Insurance availability and risk-based pricing

Insurance makes an important contribution to New Zealanders’ financial and economic wellbeing

By spreading the costs of risk events over a large number of policyholders, across borders and across time, insurance reduces the impacts of a given risk event on affected households and businesses. This means that policyholders can confidently take on and manage risks, supporting investment and economic growth. Similarly, through global reinsurance markets countries like New Zealand can reduce the impacts of very costly events through overseas reinsurers taking on part of the risk. The availability of insurance also supports financial stability by protecting against risks to the value of property that is used to secure much of the New Zealand banking system’s lending, such as home and commercial property lending.

This Special Topic focuses on recent developments in the residential dwelling insurance market, particularly the trend towards a greater use of risk-based pricing of insurance contracts and the impacts this may have on future insurance affordability and availability. While our focus is on residential dwelling insurance, the trends and implications we describe here are equally applicable to the multi-unit (apartment) and commercial building insurance markets.

Residential insurance costs have risen significantly in recent decades

The residential insurance market is important for financial stability, given that residential dwellings and land account for around 25% and 36% of New Zealand households’ net worth respectively. Similar to past decades, households continue to have a very high uptake of residential insurance by international standards, at around 96% currently based on surveys conducted by the Insurance Council of New Zealand. High uptake in part reflects the fact that insurance is a requirement for obtaining a home loan.

Premiums for residential dwelling insurance have increased significantly over the past decade, well above the general level of consumer price inflation (figure 2.11).

Contributing factors include:

• Construction costs have outpaced general inflation, increasing the cost of replacing insured dwellings on a like-for-like basis. Insurers use construction industry price benchmarks to recommend adjustments to policyholders’ sums insured in the event of a total loss of a property. Rising construction costs also increase insurers’ claims costs for events where a house is only partly damaged, which impacts premiums. These 2 factors have accounted for significant increases in average premiums in recent years (figure 2.12).

• Global reinsurers have raised their premiums for New Zealand insurers after revising their assessment of New Zealand’s risk profile, particularly in relation to seismic risk. New Zealand is a relatively large consumer of global reinsurance, underlining the need for reinsurers to assess New Zealand's risk profile accurately. Following the Canterbury and Kaikōura earthquakes, the industry updated its assessment of the potential damage that liquefaction can cause to the land underlying buildings, and gained new information on regional seismology and how buildings perform through complex earthquake sequences.

Climate change is also contributing to higher underlying physical risks, including floods, storms and other damaging weather events. Insurance premiums will increase if insured losses from these events also grow. Claims from the 2023 Auckland Anniversary weekend floods and Cyclone Gabrielle have totalled $3.7 billion so far, contributing to New Zealand insurers bearing higher reinsurance premiums over the past year.

Approaches to insurance pricing and product design

The basic business model of an insurance company is to:

• assess a risk and its potential losses
• determine the premium needed to compensate for losses covered by the policy and allow the company to make a profit over time, taking into account any reinsurance arrangements, and
• collect and invest premiums and pay out assessed claims as necessary.

Two contrasting approaches to assessing risk and determining premiums are community-based and risk-based rating.

• Under a community-based approach, an insurer assesses a risk based on broad averages across policyholders and does not apply much or any differentiation in premiums charged, even if an individual policyholder is materially more or less exposed to an insured risk than others. Insurers typically apply a community-based rating where they have limited data or abilities to predict which customers within the population would be more likely than others to suffer losses from a given risk.
• Under a risk-based approach, an insurer will vary premiums charged based on a more individualised assessment of policy-holders’ risk profiles and likelihood of making a claim. For example, risk-based pricing is commonly applied to car insurance. Insurers can use their extensive data on historical claims to statistically assess a policyholder’s risk based on their age, gender, type of car and driving history, and how the car is stored etc. While a risk-based approach may lead to the exclusion of high-risk customers, it can be beneficial for society’s overall risk management because it provides a price signal to encourage the proactive mitigation and reduction of risks.

When designing insurance products, insurers also choose what risks will be bundled together in the same policy. New Zealand’s residential insurance market is currently characterised by the widespread offering of comprehensive ‘all perils’ policies by insurers. Generally, New Zealand house insurance policies cover all major risk events, such as fires, storms and floods, earthquakes and volcanic activity. New Zealand insurers’ all perils policies can be contrasted with those of other markets.

• In Australia, coverage of flood risks in residential policies was historically uncommon. The inclusion of flood cover gradually increased from around 3% of policies in 2006 to around 93% of policies by 2020, following government and industry efforts to improve coverage after large flood events in Eastern Australia in 2010 and 2011. Owners of high-risk properties continue to opt out of flood cover given the very high premiums they would need to pay to obtain it. In the absence of flood cover, owners are reliant on their own savings and potential government assistance, which may not fully compensate for their losses.
• Only around 13% of Californian households opt to add earthquake cover to their standard residential policies. Insurers withdrew earthquake coverage from their standard policies in the 1990s. Informed by the experience of the Northridge earthquake, projections of the potential losses from a major earthquake highlighted that insurers might not have been able to meet their potential claims.

