Home Warranty Insurance Briefing Note

Home Warranty Insurance Briefing Note November 2015

Contents Introduction What is Home Warranty Insurance? Inequities of the Current System - Financial and the long tail liability - Risk management of the home warranty - Cost to administer - Recovery of claims expenditure Builder Issues - Access - Restraining growth - Customer issues Framework for Change - Who are we insuring - How are we insuring - What are we insuring Appendix 1 - History of Home Warranty Insurance in NSW Appendix 2 - Home Warranty in Australia

Introduction The aim of this Briefing Note is to raise awareness of the main issues facing the NSW home warranty scheme and commence discussion on a potential new framework. The New South Wales residential building market is currently worth approximately $8.7 billion to the NSW economy. It is a significant pillar of the State economy which makes it critical that all stake holders have confidence in industry infrastructure and regulation. Home Warranty Insurance is designed as a safety net for consumers to provide them with confidence that in the event of their project de-railing the warranty policy would provide them with support to complete or repair their home. The NSW home warranty scheme, in its current form with the Home Building Compensation Fund (HBCF), has existed since the exit of the private insurance industry in 2010. The scheme attracts criticism from its three principal stakeholders, builders, consumers and the Government as underwriter. Master Builder Association of NSW (MBA) see this time as an opportunity to form a new model for home warranty and present options to the NSW Government. The primary aim of the new model is to provide NSW a balanced, transparent, sustainable product that supports industry and drives consumer confidence. What is Home Warranty Insurance? Warranty premiums are paid in one instalment at commencement of cover. In insurance lingo this is called long tail insurance. In NSW a home warranty insurance policy has a 6 year life for one premium payment and claims can take several months or even years after the expiry of the policy before they are reported. In the majority of cases the cost of the insurance is passed onto the consumer through the preliminary costs in a builder s contract. The triggers for a home warranty policy in NSW include the death of the builder, the builder disappearing or being insolvent. Since 19 May 2009, a fourth trigger was added where the builder s license is suspended for failure to comply with an order of a Court or the NSW Civil and Administrative Tribunal. In NSW a feature of the policy is non-structural defects carry a two year reporting period. Also, in NSW the maximum sum insured is $340,000. See Appendix 1 for a brief history of Home Warranty Insurance in NSW. See Appendix 2 for a comparison table of home warranty policies that apply in respective Australian states. 1 Page

Inequities of the Current System In NSW the three principal stakeholders have valid concerns related to the cost of the product, the ease of access to the product and the cover provided by the product. The principal stakeholders include; Government as the Underwriter Builder and Contractors Consumers Government/Underwriters Issues 1. Financial and the long tail liability In general terms the greatest claims risk in the first two years of a policy is project non-completion. After year three of the policy life defects claims start to appear. The more complex and costly structural defects take at least six years before there is a claim. As stated previously one premium instalment is paid at the start of the policy and this must compensate for claims over at least 6 years. In the 2013/2014 financial year the NSW home warranty scheme collected $54.3 million in premium (excluding charges) for projects commenced in that year. A conservative estimate of the cost of claims paid for the same projects in 2013/14 is $12.25 million. The claims experience of the NSW home warranty system is the first year s claims expense is typical of the 6 years of the insurance tail. Therefore at the end of 6 years (years 2020/2021) the payout on policies written in 2013/2014 would be in excess of $73.5 million against total premiums collected of $54.36 million. An additional factor that compounds the adverse financial outcomes is the reporting period allowed under the scheme may extend the tail to around eight years and the extended period has been supported by court decisions. 2. Risk management for home warranty. Management of risk is part of an underwriter s toolkit for managing the performance of a product. Home warranty risk management comes in several forms traditionally in NSW most of which are outside a general insurers control or influence as they sit within the State Governments building regulatory framework. Risk management tools include: standardised documentation (such as contracts and specification documents), financial requirements for building licensees, penalties for non-compliance with official directions, education for building licensees in both technical skills and business management skills, education for consumers entering the building process, 2 Page

