Flooding at Selwyn Huts, Canterbury. Photo: Chris Skelton/pool

The Treasury is considering whether a public re-insurance scheme should protect homes from climate flooding, with the Government to agree next steps by the end of the year. That may encourage homeowners to keep building in risky places, warns associate professor Chris Nicoll.

Opinion: Now that climate change flooding is becoming more frequent and destructive, both the government and the insurance market need to address “moral hazard”, a concept well known to economists but set to be more widely understood by the public.

Moral hazard is where an ‘at risk’ actor fails to reduce a risk to an optimal level because that person is likely to receive assistance or compensation.

In the case of climate change disaster, that assistance or compensation could be (a) for nothing or at a bargain price from national or local government or (b), at an actuarial price, from insurance. An example of the former is a mayoral fund set up in Sydney for the uninsured after the 1999 hailstorm. In many cases the beneficiaries received more than their insured counterparts.

Insurers currently have limited ways of addressing this well-documented human behaviour. One common way is to require an “excess”, the amount of money an insured person contributes to a claim. An excess is enforced in most policies because it avoids the administrative cost of processing many very small claims but, as far as moral hazard is concerned, it is also used to make the insured its own insurer for the lowest slice of the risk represented by the excess.

Risk reducing measures by insurers can be positive or negative: a carrot or a stick. A no claims bonus is a carrot. Increasing premiums for presenting an above average ‘risky’ situation is the stick.

Aotearoa, at present, leaves climate change flooding to the local insurance market. EQC does not cover flooding, or any other category of risk caused by climate change apart from landslips and, arguably, flood damage to land. It deals in risks presented by largely unpredictable natural hazards (such as an earthquake) whereas climate change is with us, flooding is only going to get worse and is, to a much greater extent, predictable.

According to Statistics NZ general social survey figures published last week, 21% of people live in a household that meets the basic emergency preparations requirements. 13% aren’t prepared at all for a natural disaster such as an earthquake, flood, or tsunami, says wellbeing and housing statistics manager Sarah Drake.

Were the state to legislate for a state-controlled insurance pool such as EQC to cover homeowners against climate change flooding (and this is a possibility given the “solidarity” principle behind the precedent of EQC) it would have to address moral hazard. EQC currently bears this burden. For one reason, its levy does not reflect the real price of the risk; brushing it with the government-run moral hazard category described above.

However, an insurance pool that does cover climate change flooding and, possibly, other climate change induced losses, would be burdened by both moral hazard categories if, as one assumes is likely from the precedent of EQC, it fails to charge an actuarial levy. I believe such an insurance pool should charge an actuarial levy, because the homeowner has more options to reduce flooding risk than they do for less predictable risks such as earthquake or volcano.

It is not known at this stage whether a climate change pool is on the cards or whether any such state-controlled entity would work in partnership with the market. But, if it were to happen, moral hazard would need to be minimised by all risk-assuming players. In other words, given that we know we’re living with climate change, we might be obliged to take more responsibility for mitigating our risk.

The first step would be to prohibit further building or rebuilding in areas where no amount of risk mitigation or resilience measures are going to stop flooding damage within the natural life of the building. These decisions could be revisited if future technology or more accurate weather predictions offer a reprieve.

In other cases, the insurance market and any future state-funded pool would need to devise new incentives and disincentives to counter moral hazard, but few state pools overseas have the authority or the will. The power of the market is limited to what it can achieve by private contract and pulling the lever to account for moral hazard may put an innovator at a competitive disadvantage.

Nevertheless, there are some ‘low hanging fruit’ for the insurance market. At the very least, an insured building that has been flooded must be reinstated under the insurance policy to be more resilient to future floods. Most policies currently give the choice of reinstatement or lump sum payment to the insurer, but its contractual reinstatement obligations are only, commonly, to restore the building to its state ‘as new’ or ‘when new’.

The insurer often chooses, under the terms of the policy, to take responsibility for a rebuild itself. This usually appeals to the insured, as it avoids the need to navigate builders and other trades. But the insurer’s contractual obligation is only to rebuild to a former state without mitigation measures.

If the insured wants to rebuild, for example, to a higher floor level to mitigate against future floods, they must do so at their own expense. Moreover, anecdotal evidence suggests the insurer is not likely to enthusiastic about incorporating mitigation measures into the rebuild plan as this complicates its contractual obligations.

We are beginning to recognise the devastating impact of climate change, and both insurers and the insured need to adopt an attitude of partnership in favour of building back better. This calls for amended insurance policies, setting out clear procedures to facilitate the process and, on the insureds’ part, greater awareness of their options and that such adaptations are their responsibility. It is in everyone’s interest that our insurance relationships better reflect adapting to climate change.

There are obvious resilience measures to reduce the severity of damage should a flood occur and not always at huge cost: raising the level of power points, fixing interior wallboard horizontally rather than vertically, installing vulnerable electrical equipment such as freezers and heat pump equipment at a higher level, to name a few examples.

Again, insurance market incentives would help. A policy may require these things to be done as a pre-condition to continuation of cover, with the ‘carrot’ of a reduced premium in the meantime and the ‘stick’ of cancellation if the work is not done on schedule. Insurers could provide premium holidays or other positive incentives for homeowners to build for resilience on both rebuilds and, as yet undamaged, properties.

It seems prudent for both insurers and any future government pool to share the latest ideas and technology about the best and most efficient ways to reduce risk, of both flooding, and of moral hazard. This knowledge should inform every insurance proposal.

Establishing a shared database, including the latest technology on resilience must be a priority, as is more public education about the need for insurance and its limitations. Education and research are stated goals of EQC in the Natural Hazards Bill and any future state-sponsored climate change insurance pool should have the same statutory goals, supported by proper funding.

Chris Nicoll, Department of Commercial Law, Faculty of Business and Economics, University of Auckland, is co-author of 'Colinvaux' Law of Insurance in NZ'.

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