03 Feb 2011

Floods and insurance - Q&A with Fred Hawke, head of Insurance at Clayton Utz

by Fred Hawke

What are the most important insurance lessons likely to be learned from these floods, in your opinion?

There will be lessons delivered, and hopefully learned, on several levels.

Problems concerning the availability of flood insurance for properties located on a flood plain, whether it should be individually underwritten or community rated, how to generate a large enough premium pool to cover the risks without some form of Government-sponsored scheme, and the competition and moral hazard issues which that would generate, are public policy rather than legal problems and can only be addressed at a whole of community level, with an honest commitment from all interested parties.

Insurance has been simplistically described as a mechanism whereby the premiums of the many pay for the claims of the few. Quite so, but what happens if the claims are many, or large, and the premiums are few, as in the situation where only a relatively small portion of the population, who are disproportionately likely to have to claim on the insurance, take it out? This is what Underwriters refer to as "negative selection" and the thought of it keeps them awake at night. Either such insurance becomes prohibitively expensive or the Underwriter offering it goes broke and it is not always clear which will happen first.

My own view, for what it is worth, is that for standardised flood cover to be generally available through the private insurance industry in Australia, some form of mechanism similar to the Terrorism Insurance Act and the Australian Reinsurance Pool Corporation is going to be necessary. Perhaps that Act could be extended so that it strikes down flood exclusions in Domestic Property policies, with the Insurers able to buy reinsurance against that risk from the ARPC if necessary. These are matters, however, of policy rather than law and a calm and careful investigation of all options and their potential consequences needs to take place, before any decisions are taken.

At the legal level, there are likely to be different lessons according to whether the flood-affected property was domestic/residential or commercial/industrial. The policies are very different and different sorts of legal and factual disputes are likely to arise.

What is the main difference between the issues affecting home owners' insurance flood claims and those relevant to businesses, factories and mines?

In the context of household building and contents insurance policies, issues are likely to focus on how clearly and obviously the Policy and its Product Disclosure Statement make plain that the insurance does not cover flood, what the Insurer means by flood and whether this was properly explained to the consumer at the time they bought the Policy.

In the case of commercial and industrial property, the debate is more likely to be around matters such as whether all of the water which caused the damage was, in fact, flood water as the Policy defines it, whether there was actual physical damage to the Insured's property or the property of one of their suppliers or customers, how many excesses should apply, how policy entitlements are calculated and the like.

Can you explain more about the issues affecting consumer insurance and flood claims?

Home Buildings and Contents policies are one of the classes of insurance regulated under section 35 of the Insurance Contracts Act, the regulations to which prescribe minimum terms of cover. The minimum statutory requirements for both home buildings and home contents policies include flood cover. Insurers are free to "derogate" from the prescribed minimum terms by offering cover which is less favourable, for example by excluding flood, but only if they clearly draw the customer's attention to that fact before the Policy is taken out.

They can do that by showing the Insured a copy of the Policy, or a PDS which "clearly, concisely and effectively" summarises the relevant terms, but only if the documents are plain and unambiguous in this regard and are drawn to the customer's attention, before he or she buys the Policy. If deviation from minimum cover is done by giving the customer a copy of the policy wording or PDS, then it has to include also giving them enough time to read and understand it before committing to the Contract, or a cooling off period afterward during which they could change their mind when they realised that the Policy did not cover flood damage, and shop elsewhere for one which did.

Insurers' documents and sale processes differ and there may well be cases where the flood exclusion has been worded in a way which is confusing or ambiguous, where it is hidden in a long document which the consumer could not be expected to read and understand before making the decision to buy, where the shorter summary on which they rely does not properly explain it, or even where the customer was not shown any relevant document before committing to the Policy (although such latter instances would be rare in Australia). Also, merely giving the Insured a copy of the policy wording or PDS before the insurance is purchased will not necessarily always be sufficient, of itself, to absolve the Insurer from the obligation to provide the statutory minimum cover. What matters is whether, in all the circumstances, the "derogation" from minimum terms was properly drawn to the customer's attention.