the building certification process, regulated premium charges and policy terms and ability to improve building standards to reduce recurring defects. All of these issues have a direct impact on the ability for a home warranty product to perform well. The HBCF is concerned about a correlation between protracted job time and insolvency and recently introduce open job and job duration procedures that reward builders completing jobs expeditiously. 3. Cost to administer In NSW the warranty underwriter i.e. the Government has had to develop and maintain a complex prequalification system to ascertain the financial capacity and therefore the risk of each builder. The cost to administer the Queensland warranty scheme is approximately 22% of premium income (as per their 2013/2014 annual report data). The NSW scheme is underwritten by the H.B.C.F. but administered by two licensed agents. Builders gain access to the fund via a network of brokers. We understand the cost to administer this scheme is approximately 55% of premium income. 4. Recovery of claims expenditure In the unwelcome event that a builder fails to complete a contract or there is defective work, assuming the policy triggers are activated, an underwriter will pay a claim. If a contractor s liability policy exists the underwriter may seek to access this as a cost recovery vehicle. Given one of the main triggers for a home warranty policy is often insolvency the underwriters cost recovery experience is normally poor. Builder Issues 1. Access Builders generally enter the industry to build. Increased administration for the builder either decreases profits and/or leisure time. The financial requirement on builders to increase capital in their business in order to increase work originated from an insurance criteria. In certain contexts this financial burden seems oppressive after a builder has successfully negotiated all the hurdles to achieve a Builder s license. The oppressive nature of the insurance criteria is compounded when the policy exposure tail may extend for many years. Builders and contractors seek a value for money product with minimum administration, ease of access for new starters and simpler less burdensome mechanisms that support business growth (more on this in the next section). 2. Restraining Growth Builders must grow the capital in their business in order to increase their eligibility for greater turnover under the scheme. 3 Page

Once assessed the builder is issued with an eligibility certificate which is a pre-qualification for home warranty. Eligibility can be suspended or cancelled by an insurance agent at any time. In addition to the eligibility assessment a builder must then have a project specific certificate issued. Limitations attached to a certificate that may be placed on the builder include a limit on the type of construction permitted, restrictions on con-current projects and/or an impost of additional capital or security requirements (usually by means of a deed of indemnity). Builders wishing to change the type of construction they undertake, say from single detached dwellings to three storey walk-ups, must be subject to an eligibility profile change which, again, carries financial implications as it will usually require changes to working capital. The conditions imposed on builders as a result of these assessments can and do restrict a builders ability to grow and/or diversify their business. In this area the home warranty underwriter becomes a pseudo building regulator and while this may be of benefit to the insurer in potentially managing their risk, for many building businesses it has been detrimental to growth and development. Consumer issues Consumer demands are fairly simple, they want someone to take their problem away and fix it. The initial challenge is actually having an event which triggers access to the product. In NSW this can involve a significant amount of time and expense for a consumer often including protracted and expensive legal action. It is not just a simple matter of submitting a claim. Other challenges include a lack of appropriate paperwork to establish just what specification is to be constructed, the technical issue of whether the problem is in fact a defect or how to fix a defect without demolishing half the house. Consumers constantly complain home warranty lacks transparency, has insufficient and complex triggers to access cover and has a long drawn out claims process. 4 Page

