Royal commission: Insurance price signals fail

  • By Keith Rovers, MinterEllison partner

The royal commission has now rolled through a number of financial industry segments and next up is rural markets and insurance. 

This reminds me of the regulator’s approach where they name and shame one institution per industry sector as a cheap means of regulatory enforcement. 

You can’t bring action against every instance of wrong doing in every institution, so you find an egregious example and that entity cops the brunt and all the others fall into line to avoid the humiliation.

Work across the institutions and the segments to tackle the whole industry.

With the royal commission, it's one better - you ask all the market participants to fess up in advance and pick the worst examples of poor behaviour and use that lowest common denominator to shame the industry and make the case for reform recommendations. 

So to general insurance. Catastrophes are always dramatic and we've had a few in the past decade - from floods, to fires, hailstorms and cyclones, so there is human drama behind flood and other legal definitions and the inadequacy of claims handling processes.

Show trial

There will inevitably be the show trial element, so the insurers may be dragged out and the warts of the claims process examined. 

The idea of systemic failure - as noted in the Enright report released by the royal commission notes -  is an interesting one and may go to cover for catastrophic events.

But what can you do? Improve systems for claims handling and prompt remediation?

The mis-pricing of risk and policy term confusion (or obfuscation) will become apparent.

Clarity of policy language is critically important, as is the ability of consumers to be able to understand and compare the market.

This goes to proper and transparent pricing and the critical importance of price signals in risk and capital allocation.

As the Enright report notes by way of example, the definition of 'flood' has been clarified following the 2011 floods to standardise policy wording to facilitate comparability of coverage and pricing.

Moral hazard

It is important that people can compare apples …and that the price signal works transparently to encourage mitigation and adaptation – and avoid the moral hazard.

Look at some of the US statutory schemes which promote re-building of the same coastal properties without regard to the risk.

The real systemic issue is the interaction between the real world, the insurance market and government policies in relation to land use planning and built environment – coupled with changing climate risk profiles which impacts those factors to intensify risk and magnify losses.

At its simplest, insurance is about the sharing of the risk of loss, with the pricing of insuring risk creating a pool of funds sufficient to meet claims on an ongoing basis, but the reality is always more complex.

Insurance therefore has a behavioural aspect through the understanding and pricing of risk.

The pricing signal (premiums, exclusions and limits) is the mechanism that impacts capital allocation – by governments, the finance sector down to the individual level.

Faulty price signals

These pricing signals need to be coupled with government policy around building and development codes and proper land use strategies to build assets which are as resilient as possible to climate events and physical loss – today’s design is tomorrow’s physical risk.

This is the ‘systemic failure’ – where the pricing signals highlights risks that are not adjusted for through changes in land use policy and better improved building codes.

We have more data and spatial tools and super-computing capacity to build sophisticated climate models and this information is allowing insurers to better price risk or work out the limits of risk – albeit this issue raises its own societal issue.

What happens when insurers won’t underwrite a risk or the insurance cost becomes prohibitive?

 How is that disruption managed? Does government step in to pool risk and provide cover which is what happened with terrorism cover.? Such schemes can also introduce moral hazard.

Insurers are at the coal face. Innovation in big data, modelling and pricing raises the possibility of the insurance industry introducing innovative pricing strategies that induce private real estate owners and local governments to take efforts that together yield a more resilient real estate capital stock.

Accordingly, the insurance market adaptations are leading indicators of required societal adaptation. This is also mirrored in other strategies used by insurers to signal required systemic changes. 

When insurers bail

The use of litigation as a ‘strategic signal’ to government and other infrastructure owners that they cannot sit back and assume insurance will pick up the tab for climate-related damage is another example.

Think “Big Oil" strategy which has taken a leaf straight out of the tobacco litigation playbook. 

Big oil and carbon may not be directly related to identified catastrophic events, for instance, and causation and remoteness preclude direct claims – the issue is more that the local councils - or their insurers - are seeking damages for adaptation from gradual onset impacts, rather than a particular extreme weather event. 

Instead of relying on physical loss where causation is remote, they are relying on failure to disclose as the basis to sheet home liability – arguing that those companies have known for many years the dangers posed by climate change and failed to disclose the scenario testing and other data which demonstrates this.

In the end it may be insurers suing other insurers so who knows where the loss ultimately falls, but an important signal is sent.

So back to the royal commission - it will be most interesting to see its ultimate recommendations and how they’re picked up and implemented. 

What does success look like in this sense and what measures do we use to test the outcomes? 

It comes back to the ultimate role of finance and insurance in our system and its utility – these systems are meant to serve, not rule us.