Adopting risk-based pricing

The preconditions for adopting a risk-based approach are that an insurer can accurately identify granular risks and that adoption of a risk-based approach would have a material financial impact for the insurer, given that it is operationally more complex. Risk-based pricing requires an insurer to develop their information systems so that they can integrate a range of information sources. In general, insurance companies will have a tendency towards risk-based pricing over time as their data, systems and understanding of different risks improve.

Competition between insurance companies drives a greater use of risk-based pricing, as companies that are able to differentiate risks and premiums accurately will be able to grow their market share by offering more attractive pricing to lower-risk policyholders, leaving insurers that continue to use community-based pricing holding onto a higher-risk pool of customers. In that situation, the community-based pricing approach would necessitate a continued rise in premiums to compensate for the increased risks the companies carry.

Reinsurance costs also play a part in insurers’ decisions to adopt risk-based pricing. For risks that are relatively small and statistically predictable and where claims tend to be uncorrelated, such as house fires, insurers will generally be able to pay claims out of the premiums they collect over time. However, for very large but infrequent risk events such as a major flood or earthquake, insurers will face many claims from policyholders all at once. Insurers take out reinsurance contracts with large, global reinsurers to ensure that they would still be able to cover all claims following catastrophic events. Insurers with the granular risk data that underlie a risk-based pricing model are best placed to obtain more favourable reinsurance terms and costs than competitors using more community-based approaches. This is because they can demonstrate to reinsurers that they better understand the underlying risks being insured, and because they will be less exposed to high-risk properties.

Risk-based pricing is becoming more prevalent

Improved data, modelling and systems over the past decade have prompted an acceleration of risk-based pricing for seismic risk. This has been felt strongly in some regions, such as Wellington (figure 2.13).

The Earthquake Commission’s EQCover, which covers the first $300,000 (plus GST) of losses to residential properties from earthquakes and some other natural disasters (including flood cover for the land only), is based on a uniform levy throughout the country (community-based rating). Losses for sums insured above the EQCover cap are covered by a policyholder’s insurance company, and consequently insurers can apply risk-based pricing to that portion. A tripling in the EQCover cap between 2019 and 2022 helped to dampen the divergence in premiums between regions, as with a uniform levy EQCover effectively acts as a cross-subsidy from low-risk to high-risk areas and helps to ensure that premiums are more affordable than otherwise for higher-risk homeowners. However, because the EQCover cap only partially covers most properties, the trend towards more risk-based pricing for seismic risk is likely to continue.

Historically, New Zealand insurers have taken a partially community-based approach to flood risks for most residential properties, being limited by insufficient modelling and data to inform a more risk-based approach to pricing. While seismic risks can be modelled and differentiated at regional or local levels, flood risks depend on the characteristics of an individual property and can vary considerably between houses on the same street. For example, flood risk can depend on the topography of a section and the nearby land, and the floor height above the ground. 

Currently, insurers are taking varied approaches to adopting risk-based pricing of flood risks. Several vendors offer datasets and models covering flood risks for New Zealand, which insurers use in their underwriting decisions. However, each has limitations in terms of its accuracy - for example, national models based on elevation maps can provide insights into the general flood risks for a section but may not have granular detail on the specific location and height of the house relative to the flood risk. Hydraulic processes play an important role in determining flood risks but are difficult to model accurately without detailed datasets.  Larger and better-resourced local governments are generally better placed to provide detailed hydrological information not contained in national datasets. In practice, insurers are currently using a combination of data sources to improve their understanding of flood risks.

Residential insurance remains generally available, even in higher risk areas

While a long-term trend towards risk-based pricing poses challenges for insurance availability and affordability for higher risk properties, the evidence to date suggests that insurance continues to be generally available. Full insurance retreat is uncommon so far, even for properties exposed to high seismic and flood risks.

Since 2022 the Treasury has contracted Finity, an actuarial and insurance consulting firm, to provide regular reports on the pricing and online availability of residential insurance. The report includes an analysis of 57 specific suburbs around New Zealand exposed to the risk of flood, with both high and low-risk properties in each suburb selected in the sample. 

Quarterly reports provided by Finity Consulting on the Treasury website

Availability is assessed based on whether an insurer offers online quotes to the majority of properties in the suburb, as this will reflect insurers’ risk management strategies. Insurance may still be available through other methods outside automated online systems. The four underwriters surveyed are AA Insurance, IAG, Vero and Tower, which collectively comprise about 88% of the private residential insurance market. It is possible that properties for which quotes are not automatically generated online can still obtain insurance on a case-by-case basis with a given insurer.