The courts have dealt with disputes over that issue in the past and are likely to do so again, in the context of these floods. The Financial Ombudsman Service, which adjudicates insurance claim disputes at no expense to the consumer, will also have to deal with the issue. If it is found that an Insurer has not properly drawn its flood exclusion to the Insured's attention and explained its effect before the Insured was committed to the Policy, then the law is simple. The Insurer is providing flood cover in accordance with the regulations under section 35 of the Act regardless of what its policy says. Since the Regulations themselves do not define flood, it will mean what the ordinary member of the community would understand it to mean and the Insurer will have to pay a claim.

That is why it is important that policyholders themselves look at what their policies say and think hard about the circumstances under which they took out or renewed the insurance, any other information that was provided to them including what was on the Insurer's website at the time, before deciding whether or not to lodge a claim. They should not be put off merely by denials from call centre staff or general statements from the Insurer that "we don't cover flood".

But what if the Insurer has, in fact, plainly and obviously excluded flood damage from its Policy and clearly and concisely explained this to the customer, before they bought the Policy?

Well in that case the minimum cover regulations will not apply and the Insurer will be legally entitled to refuse a claim for damage caused by flood, as defined in its Policy. It is hard to see why that should be considered "harsh" or "unfair", given that the consumer knew what they were buying, that it did not cover flood and they had the opportunity to buy insurance elsewhere which did, although perhaps at a higher price. They may or may not have realised that they might need flood cover living where they did, however, other parties besides the Insurer, such as developers, local government and planning authorities, may have questions to answer in that regard.

Should Insurers nevertheless pay all flood claims, regardless of their policy wordings, as a gesture to the afflicted communities?

That is a moral rather than a legal question and not easily answered. On the one hand, it is hard to see why an Insurer which has complied properly in all respects with the law regarding derogation from minimum cover, made the terms of its contract explicitly and unambiguously clear to the purchaser and sold them a Policy which does not cover flood damage, presumably for a lower premium than one which did, should be called upon to pay such claims effectively out of its shareholders' pockets, especially when you consider that they will not be able to collect on their own reinsurance policies in respect of such payments. I don't think that the community or its elected representatives have a right to demand charity of Insurers in such a situation, or to vilify them if it is not forthcoming.

On the other hand, any business enterprise is free to make a gesture to the community in which it operates and there may be cogent business reasons for doing so. There is a precedent for this in the context of insurance. The story goes that after the great San Francisco earthquake and fire of 1906, the legendary Lloyds Underwriter CE Heath, whose name is to insurance what Rothschild's is to banking, instructed his local claims agent to "pay all claim, regardless of wording". Apparently, Lloyds was struggling to achieve much penetration into the isolationist American insurance market at the time and the gesture was seen as a good investment.

One also assumes that before making it, Mr Heath had a pretty good idea of how many affected policies he had and the total amount it was likely to cost. Most Australian Insurers affected by the floods would still be working that out and it is probably unreasonable at this stage to expect them to promise any more than to look at hardship claims on a case by case basis. There look like being an awful lot of hardship cases.

Lawyers and other professionals regularly donate their time and resources on a pro bono basis and these floods will provide ample scope for that, just as the bushfires did in Victoria. That is partly a matter of simple good will but it is also an investment in reinforcing the rule of law, from which everyone derives protection but of which lawyers are the guardians and from which we also derive our livelihood.

You mentioned other issues affecting flood claims under Business and Industrial insurance policies. What do you think might be the main ones?

These policies are not subject to standard cover regulations and disclosure and understanding of their terms is generally not such an issue as with consumer insurances, since they are usually negotiated between experienced insurance brokers and risk managers. Although the majority of business insureds will probably have Property Damage and Business Interruption insurance using the National Insurance Brokers Association's Mark IV or V Industrial Special Risks wording as a template, there are a myriad variations of individually negotiated coverage terms that can be written on those wordings. Moreover, Insureds in some industries may have policies providing the same sort of cover, but issued by overseas-based insurers using wordings radically different from the common Australian market ones. These factors alone are likely to generate some uncertainty around claim entitlements.

Although the standard NIBA wordings exclude flood, the exclusion distinguishes between water which escapes from a natural water course and other forms of inundation, for example, storm water drains backing up. It can require complex technical evidence to determine where the water which actually caused the loss came from and there was a leading case on this very point in Queensland a few years ago.

