A risky business — so is it time to rethink insurance?

Damage in the Christchurch CBD following the 2011 quake. PHOTO: SIMON BAKER
Damage in the Christchurch CBD following the 2011 quake. PHOTO: SIMON BAKER
Risk is a central pillar of the insurance business, Alan Race writes.

I read with interest the ODT article (1.5.24) citing the Reserve Bank of New Zealand’s recent report on insurance premiums.

The report noted that insurance premiums rose significantly more than the general rate of inflation over the past decade, with the increase reflecting higher rebuild and reinsurance costs.

However, what has not been reported is that ongoing claims costs determine future premiums, not inflation. As insurers’ financial reserves are required to meet expected losses, premiums need to be set to ensure sufficient funds are held to pay out. After all, if an insurer continually pays more than they earn, they will inevitably fail.

Reinsurance supports an insurer’s financial ability to meet catastrophe losses, but the cost of this is determined by the overall financial performance of the insurer and the global scene.

As with all businesses, inflation will impact an insurance company’s operating costs, but by far the largest impact will be the number and value of losses sustained, and substantial losses are occurring with greater frequency.

The report went on to state that insurers were moving towards a greater use of risk-based pricing, which recognises the degree of risk a property faces. What amazes me is that an industry which derives its business from measuring risk, should ever use a basis to calculate premiums by any other method.

Risk-based pricing is not new, and was the only method used when I joined the general insurance industry in the mid-1960s. At that time, property premiums were calculated by determining the construction, location, and occupational use of a building.

Earthquake risks were insured for a building’s actual value through the Earthquake and War Damage Commission but based on a levy set by statute, not by the degree of risk. Property owners could then obtain earthquake cover for the balance to full replacement from their insurer, the premium for which was a risk-based charge reflecting various local factors.

The reality of the inadequacy of the commission’s funding capability for commercial buildings was recognised in the early 1990s when the commission was restructured as the EQC, and commercial risks were gradually phased out.

Insurers then took over the entire earthquake risk themselves, but simply continued with a charge based on the previous levy. No risk-based pricing was used at that time. So, in effect, insurance pricing for commercial properties became market driven, rather than based on the degree of risk they represented.

Under the EQC, cover for dwellings changed to replacement value and was regulated to an initial limit of $100,000. Insurers picked up the top-up balance to the full replacement value under their policy, but not only was risk-based pricing not used, but also — stupidly — insurers included the extra cover at no cost at all to their customers.

Over the 40-year period from 1980, insurers have consistently added more perils and benefits covered under their domestic policies and have done so without increasing their charges. Little wonder then, that they are now at a point where risk-based prices are once again being used.

It is a bitter pill to swallow, but in my view insurance premiums have not reflected the real risks for several decades, and we are now all facing a dose of reality ourselves. The challenge to insurers is now to create a solution to make policies more affordable.

Perhaps a "build your own" cover where you choose which perils you want, and in turn which risks you can accept yourself.

Few of us like paying for insurance, but to not do so could be financially catastrophic.

— Alan Race is a retired insurance director.