EQC and flood risk

As we're still awaiting the Treasury review of the EQC legislation, which will be followed by proposed legislation, now seems the time to be thinking about premiums, risk adjustment, and flood damage.

As reminder, EQC provides cover for natural disasters like flooding or earthquakes. EQC coverage is compulsory when you're taking out home insurance; it's a levy attached to your insurance policy providing natural disaster coverage.

EQC coverage, as it stands now, has a few issues apart from the one about which I bang on continually here. The main one for present purposes: failure to risk-adjust premiums.

In a perfect world, we'd have perfect risk adjustment of EQC premiums, in the way I'd set out here a couple months ago:

Wouldn't it make more sense simply to have EQC set risk adjusted insurance premiums? Zoning changes mandating higher floor levels only really apply on new builds or, potentially, on substantial-enough building redevelopments. While new buildings will then get the higher floor levels, some older ones will have replacement or refurbishment delayed because the relative cost of a new building's gone up. If EQC set actuarially fair rates for their disaster insurance, the distortion would be gone. We'd also then avoid all of the fights and rent-seeking that will result when Council starts deciding where people will be allowed to build in future due to flood risk, arguments about how seriously we should take the upper-limit projections on sea level changes, and the like. Let the insurers set the premiums, then let individuals sort out whether they like current beachside property. And let EQC's premiums basically reflect the incremental effects of insuring different types of properties on EQC's reinsurance costs. If Swiss Re won't provide reinsurance for my house except at additional charge, I should be paying the costs of that. Where EQC's trying to minimise its reinsurance costs and where the international reinsurance markets are at least somewhat competitive, this knocks the political fights around global warming out of the mix.

Tim Harford comments usefully on distortions caused when government subsidises living on flood plains. EQC premiums are scaled by value at risk, but not by the likelihood of adverse events. The country varies in seismic and flood risk; buildings vary in robustness to those risks. But nobody pays more than $150 per year for their EQC cover. While you might think the distortion can't be that big as EQC only covers the first $100,000 in damage to your house, with insurers charging actuarially fair premiums taking on the bigger part, EQC also covers land remediation.

Now suppose we add in that the Government could be worried that actuarially fair rates might have some folks abandon taking out insurance altogether. For some now very low-lying parts of Christchurch, subject to regular flooding, it's not inconceivable that risk-adjusted premiums would be sufficiently high that everybody in the neighbourhood drops their insurance coverage* and hopes for a bailout should a flood happen. Then the government's got all of the payout risk but none of the premium revenues.

Now that could be an argument for setting some upper bound on the potential risk-adjustment, and especially for lower-value homes in lower-income neighbourhoods, but it isn't really an argument for having no risk adjustment. And, as I understand things, EQC premiums scale only with the value insured, not with the risk.

EQCover costs 15 cents (+ GST) for every $100 of home or contents fire insurance that you have. You pay this amount to your private insurance company, who pass it on to EQC.
The most you can pay, per year, for one home and its contents is $180 (+ GST). This would give you the maximum cover of $100,000 (+ GST) for your home, $20,000 (+ GST) for contents, and cover for your insured residential land. This amount of insurance is available for each event of natural disaster damage.

This has a couple of effects:

• Because the maximum EQC payout is capped at $100,000, the maximum premium is capped at $180. But consider two houses. The first is worth $100,000; the second is worth $1,000,000. Both purchase insurance and both pay the maximum levy to EQC. An earthquake or flood hits both of them; repair costs are proportionate to the value of the house. Say it costs half the value of the house to fix it. So the first one gets $50k in repairs; the second gets $100k, with the rest paid for by the private insurer. The insurance scheme is then somewhat regressive: where we expect greater repair or replacement costs for more expensive homes for any given-sized event, and where the premiums cap out in the way they do, more expensive homes effectively get more coverage for a premium of a given size.
• Because there is zero risk adjustment other than the bit that comes through the value of the house, people who live in safe areas provide a large subsidy to those who live in dangerous areas. And then all of the distortions Harford pointed out apply.

Why not start risk-adjusting the EQC premiums? Even just putting a small surcharge on spots known to be flood-prone would be a start.

* If their mortgages are paid off: the banks kinda make you have insurance if you have a mortgage.