What does the future of insurance look like in a warmer Aoteroa?

We are not yet a quarter of the way through 2023 and Aotearoa has already experienced the two largest weather events in our history. Insurance costs for the Auckland anniversary weekend floods that occurred in late January have already exceeded $1B. This event was followed by Cyclone Gabrielle, which battered large parts of the North Island in February, causing widespread flooding. The total costs of this event are expected to run into the tens of billions of dollars.

These events have highlighted the impact climate change will have on weather-related risks for Aotearoa. As noted in the National Adaptation Plan (NAP), released by the government last year, climate change is expected to result in more frequent and extreme weather events in the future. A warmer climate means the atmosphere can hold more moisture which is predicted to increase total rainfall (total global precipitation is expected to increase by about 3% for every degree Celsius of global average warming) as well as lead to more intense rainfall hence an increasing flood risk.

So how can we better prepare for the floods expected at our doorstep and protect New Zealanders from the devastating impacts? With flood protections tending to fall into two categories – mitigation and mop up – we break down the options and what they mean ahead for the future of insurance and the communities at risk.

To pool or not to pool

In the past flood risk was largely ‘community-rated’ for home insurance in Aotearoa – that is, the cost flooding losses is spread across many homes – as flood risk information was patchy and unreliable at an individual house level. In recent years insurers have been improving their understanding of flood risks. Insurance catastrophe modellers have released a model that estimates the flood risks for all properties in Aotearoa. This enables insurers to charge premiums that more accurately reflect the flood risk for each individual property, known as ‘risk-based’ pricing. To date, most insurers are yet to implement risk-based pricing for flood risks. Given the scale of the two recent events, we can expect an increase in risk-based pricing for flood insurance in Aotearoa.

Internationally, the introduction of risk-based pricing for flood risks has resulted in insurance becoming unaffordable for high-risk properties. In Australia and the UK, the introduction of risk-based pricing has resulted in the governments establishing insurance pools, in tandem with mitigation strategies, to provide affordable insurance.

Would pooling work in New Zealand? The answer is not straightforward. In Aotearoa private insurers cover all hazards, including flood. As a seismically active country, the largest risk insurers face is from earthquakes. The Earthquake Commission, Toka Tū Ake EQC, is an insurance pool established in the 1940s to provide insurance coverage for seismic perils. The EQC also covers some land damage caused by floods, which is not covered by private insurers. Unlike flood risks, seismic risks are much harder to mitigate. As a result the Insurance Council of New Zealand is urging the government to focus on flood resilience measures to support properties and protect lives, as opposed to an insurance pool solution for flood risks

The case for mitigation

Following the recent events, the insurance industry and local government in Aotearoa have been vocal in the need for the central government to invest in flood mitigation. This will improve the ability of communities to withstand flood risks and reduce the cost of damage caused by floods. Regular investing in mitigation means costs are pre-funded prior to events occurring, rather than waiting for events to happen and incurring costs through disaster relief and recovery efforts. In a risk-based pricing insurance environment, investing in mitigation options lowers insurance premiums, as they reflect the underlying risks faced by a property.

Managed retreat and a government buyout

Another area discussed recently is the potential for managed retreat. This means houses in high flood-risk areas are not rebuilt in their existing location but are instead relocated to safer areas. Following the Auckland floods, there have been calls from some property owners for the government to buy them out, due to the flood risk their properties face. This approach was used in Christchurch following the 2011 earthquake, where several residential areas were declared as red zones due to the land damage. Properties in these red zones were bought out by the government. Managed retreat is not without its issues. Potentially some property owners will not want to leave but may to be forced to leave if their land is rezoned. There are also funding issues to consider, as traditional insurance does not cover land values.

Managed retreat means that houses in high flood-risk areas are not rebuilt in their existing location but relocated to safer areas. It’s not without its issues though, as traditional insurance does not cover land values.

Resilience-focused adaptation

The NAP released by the government last year is part of the government’s strategy in response to the expected impacts of climate change. Two of the four priorities of the NAP are to enable better risk-informed decisions and to drive climate-resilient development in the right places. The recent events have highlighted the dangers of building in flood-prone areas. The NAP has various actions that aim to provide improved information to local councils and property owners, as well as reforming the resource management system to encourage development in areas that are less prone to climate hazards.

