Mixed use high rise building report

Mixed use high rise building report

Contents

Terrorism Insurance Act 2003

Examination of the effects of extending the terrorism insurance scheme established by the Act to mixed use high rise buildings which are not predominantly for commercial use

Executive summary

One of the recommendations made during the 2009 review of the need for the Act to continue in operation was that ARPC examine the effects of extending the scheme to mixed use high rise buildings that are not predominantly for commercial use. 1 ARPC was required to have regard to the need to maintain, to the greatest extent possible, private sector provision of terrorism insurance and to allow the re-emergence of commercial markets for terrorism risk cover.

ARPC consulted widely during its enquiry. 2

Finity Consulting Limited (Finity) was engaged to assist in estimating the additional risk to ARPC by including mixed use buildings alongside commercial risks already covered by ARPC. 3

In conducting its examination ARPC was asked to have regard to the issues outlined below.

The availability of commercial terrorism insurance for mixed use high rise buildings

It became clear that there is a gap in the market for terrorism cover for mixed use high rise buildings.

For mixed use high rise buildings valued at up to $50 million and up to 20% floor space devoted to commercial use, some companies can offer terrorism coverage within their residential portfolio. Once the floor space devoted to commercial use is greater than 20% the property is insured within the commercial portfolio, which excludes terrorism cover. Consequently, for properties with between 20%-50% of their floor space devoted to commercial use the insurance policy excludes terrorism coverage but (because the building is not predominantly commercial and, consequently, the insurance policy is not an eligible insurance contract) the Terrorism Insurance Act 2003 will not write back the terrorism exclusion in the event of a declared terrorist incident.

Mixed use high rise buildings valued at more than $50 million and with less than 50% of floor space devoted to commercial use are insured within insurers’ commercial portfolios. Those policies exclude terrorism. Because the policies are not eligible insurance contracts for the purposes of the Act, the Act will not write back the terrorism exclusion in the event of a declared terrorist incident.

The investigation found that facultative cover is available for mixed use high rise buildings, albeit at a very high price and with limited capacity.

An appropriate ratio of commercial to residential use

ARPC and the Insurance Council of Australia developed a protocol to assist insurers to determine whether or not a building is a residential building. (See Appendix D for a copy of Insurance Council of Australia Circular No G1573 dated 26 September 2003.) The protocol recognises that a degree of flexibility is required and allows insurers to have regard to the overall character of the building and the pattern of occupancy. The review considers that the protocol is still appropriate.

Appropriate measures to determine the ratio of commercial to residential use

ARPC examined assets values and contributions to strata title levels as an alternative to the floor area predominance test. However, it appears to ARPC that floor area is the most appropriate test because it is measurable and objective and used by all the insurers consulted during the course of the enquiry.

Risk profile of mixed use high rise buildings

Finity’s actuarial analysis concluded that there are no major mixed use buildings located within ARPC’s peak exposure zones. Consequently, it is unlikely that the extension of the scheme to include those buildings will have an impact on ARPC’s maximum expected losses.

Impact of extending the scheme to mixed use high rise buildings

If the scheme was extended to include mixed use buildings with 20-50% commercial use, ARPC’s exposures would increase by 2% in Sydney Tier A postcodes and by 1.8% in Melbourne Tier A postcodes. If mixed use buildings with 10-50% commercial use are included, ARPC’s exposure would increase by 4.5% in Sydney Tier A postcodes and by 9.2% in Melbourne Tier A postcodes.

Maximum loss scenarios across Australia will not be affected in a material manner by the inclusion of mixed use high rise buildings in the scheme.

Impact on policy holders’ premiums

The impact on policy holders’ premiums for mixed use buildings in Tier A locations is likely to be an increase of approximately 15% of their fire or industrial special risks policies.

Rate and structure of reinsurance premiums payable to ARPC

Assuming that the existing rates are applied, the additional premium from all mixed use buildings in all Tier A postcodes would total $267,000-$400,000 per annum. This represents an increase in overall Tier A premium of between 1.3%-2%.

Insurers’ retentions

Some insurers’ retentions would increase slightly if the existing method of applying 4% to their gross fire and industrial special risks premium is applied.

Adequacy of the reserve for claims

The extension of the scheme to include mixed use high rise buildings which are not predominantly commercial would not increase ARPC’s maximum loss scenarios. Consequently, there would be no need to seek additional capacity for the scheme in order to extend the scheme to cover those buildings.

