This article sets out the issues arising from the widespread move to 'sum insured' cover for house insurance and assesses the risks this may pose to New Zealand.
The move to 'sum insured' cover for home insurance policies in recent years represented a major change in the cover provided to homeowners, and gave rise to a lot of media attention. We wanted to know what risks this change presented, whether homeowners were able to take them on, and whether there was a risk that the Government would end up carrying the can.
The move to 'sum insured' home insurance policies shifts responsibility for assessing rebuild costs to homeowners
Following the Canterbury earthquakes in 2011, most residential insurers in New Zealand moved home insurance policies from 'full replacement' cover to a capped 'sum insured' value. In simple terms, under 'full replacement' cover, the insurer would repair damage to the policyholder’s home and in the worst cases would completely rebuild the house with a replacement of similar size and quality. Under 'sum insured' cover, the homeowner needs to specify an insurance value which is sufficient to cover the cost of a complete rebuild. That represents a cap on the total amount the insurer has to spend when repairing or replacing a home.
It is easy to see the benefits for insurers of the 'sum insured' model, which is widely used around the world. In the event of a natural disaster, insurers can predict their overall liabilities with much greater accuracy. However, the new arrangements transfer responsibility for assessing rebuild costs to homeowners, and the evidence shows that many homeowners are not willing or able to calculate an accurate rebuild cost for their home. This can be a difficult calculation as, in the worst cases, the costs may involve total demolition, removal of the rubble and rebuilding a new home that is compliant with the current building code. Therefore rebuilding costs often exceed the market value of the existing dwelling.
Under-insuring may leave the homeowner with a shortfall
Getting the calculations wrong may leave the homeowner exposed to under-insurance, where the insurance policy would not pay out enough to rebuild a home fully. In some cases, homeowners could deal with the shortfall by accessing their savings, by borrowing more or by building a smaller or simpler house than they had before. But homeowners would still feel this as a loss, and if the shortfalls were repeated on a wide scale after a major event, there might be political pressure for government to provide financial support to home owners who have suffered these losses. The anticipation of such support can lead to home owners further under-insuring. This is known as a moral hazard problem.
What is the scale of under-insurance in New Zealand?
We were keen therefore to get a better idea of the scale of the under-insurance problem. The challenge was how to measure under-insurance. Every house is different and there is no single right estimate about how much it would cost to rebuild after a disaster.
In doing this research, we were able to access information from insurers, brokers and valuation consultants working in the New Zealand market. We are grateful for their cooperation, particularly in providing us with commercially sensitive information which helped us to build a picture of the cover in place and how it was assessed.
We examined a variety of different approaches to measuring under-insurance, including samples of valuations and rebuilding costs. We concluded that under-insurance was a real issue across New Zealand. The estimates spanned a wide range, both in terms of the number of homes affected, and the amount of under-insurance. Our final assessment was that up to 85 per cent of homes could be under-insured by an average of 28 per cent.
Applying those figures across the whole country produced an estimate of under-insurance across New Zealand of up to $184 billion.
How much of a problem does under-insurance actually pose?
That figure is large, but it overstates the risk. Even a major event like an earthquake would be limited to one location, and most houses in that area would not suffer so much damage as to reach the limits of their cover. To investigate the effect of a realistic major event, we used modelling from the Earthquake Commission to calculate what the under-insurance shortfall might be after a magnitude MW 7.5 event on the main Wellington fault, using the under-insurance assumptions previously identified. This produced a shortfall of around $135 million, which is far smaller than the national figure. Most homeowners (95 per cent) would not experience a shortfall at all, but the impact on some households would be severe, with several thousand households facing an average shortfall of around $40,000.
On the basis of that modelling, our assessment was that, although under-insurance could cause difficulties for some householders after a major event, the total shortfall would represent only a very small proportion of the overall costs of the event.
We therefore concluded that the Government would be unlikely to be called upon to fill the gap and that specific Government action, for example imposing new requirements on brokers or insurers, was not necessary to deal with this issue. But that does not mean the problem has gone away. What then should be the next steps?
What then should be the next steps?
Some insurers have continued to offer a full replacement product, or to offer full replacement cover in certain circumstances. There is no sign that the larger insurers are planning to move away from 'sum insured' for their standard product. Our discussions with insurers and brokers showed that they want to avoid widespread under-insurance, and want to encourage customers to assess their rebuild values carefully. The insurance industry needs to continue its effort to support well-informed home owner decisions on their sum-insured values. Banks also have an interest in mortgage-holders having sufficient cover in place, in order to protect the value of their collateral.
Thinking about rebuilding costs is still a new experience for most homeowners. One of the issues has been that many homeowners are put off by the cost of getting a detailed rebuilding cost valuation, and online calculators need to balance accuracy against usability and can only be as accurate as the information provided. Homeowners seldom know all the relevant information about their house and locating it can take some effort. But if homeowners are in doubt about their rebuild cost or want to include a risk margin for future increases in repair or rebuilding costs, additional cover to increase the sum insured can be bought relatively cheaply. For example, an extra $2 a week could obtain more than $200,000 of extra cover, based on online quotations for a house in Wellington. Customers can check with their insurers and banks what cover they provide and what tools or offers are available to improve the accuracy of their insured value.
- This article is based on a Treasury Report prepared by James Sergeant and Dillion Watts in June 2015.
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