The latest set of results from this reporting indicate that a majority of insurers continue to offer insurance online for properties with both high seismic and flood risks (figure 2.14).

• For suburbs with high seismic risks, on average three quarters of the insurers surveyed make insurance widely available online. However, insurer participation varies geographically, with some insurers having withdrawn online quoting in recent years from some parts of the Wellington, Marlborough and Canterbury regions, for example.

• Around 6% of properties (around 120,000) are assessed being at high flood risk, defined in the analysis as properties where a riverine or surface water flood event is expected to occur more frequently than once every 100 years. For these properties, an average of around 20% of the insurers’ quotes were assessed as including additional flood risk premiums averaging $250 or more annually (‘flood pricing’), relative to properties in the same suburb assessed as not being subject to flood risk. This result varies by suburb, with no insurers applying flood pricing in some suburbs, and many insurers applying flood pricing in others.

• 0.6% of residential properties are subject to both high flood and seismic risks. On average, more than half of the insurers offered policies with no additional flood risk premium in these areas. However, in a small proportion of sampled suburbs availability was lower, meaning that there were fewer participating insurers to choose from. Even without flood risk premiums, owners of these properties may find insurance unaffordable if a high earthquake risk premium is also charged.

Implications of more risk-based pricing and insurance retreat

Insurers’ adoption of greater risk-based pricing is a rational response to a changing operating environment. For many decades, the prevalent approach for New Zealand residential insurers was community-based rating for both earthquake and flood risks.

So far, a lack of granular, property-level data on hazards has been the main constraint to a more widespread and comprehensive adoption of risk-based pricing. Pricing for seismic risks at regional and local levels has become more prevalent over the past decade. Higher premiums for properties with elevated flood risks are being introduced by some insurers as data and modelling improve. As some insurers have moved to risk-based pricing, the pressure has increased on others to do likewise to avoid their insuring a disproportionately large number of higher-risk properties for which community-based premiums are insufficient.

Risk-based pricing acts as a price signal to encourage proactively mitigating and reducing exposure to risks, which can be beneficial for society’s overall risk management. Risk-based pricing also supports the financial stability of insurers and is one way that they can manage their exposure to climate-related risks in the future. It is difficult to pinpoint if and when insurers will completely withdraw the availability of insurance for certain properties and/or areas or risks, although it could occur relatively quickly given that contracts are typically annual. The withdrawal of insurance will depend on the severity and frequency of flood events in a location, improvements over time in the understanding of flood and seismic risks, the competitive dynamics between insurers, and how risks evolve (for example, due to climate change and mitigation actions). Withdrawal would tend to first occur in communities where these physical risks are already well known. Owners of properties where natural hazard risks have already manifest through claims (and particularly repeated claims), such as those properties badly affected by the 2023 Auckland Anniversary weekend floods and Cyclone Gabrielle, are unlikely to be able to obtain comparable cover in the future, unless there has been a substantial mitigation of the now known risks. Even if the complete withdrawal of insurance availability in certain areas is some time away, owners of high-risk properties may find insurance increasingly unaffordable.

Similar to overseas markets, a potential outcome of the trend towards more risk-based pricing is that insurers begin to unbundle different risks, particularly if one type of peril is a dominant driver of the unaffordability of premiums for an all perils policy. For example, unbundling could take the form of removal of flood cover for a flood-prone property in an area with low seismic risk. This may help to maintain insurance accessibility for other risks such as fire and EQC cover (which typically requires a policyholder to have private insurance), but it comes at the expense of leaving property owners uninsured for flood risks. Moreover, with optional cover for some risks such as flood, property owners who need that cover the most may not be able to afford it, as the risk pool for flood risk could shrink as owners not exposed to flood risk choose to opt out of cover. Homeowners may also respond to decreasing insurance affordability by reducing their coverage through higher excesses and reducing their sums insured, although this would leave them more exposed to a total loss event.

Insurance retreat presents a long-term challenge for the financial system. It is important for all stakeholders (insurers, central and local governments, buyers and lenders) to take action now to improve their understanding of natural hazards, so that future insurance affordability challenges can be better managed. Central and local governments have an important role in collecting and sharing natural hazard data, setting policies for land use and coordinating adaptation plans. Improvements in data will help support insurers’ risk modelling, and thereby enhance the price signals sent by premiums for different natural hazards.

Banks need to be conscious of the ongoing insurability of the properties against which they lend, which will require greater scrutiny in their lending decisions than currently. Banks also need to pay close attention to insurance coverage given the increasing risks of underinsurance of high-risk properties over time. Banks need to work with insurers to obtain better and more regular information on mortgaged properties’ insurance status. This was a finding from our Climate Stress Test.