It is not uncommon for the flood exclusion to be deleted from or modified in Industrial Special Risk policies so that flood, or certain forms of it, is covered. Miners, for example, generally require flood cover under their Property Damage and Business Interruption insurance, for obvious reasons, but it will not always be as extensive or effective as they may have assumed. All Industrial Special Risks-type insurance requires that insured damage to property have occurred in order for the Business Interruption loss to be covered, however, there are usually extensions providing that if damage occurs to the property of a supplier of services (such as utilities) to the Insured, or even in some cases of a customer of the Insured, and that damage would have been covered had it happened to the Insured's property, then the Business Interruption loss which the Insured sustains as a result of its supplier or customer being out of commission can be claimed. Not all Insurers, however, give these extensions in respect of flood damage.

It is a basic principle of ISR Insurance that there must have been covered material damage, to property of the Insured or of some person on whom the Insured's business directly depends, for a Business Interruption loss to be covered. There is unlikely to be cover for a loss of turnover or sales, however substantial, which occurs merely because the Insured, their employees and/or customers are denied access to their business premises or because state wide infrastructure has been shut down or compromised. Nor are so-called "de-population losses" representing the long term impact on a business of people simply leaving the area, likely to be covered.

You have talked a lot about what is not covered. Are there any entitlements which people can pursue of which they may be unaware?

Some business Insureds with flood exclusions in their policies may nevertheless have cover for a large part of their losses, without realising it. The flood exclusion only applies to damage directly caused by the flood itself. If a flood causes the occurrence of another peril which is covered under the Policy and that insured peril actually damages the business before the flood does, the damage and resulting business interruption is insured. An example might be where flood waters, on their way to the Insured's premises, take out the local electrical sub-station. Loss of power to the plant results in an uncontrolled shut down and extensive physical damage, before the flood waters even get there. That damage and the resultant business losses are covered, notwithstanding that the flood may have caused similar damage when it arrived.

Also, of course, it will be an important question of fact, in some cases, whether the water which actually did the damage did, in fact, come from a source, eg. overflowing of a natural watercourse, which brings it within most flood exclusions. Since flood cover is deleted by means of an exclusion, when it would otherwise fall within the cover under most policies, the Insurer bears the burden of proving that the exclusion applies. In other words, it is their job to prove where the water came from, before they can reject a claim. In many cases, of course, this will be obvious and indisputable, however, there will also be some cases where experienced technical evidence will be needed to determine whether the exclusion applies. It is up to the Insurer to provide it, not the Insured, although Insured are free to produce their own evidence if they wish.

What are the major areas of dispute that are likely to arise over calculation of losses and claim entitlements, where there is coverage?

An interesting issue sometimes arises in the context of business losses by professional firms, who charge for their services by the hour on an ongoing basis, involving the distinction between cash flow and revenue. The question, in a nutshell, is whether sales or turnover have been lost or merely deferred, and under Business Interruption accounting principles the Insurer is entitled to take into account various contingencies affecting the business in order to determine the actual loss.

With this many Property Damage and Business Interruption losses, there are bound also to be issues arising over the adequacy of declared limits and amounts of cover purchased, which will bring into play so-called "average" or "co-insurance" clauses, whereby the Insured which has underinsured its risk has to share proportionately in the loss, even where it is not a total loss. Some ISR policies also have "premium adjustment" clauses in them and the combined effect of these and the average clauses is that the Insured who has under declared not only may not get paid the full amount of an inadequate limit, but may be hit with a claim from the Insurer for additional premium into the bargain. That is a pretty sure recipe for an insurance dispute.

Finally, because of the sheer scale and cumulative affect of these floods, there are likely to be issues around the number of excesses which policyholders should bear. Most, but not all, ISR and Fire and Perils policies contain a "72 hour clause", providing that all the damage which occurs during that period is treated as one claim and attracts only one excess. Even where there is such a clause in the Policy, there are often arguments over precisely when the period starts and finishes. Where it is absent. it can be very difficult in the context of successive waves of flooding to determine how many events, occurrences, accidents or what have you have taken place and how many excesses should apply. For Insureds carrying high deductibles, this can make a substantial difference to the amount of their claim.

Is there any basic tip which you would give to flood-affected policyholders, consumers or business people?

Read your policy and related documents closely and if you have any doubts or concerns at all regarding your entitlement or the way you have been treated, talk to your friendly neighbourhood insurance lawyer before you accept either a settlement or a knockback.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.