Buyer beware? Climate risk & the future of home insurance

Welcome to the latest Finity Climate Risk Blog, which looks at price dislocations & the future of fire insurance.

The current home insurance pricing framework in Australia has evolved to incorporate detailed address level risk, taking advantage of robust hazard information for major perils (cyclone, flood, earthquake and bushfire). The system has generally been successful in maintaining a vibrant private market based on matching risk and premium. However, as pricing sophistication has increased, some risks have experienced significant increases in premium, balanced by lower premiums for those with less risk. This disruption has triggered consumer backlash and government inquiries. In the future, the combination of modern pricing tools and climate change is likely to result in more Australians experiencing price dislocation.

This is an important issue that has been raised by the Practical Justice Initiative at UNSW in their report ‘Social Justice and the Future of Fire Insurance in Australia’ and has also been highlighted in our previous Climate Risk Blog entry, ‘Climate change and insurance affordability’.

Social justice advocates often favor cross subsidies to protect against higher prices, but often the impact on those asked to pay these subsidies (those with lower risk) is overlooked. As a solution to customer segments facing high bushfire premiums the Practical Justice Initiative has proposed a Medicare-like government insurance scheme, where everyone bears the same cost of fire risk regardless of their actual individual risk. However, the underlying nature of health insurance and property insurance are quite different, and there are a number of other issues regarding incentives and government run schemes, as we will discuss below.

Why a Fairness as social justice system works for healthcare but perhaps not for bushfires

Everyone can be injured or become ill, and therefore there is incentive to make the Medicare scheme equitable, so that all Australian citizens have equal access to public healthcare. In the case of CTP schemes, all vehicle owners are mandated by law to require CTP insurance, providing a rationale for regulation to limit risk based pricing, which in some jurisdictions is not possible at all. [1]

The Practical Justice Initiative describes the CTP scheme as a Choice-Sensitive Fairness model where “insurance costs to individual should reflect only those risks that result from each individual’s choices”. In fact, CTP premiums, due to state regulated pricing, do not reflect the full extent of a policyholder’s risk profile.

In property insurance most policyholders are not exposed to significant bushfire risk, and some will never be even under climate change. From a social fairness perspective, should property owners pay a bushfire premium without the prospect of ever benefitting?

The authors of the Practical Justice Initiative report argue against a Pure Actuarial Fairness approach by stating that “only owners of high-risk properties may choose to purchase fire insurance while those with lower-risk properties will opt out”. Actually, that is unlikely to happen under risk based pricing but is almost certain under a scheme where everyone pays regardless of risk. If purchase is not compelled in a scheme with large cross-subsidies, low risk consumers will not buy cover, resulting in a scheme either suffering large losses or having to raise prices to the same level the risk based system is charging today.

Placing the cost on those who should take action

Risk based premiums serve a public purpose by incentivising individuals to lower their risk. Unaffordable or uninsurable risks are indicative of high burden to society. Subsidised premiums can create incentives to build in high risk areas, thus raising costs for everyone. This is precisely what has been observed in the US where the government makes highly subsidised flood and windstorm insurance available in high risk areas.

Ideally, the responsibility for risk mitigation should lie with both the individual and the government. The government should implement effective measures to protect against bushfire, while individuals should ensure their properties have effective risk mitigation, such as protection zones, clean gutters, and water pumps. For this reason, it is important for individuals to pay a premium that is at least partially reflective of risk.

Climate change will exacerbate current risk levels for many, particularly for bushfire. It is appropriate to ask whether it is fair that policyholders be punished with higher premiums as a result of increasing risk due to climate change, when there is no action they could have taken to mitigate or avoid that risk. This is a difficult social question which may require targeted subsidies.

Concerns about a Fairness as Social Justice System

In addition to bushfire risk, climate change is leading to shifts in the frequency of floods, hailstorms, and other natural disasters. Should the government intervene for these perils also? Currently insurers fund extreme event losses from their capital and the reinsurance market; if the government takes on all natural hazard risk it will be exposed to large unexpected losses and potential funding deficits.

Historically, there have been concerns with government run risk pooling schemes, which can solve one problem (such as high premiums for certain segments of the risk pool) while creating others (such as reduced mitigation incentives or the need for levies on low risks). In the case of Medicare, costs have been rising and there have been discussions regarding privatisation to promote efficiency, and the government has encouraged private health insurance and out of pocket costs in an effort to alleviate such cost pressures. In CTP, the system design includes some risk differentiation to manage the flaws it would otherwise create.

Lastly, some of recommendations from the Practical Justice Initiative may also be problematic to implement. For example, they seem to advocate for total replacement cover over sum insured cover policies. Total replacement cover has been seen to create issues after major catastrophes, such as the 2011 Christchurch earthquakes and US hurricane Andrew, where cost blowouts, disagreements in building valuations, and delays in rebuild and repairs were experienced.

Another issue involves separating bushfire from other perils. To our knowledge, there is currently no insurer in the market that offers bushfire cover as a separate option for Buildings and Contents insurance in the personal lines market. It would not be easy to disentangle bushfire from other cover. While there is no question that the existing pricing framework has pockets of dislocation, there is value in the risk based pricing approach, as it leads to increased incentives for bushfire risk mitigation which will be reflected in lower prices overall.

What next?

The UNSW report raises important issues which merit thoughtful consideration. Price dislocations can be expected to arise from other perils, such as flooding, due to climate change, and one year term insurance policies will not send proper price signals for long term risk. Individuals experiencing price dislocation in high risk areas may need assistance, though there are less disruptive solutions than transforming part of the property insurance system into a version of Medicare.

The ACCC will issue its final report later this year and the Actuaries Institute has formed a General Insurance Affordability Working Group. The goal of these efforts is to find the right public policy mix to balance mitigation incentives, social fairness, long term government finances, and protection of property.

Finity's Climate Risk Team

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