Impact on retrocession program

The number of large mixed use buildings is small and these buildings do not impact on ARPC’s probable maximum loss scenarios. Consequently, it is unlikely that there would be a significant increase in the cost of ARPC’s retrocession program. Both insurers and retrocessionaires would need to be given at least 12 months notice of any changes to ARPC’s exposures and risk profile.

Financial risk to the Commonwealth

Finity’s view is that the inclusion of mixed use high rise buildings in the scheme would not materially change the Commonwealth’s exposure in the event of a declared terrorist incident.

Conclusion

While Finity’s actuarial analysis concluded that there were few mixed use high rise buildings in the CBDs of Sydney and Melbourne and their inclusion in the scheme would not have a material effect of ARPC’s exposure, ARPC is of the view that including mixed use high rise buildings in the scheme may restrict the introduction of an industry solution to the unavailability of terrorism insurance. This is unlikely to promote the Government’s objective of operating the scheme only while terrorism insurance cover is unavailable commercially on reasonable terms.

Recommendations

Recommendation 1

That the existing test of predominance be retained, thus continuing to exclude mixed use buildings in accordance with the existing protocol.

Recommendation 2

That ARPC conduct an education campaign with it cedants to raise awareness of the protocol contained in the Insurance Council of Australia General Circular No G1573.

Recommendation 3

That the existing floor area test be retained.

Introduction

Overview of the scheme

The Terrorism Insurance Act 2003 (Act) establishes a scheme for replacement terrorism insurance coverage for commercial property and associated business interruption and public liability claims. The Act also establishes ARPC as a statutory authority to administer the scheme. The scheme commenced on 1 July 2003.

The scheme was established in the wake of the withdrawal of commercially available terrorism insurance following terrorist attacks around the world, particularly the events of 11 September 2001 in the United States of America.

Before introducing the scheme, the Government considered the broad economic impacts which could result from a large pool of assets uninsured for terrorism risk. The potential impacts included delaying commencement of investment projects and altering portfolio management decisions as banks and commercial property trusts became concerned about the amount of property without adequate cover. The Government was concerned that lack of comprehensive insurance cover for commercial property or infrastructure would lead to a reduction in financing and investment in the Australian property sector and that this would subsequently have wide economic impacts. These considerations led to the Government to conclude that intervention was necessary.

The Government decided that any intervention should be consistent with the need to:

  • maintain, to the greatest extent possible, private sector provision of insurance;
  • ensure that risk transferred to the Commonwealth is appropriately priced to minimise the impact on the Commonwealth’s financial position;
  • ensure that the Commonwealth is being compensated by those benefiting from the assistance;
  • allow the commercial insurance and reinsurance markets to re-enter the market when they are able (that is, ensuring an appropriate exit strategy for Government); and
  • be compatible with global solutions.4

The Act overrides terrorism exclusion clauses in eligible insurance contracts to the extent the losses excluded are eligible terrorism losses arising from a declared terrorist incident. Insurers may reinsure this additional risk with ARPC.

The compulsory application of the scheme to all eligible insurance contracts is essential. It allowed the accumulation of a credible pool of funds within a reasonable time. It also avoids problems associated with undiversified risk (for example, insuring only high risk buildings) and uncertainly as to who will be eligible for compensation in the event of a declared terrorist incident.

An eligible insurance contract is a contract that provides insurance coverage for:

  • loss of, or damage to, eligible property that is owned by the insured;
  • business interruption and consequential loss arising from:
    • loss of, or damage to, eligible property that is owned or occupied by the insured, or
    • an inability to use all or part of such property;
  • liability of the insured that arises out of the insured being the owner or occupier of eligible property.5

Eligible property is the following property that is located in Australia:

  • buildings (including fixtures) or other structures or works on, in or under land;
  • tangible property that is located in, or on, such property;
  • property prescribed by regulation.6 Tangible property in, on or under the seabed is prescribed by the Terrorism Insurance Regulations 2003 (the Regulations).7

Cover is also available for all Commonwealth and state and territory public authorities. Farms can also obtain cover if they hold insurance against business interruption.

The scheme does not cover residential property or the contents of residential property.

The Regulations also exclude contracts of insurance which provide cover for, inter alia, workers’ compensation insurance, marine insurance, aviation insurance, motor vehicle insurance, life insurance, health insurance, private mortgage insurance, medical indemnity insurance and professional indemnity insurance.8

Insurers may, but are not obliged to, reinsure their terrorism risk with ARPC.

The scheme covers eligible terrorism losses for any declared terrorist incident covered by an eligible insurance contract where the insurer has a reinsurance agreement with ARPC. Eligible terrorism losses do not include a loss or liability arising from the hazardous properties of nuclear fuel, material or waste.9 They do, however, include loss or liability arising from incidents caused by biological and chemical agents.