The catch is that these actions will take several years to be developed. In response to the NAP, IAG NZ called for more specific, urgent and targeted steps to reduce the risk of flooding via a three-step plan:

• A joint government and private-sector project to build common understanding of priority flood-prone communities
• Implementing a National Policy Statement to cease development in flood-prone locations
• Establish a national program of investment in flood.

The last two points are mitigation actions, designed to reduce costs prior to a severe flood event occurring. This benefits communities and insurers whilst aligning with the key priorities of the government, as outlined in the NAP.

The right path – finding balance amid complexity and uncertainty

Due to the management and costs of flood risks being shared across multiple stakeholders, there is no clear single solution when considering how best to manage the flood risks for Aotearoa.

The management of flood risks in Aotearoa primarily rests with local governments. Although, with the introduction of the Three Waters reform program, due to be implemented from 1 July 2024, the management of stormwater will be more centralised. When flood events occur, the costs of these events are covered by a combination of insurance companies, property owners, local and central governments.

High premiums provide a signal for investment

Insurers have traditionally provided financial support to their customers following an event, with no influence on how flood risks are managed, through either mitigation actions or the location of development of new properties. As insurers increase the sophistication of their premium setting for flood risks, properties that are most at risk of flood damage could see a significant increase in their premiums. In extreme cases this can result in the premiums becoming unaffordable. This risk signalling can highlight the areas where government investment in flood mitigation can have the largest impact. For example in the town of Roma in Queensland, insurance premiums increased significantly due to flood risk. Following the build of a levee, a major insurer cut property insurance premiums in Roma by 45% on average, returning these to more affordable levels.

Risk-based pricing, relocation and buybacks

An alternative approach to mitigation for extreme flood risks is aiding property owners to relocate to lower risk areas. Following the 2022 floods, for example, the Queensland government established a $741M Resilient Homes Fund, which includes a voluntary home buy-back program for homes that are at risk of severe and frequent flooding. As with mitigation, risk-based insurance pricing can be a driver to highlight the areas where such an approach may be needed.

Pools as part of the solution

Mitigation or managed retreat may not be possible for all properties that are at risk of flooding. If increasing insurance pricing sophistication results in insurance becoming unaffordable for certain properties, this can result in property values reducing as property owners will be unable to secure a mortgage. This is turn results in political pressure on government to either intervene in the insurance market, or to provide a protection pool for high-risk properties. Examples of such schemes include Flood Re in the UK and the cyclone reinsurance pool, which was established last year in Australia. Both of these schemes have been established with the aim of keeping insurance affordable.

Insurance pools can be fraught with problems and should generally be used as a tool of last resort. Establishing a pool with no additional consideration of mitigation options does not change the underlying risks that properties face, it just changes how these risks are funded. This dampens the risk signals that private insurance provides to property owners about the risks their properties face and may result in continued poor risk management practices, such as building houses in flood-prone areas.

Establishing pools with no additional consideration of mitigation options does not change the underlying risks that properties face, it just changes how these risks are funded.

Insurance pools can fund more than just insurance costs, as shown by the EQC, which funds research into natural disasters and ways of reducing their impact. Pools can also be used to provide cover for uninsurable risks, such as the terrorism reinsurance pool in Australia.

EQC levies for earthquake risk already make up a significant portion of insurance premiums in low-risk seismic areas such as Auckland. If flood risks were also included in an insurance pool, either through an expansion of the EQC or the creation of a new pool, this would further increase the size of levies relative to insurance premiums. While this reduces some of the claims risks insurers face, it also potentially reduces their profitability, which may result in some insurers exiting the domestic property market, which impacts the community.

Last word for decision-makers – a conversation for all

Managing flood risk is a matter of balance between risk mitigation and how to fund the costs once events have occurred. The uncertain nature of flood risks, combined with the expected increasing underlying risk due to climate change, highlight the need to continually invest in mitigation measures. Like all resources, the funds available for mitigation are finite, so thought needs to be spent on how these resources are best used. Insurers and their core function of assessing risk can assist the public sector in identifying how to get the greatest impact from mitigation costs. Bringing all stakeholders together to identify the most effective response will result in safer and more resilient communities that can adapt to the changing natural environment.