Australia: Mathematical and Moral Gymnastics: Government releases Natural Disaster Insurance Review Issues Paper

The Natural Disaster Insurance Review panel (the review panel) released its eagerly awaited issues paper late last week, entitled Natural Disaster Insurance Review – Inquiry into flood insurance and related matters (the paper).  The paper seeks to address the availability and affordability of insurance offered by the private insurance market in the aftermath of recent storms and flooding in Queensland and Victoria.

Australian insurers routinely exclude cover for 'flood' in their policies while retaining cover for storm damage or other similar concepts.  As a result, there has been considerable debate and case law developed over the years (across State lines) in respect of the interpretation and ambiguity of policy wordings.

According to the paper, there are approximately 50,000 homes subject to high flood risk in Australia which represents less than one percent of Australia's homes.  As such, the review panel has considered possible new insurance arrangements for flood and other natural disasters^[1] for homes.  It also explores whether any such arrangements ought to be extended to home contents, strata title and other residential properties, and small business. 

The request for stakeholder submissions is, regardless of the outcomes, a positive step in the Government's quest towards the development of a comprehensive natural disaster response in Australia.

Flood insurance for homes

The review panel has identified two alternative models for flood insurance:

1.       that flood cover be provided automatically as part of home insurance^[2]; or

2.       that flood cover be provided automatically but that homeowners be able to 'opt out' and have home insurance that includes cover for other causes of damage but not flood.

Model 1

According the review panel, all disputes about whether water damage is caused by flood or storm would be eliminated under Model 1.  Some homeowners, however, would face significant increases in insurance premiums under such a model unless these homeowners were given some form of assistance to enable them to continue to insure their homes. 

Model 2

According to the review panel, the take-up of flood insurance would undoubtedly be greater than under the status quo but would still remain limited under Model 2.  Disputes over whether water damage arose from flood or storm could also still occur for policyholders who opt out of flood cover. 

In considering the effects of both models, the review panel explains that

Both models require three steps to give some form of assistance to owners of homes exposed to high flood risk so that their premiums become affordable:

• identifying the homes with high flood risk;
• providing discounts to some or all of these home owners; and
• funding these discounts.

From a legal standpoint, Model 1 is probably best equipped to reduce disputes over policy interpretation.  While the definition of 'flood' for the purpose of mandatory cover remains a live issue (for further discussion about the definition of flood see gadens lawyers April 2011 update  here), the implementation of Model 1 would likely lead to a vast reduction in the legal issues arising out of 'flood' claims on household insurance contracts.

A 'full system'

The review panel premise is that in order to devise a comprehensive insurance system for high flood risk homes, such a system needs to contemplate more than just a high-risk threshold mechanism.  The review panel suggests the following additional considerations:

• a central vehicle such as a Flood Insurance Pool in the form of mutual with insurers as participants, or operating as a reinsurer;
• a pricing regime;
• an eligibility criteria, i.e. which homes with high flood risk are eligible for premium discounts;
• an insurance underwriting regime, eg. insurers would be obliged to accept homes beyond the high-risk threshold at the specified discounted price; and
• a mechanism and source of funding for the discounts, i.e. the main possible sources of subsidies are governments, councils and insurers.  In these cases, the subsidies would ultimately be met by, respectively, taxpayers, ratepayers or policyholders.

But not every home is insured...

The review panel acknowledges that key stakeholders (homeowners, insurers, councils and governments) need to have a vested interest in order to avoid moral hazard and to maintain incentives for good risk management, including flood mitigation. 

However, both models fail to address individuals (or small businesses) that simply refuse to purchase insurance.  Models 1 and 2, as well as maintaining the status quo (Model 3), contemplate freedom on the part of every homeowner to decide whether to take out home insurance.  As such, the review panel has also considered compulsory home insurance for all homeowners in Australia (Model 4).

Making home insurance compulsory would revolutionise the operation of the private insurance market in Australia.  It would require legislative amendments that would:

...take away the right of the homeowner to decide whether or not to buy insurance and there would have to be a way to oblige insurers to provide cover to homeowners that they may decline in a voluntary market.

Further, the impacts of such a major change would cross borders into other major industries with implications for lending institutions, mortgage brokers and financial planners etc.  Compulsory insurance already exists in Australia (eg Compulsory third party motor and workers compensation) however if the government was to make home insurance compulsory, this would be the first instance of compulsory 'first party' insurance.

What about small businesses?

The review panel also considers extending any new regime to small business.  As a general rule, flood insurance for small businesses is rare and price sensitivity is a key factor in the high level of under-insurance and non-insurance in small business policies. 

So where does that leave us?

The review panel encourages all interested parties to examine the multitude of questions posed.  Some additional points of inquiry put to stakeholders include:

• cost bearing;
• flood mapping;
• calculating discounts for high flood-risk homes;
• how any regime will impact on loss mitigation measures for existing and new homes; and
• funding of public infrastructure.

The review provides an opportunity for stakeholders to have their say in respect of the long term funding of disaster relief in Australia.  The Assistant Treasurer and the Attorney-General will provide the outcomes of the review to the Heads of Treasury for consideration as part of their report to the National Emergency Management Committee on insurance by the end of 2011.

Regardless of which of the four models, if any, is adopted, it is clear that there needs to be increased research and investigation in respect of the development of a 'total system' for high natural disaster risk homes.  Stakeholders need to continue to develop and maintain advanced mechanisms of flood mapping and data for the determination of flood risk in order to avoid moral hazard and to maintain incentives for good risk management including flood mitigation.  Mandating cover without these further measures would leave the task unfinished and potentially do more harm than good.

Submissions on the paper are due by 14 July 2011 and developments in this space will continue to be closely monitored by all stakeholders. 

The paper can be viewed in full  here.

^[1] Including: bushfire, cyclone, earthquake, landslides and actions of the sea.

^[2] Similar to bushfire and storm.

This report does not comprise legal advice and neither Gadens Lawyers nor the authors accept any responsibility for it.

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