Framework for Change In summary the stakeholder s issues are relatively simple. Underwriters need to control their risk to minimize their financial and reputation loss. Builders want a simple, consistent system which does not restrict their business growth and consumers want a simple, transparent and easy to access product. The HBCF states it is losing a vast amount of money, is carrying too much risk and is looking to change the framework again. MBA understands the issues are not simple to resolve. We believe it is time to look at the system from a holistic perspective and develop a new framework with input from all stakeholders that will address their respective issues. In developing a framework on a green field approach MBA believes we need to get back to basics. Initially three simple questions need to be considered by all stakeholders; 1. Who are we insuring? Is the product intended to insure the builder or the consumer? The consumers need for a speedy seamless resolution to their issues must be balanced against the builder s need for freedom to grow their business and receive a fair hearing if there are building issues; consumer and builder needs must be balanced against the underwriters need to manage risk and operate the scheme in a financially sustainable framework. We may also ask for whom should a home warranty scheme provide a safety net? Is it the average consumer building their own home using a licensed builder or an owner builder? Is it the investor building their sole investment property or the investor who builds on a more commercial basis? 2. How are we insuring? The initial question here is what vehicle we use to deliver the product. There are several options for consideration such as using a private sector insurer like Vero or QBE, a fidelity fund such as the schemes operated by the MBA in the N.T. and A.C.T., a Government body such as the H.B.C.F., or a profit distributing entity like the vehicle used in the United Kingdom and the Q.B.C.C in Queensland In essence we are talking about whether the product is run as a profit generating product, a not-for-profit product or a profit distributing product where any profit generated is put back into the building community. We must decide what type of cover we provide. Do consumers need a first resort cover or a last resort cover? For ease consumers will always want first resort but in theory if the State Building Regulations and dispute resolution mechanisms are working efficiently they will be improving standards and the safety net need only be last resort. 3. What are we insuring? Home warranty currently covers non-completion and rectification of defective work if one of the triggers are activated. Consideration must be given to varying the policy cover in relation to items covered as well as the length of the coverage tail; this will fundamentally changes the risk applicable under the scheme. 5 Page

History of Home Warranty Insurance in NSW Appendix 1 Home Warranty Insurance was introduced in NSW back in 1972. It was a Government backed first-resort scheme. 1987 saw the establishment of the Building Services Corporation (BSC) to run the scheme. The consumer cover was for seven years from commencement of the building project for major structural defects and three years for general defects. In 1995, the Department of Fair Trading integrated the BSC into its portfolio and in May 1997 private sector insurers commenced providing Home Owners Warranty Insurance. The cover remained first resort cover. In 2001, after the collapse of HIH Insurance (a major provider of Home Warranty Insurance), the privately provided Home Owners Warranty scheme was altered to a last resort scheme with overall cover reduction to ensure continued participation by private sector insurers. On 1 July 2010 home warranty returned to Department of Fair Trading umbrella, and the NSW Self Insurance Corporation, following private insurer s withdrawal from the market. The cover remained last resort but with the additional trigger of a builder failing to comply with a court order. In January 2015 the product was rebadged The Home Building Compensation Fund (H.B.C.F.) following a raft of changes to home building laws. In August 2015 further amendments to the scheme were introduced that included changes to annual eligibility limits, shifting open job limits and an open job values. 6 Page

Appendix 2 Home Warranty in Australia The following table depicts the current situation of Home Warranty Insurance throughout Australia. State Underwriter 1st or last resort Multiple Dwellings Building Threshold Maximum term Aggregate Maximum Policy Limit *Tasmania Not mandatory N/A Yes to 3 $12,000 6 yrs N/A A.C.T. MBA Fidelity Fund Last Yes to 3 $20,000 6 yrs $85,000 N.T. MBA Fidelity Fund Last Yes to 3 $12,000 6 yrs $200,000 South Australia Government Last Yes to 3 $12,000 5 yrs $80,000 Western Australia Private - QBE & Calliden Last No $20,000 6 yrs $100,000 Excess $500 Qld Q.B.C.C. Government Body First Yes to 3 $3,300 6.5 yrs $200,000 Victoria V.M.I.A. Government Body Last Yes to 3 $16,000 6 yrs $300,000 N.S.W. H.B.C.F. Government Body Last Yes to 3 $20,000 6 yrs $340,000 Excess $250 The information in this table is general information intended for quick reference and therefore does not contain details such as individual policy limits or sub-limits, definitions of what constitutes a three story building, or how the maximum term is calculated. These are individual to each States policy wording. * Tasmania does not mandate Home Warranty Insurance. Warranty is implied only for 6 years and is valid on building contracts exceeding $12,000 in value. It has been included in this table for the sake of completeness only. 7 Page

Feedback Master Builders invites comments and suggestions for a new model for home warranty insurance in NSW. Please consider the issues raised in this note and identify the matters that are of most concern to you. Additionally, where possible describe your proposal for improving the system to address your concerns. Please use the attached feedback form to present your proposal for change. Thank You. 8 Page