funding arrangement[1]. It concluded that insurers have become more sophisticated at pricing for natural perils and premiums were efficient in that they provided the right signals of risk. However, improved pricing also led to large premium increases to some in high risk areas, prompting other inquiries by the Northern Australia Insurance Premiums Taskforce and ACCC, which have explored affordability, insurer profitability, mitigation, consumer information and many other issues.

Many locations faced with higher natural perils risk are correlated with lower socio-economic and household income profiles, creating affordability concerns. The following figures illustrate the issues. The first is from the ACCC, which shows that premiums in Northern Australia are higher and also increasing more rapidly.

Source: ACCC analysis of data obtained from insurers. ACCC Northern Australia Insurance Inquiry: First Update Report, Figure 3.7.
Note: Trends for the Northern Territory do not include data for the TIO prior to 2015 - 17

The second is a study by Finity’s climate team comparing premiums to disposable income in regions, which shows that in all of Australia (left chart) the large majority of people are able to pay annual Combined Home and Contents premiums with less than 1.5 weeks of disposable income, while in Northern Australia (right chart) many must spend more than 2 weeks’ worth. In both cases the stress is greater at the lower income levels, but Northern Australia has both higher average premiums and lower average incomes, leaving more people there exposed to financial stress.

Figure 2 shows a measure of affordability created by comparing our view of average online Home premium to disposable income across Australia. Each bar represents a quintile of the SEIFA tier. The vertical axis shows the distribution of houses based on how many weeks of disposable income is required to pay an average household insurance premium.

Drivers of the Northern Australia problem

The property insurance market has been affected by a confluence of several factors:

  • Insufficient economic signals to encourage mitigation (or discourage development in high risk areas) when construction occurred in the past
  • Rapid technological change enabling a much more granular assessment of risk
  • Triggering events which prompted (re)insurers to change pricing or underwriting practices.

Most agree that people who knowingly build in high risk areas without proper mitigation should bear the cost. However, what should be done about people who built in places approved by local councils, used then current building code standards, and bought policies at low prices from insurers using low resolution community rating and/or which failed to reflect overall risk from natural disasters? Many in this group are now experiencing significant premium increases, and it may be difficult or impossible to retrofit existing property to sufficiently mitigate risk to lower premiums.

Affected consumers are asking why they should be left to pay high premiums, go uninsured or see the value of their assets decline because local councils permitted building in places they should not have, old building codes were inadequate and/or the insurance industry has discovered better risk assessment tools. This is the core issue in Northern Australia and it poses challenging public policy questions for government.

The current Northern Australia problem is an example of a “mitigation gap”, where economic signals and/or regulations at the time of past construction failed to anticipate today’s understanding of risk.

What does this have to do with climate change?

In the case of climate, the risk itself, rather than our ability to measure it, will change. This may create problems in pockets throughout the country similar to those experienced in Northern Australia, particularly given our ability to better measure risk. Importantly, due to the short term nature of property insurance policies, even if risk pricing sends perfect signals today through premiums, future risk will not be reflected, so market based pricing will not create proper incentives for mitigation of future risk. Similarly, land use policies and building codes generally contemplate current conditions, so these tools will also miss risk arising in the future. This almost guarantees that in the future some group of policyholders will find themselves facing increasing prices for insurance and a “mitigation gap”, triggering calls for government action.

Fortunately, the effects of climate change will likely arise more slowly than those of the current technology driven disruption, allowing a greater opportunity for gradual adjustment.

Can anything be done?

The problem is extremely complex, particularly in determining if it is in the public interest for the government to intervene to moderate disruption for those who experience large premium hikes due to changes in risk perception or the underlying risk itself. Any such intervention must be done carefully to avoid adverse outcomes, such as discouraging mitigation, running large deficits in pools or unduly disturbing generally well-functioning private insurance markets.

There are steps that will help prepare for the future, such as:

  • Studying future climate scenarios to develop a clear understanding of what risks may arise, such as an identification of coastal areas subject to inundation from storm driven water in light of rising sea levels.
  • Developing alternative ways to reflect future risk in economic decision making, recognising that competitive market pricing for short term (e.g. one year) insurance policies will not send proper mitigation signals for future risk.
  • Reviewing how buildings code and land use policies are promulgated to introduce “future proofing” concepts.
  • Ensuring that any response to the current Northern Australia affordability issue is robust enough to address similar problems triggered by climate change, since any such mechanism developed for Northern Australia today is likely to serve as a template for addressing climate triggered disruption in the future.

Finity is currently developing enhancements to its finperils models to reflect future climate risk, contributing to solving the first problem identified above. We hope to work with all stakeholders to help tackle the other key steps to prepare for the impact of climate.


Rade Musulin, Shirley Chau and Stephen Lau from our Climate Risk Team

Further reading

Finity's Rade Musulin was recently featured in the AFR article 'Strata insurance crisis facing unit owners in northern Australia'.
Read our previous blog post: Climate change financing issues.