Payouts for eligible terrorism losses available to holders of eligible insurance contracts depend on the underlying coverage in the eligible insurance contract. For example, if a terrorist act caused a fire, then a policyholder would be able to claim for subsequent loss if their insurance policy covers damage from fire. Conversely, if a terrorist act involved biological contamination and the underlying insurance policy does not include cover for biological contamination, then the policy would not respond and the reinsurance provided by the scheme would not be triggered.

Review of the scheme

The scheme was established as an interim measure and is intended to operate only while terrorism insurance cover is unavailable commercially on reasonable terms. At the time it was established, the Government also considered that uncertainty in the market made it impossible to stipulate the details or timing of its windup.10 As a result the Act requires that, at least once every three years after the startup time, the Minister must prepare a report that reviews the need for the Act to continue in operation.11

The first review was completed in June 2006. The second review was completed in June 2009.

The 2006 review

After consulting with stakeholders and considering international experience, the review concluded that there was still a need for the Act to continue in operation, subject to a further review in no more than three years. The review considered that, while the market for terrorism insurance had recovered somewhat since the scheme was introduced, insufficient terrorism insurance was available commercially on reasonable terms.

The review identified a need to encourage private sector involvement, to the greatest extent possible, to avoid crowding out the market and allow the Government to withdraw once terrorism insurance is commercially available on reasonable terms. It noted that it is important for ARPC to develop its exposure modelling capability to encourage greater private sector involvement in terrorism cover. It also concluded that high rise residential property and discretionary mutual funds should not be included in the scheme.

The review recommended that:

  • ARPC be required to continue charging premiums for reinsurance at the current rates, subject to further review in no more than three years;
  • once the pool reaches $300 million, ARPC have discretion to determine whether to use premiums to build the pool further, purchase reinsurance for the scheme or undertake a combination of the two;
  • insurer retentions under the scheme be increased in three increments (with effect, respectively, from 1 July 2007, 1 July 2008 and 1 July 2009);
  • in relation to bundled insurance policies, ARPC be required to only charge reinsurance premiums on those sections of the policy that exclude terrorism risk. 12

All recommendations were accepted by Government and all were implemented by ARPC. Reinsurance premiums are unchanged, a reinsurance program was introduced effective from 31 December 2008, insurer retentions were increased in line with the review recommendation and ARPC has amended the way in which premiums on bundled insurance policies are calculated.

The 2009 review

The 2009 review considered the need for the Act to continue in the context of the international terrorism insurance market which had been characterised by improvements in the availability and affordability of terrorism insurance, subject to certain limitations. Despite these improvements, the review found that there was still insufficient commercial capacity to meet demand for terrorism insurance at affordable rates. While global capacity for reinsurance of terrorism risk had improved for national pooled arrangements, there was insufficient capacity at reasonable prices for individual risks.

The review also found that the favourable market and underwriting conditions that had contributed to the improvement in market conditions deteriorated in the second half of 2008. This deterioration was a result of insurers and reinsurers responding to a decline in the value of investment portfolios due to the impact of the global financial crisis, and dealing with a series of significant weather related events.

While the Australian general insurance industry remains relatively financially stable despite the global economic environment and difficult underwriting conditions, it is nonetheless part of the international reinsurance market. Internationally, the underlying shortage of affordable reinsurance for terrorism risk is ongoing and the impact of the global financial crisis on the availability and affordability of reinsurance is as yet unknown.

The review recommended that the Act continue in operation, subject to further review in no more than three years, at which time further examination of the availability of commercial reinsurance on reasonable terms be undertaken.

While concluding that market conditions are not conducive to phasing out or ceasing Australia’s terrorism insurance scheme, the review supported maintaining, to the greatest extent possible, private sector provision of terrorism insurance. It noted that permanent government subsidised reinsurance would remove any incentive for the private sector to develop alternative arrangements.

The review then considered refinements to the operation of the scheme. A summary of its recommendations follows.

  • Premiums and the pool — ARPC continue to collect premiums at current rates and investigate the purchase of further retrocession with funds from the pool, and that the relationship between premiums and the pool, and the impact of retrocession on the pool and the scheme more generally, be further considered in the context of the 2012 review.
  • Retentions — industry retention levels remain at the levels that took effect on 1 July 2009, noting that the appropriateness of the current levels and structure of retentions should be re-examined in the course of the 2012 review.
  • Line of credit — ARPC not be required to maintain a line of credit facility for the scheme, guaranteed by the Commonwealth, at the current time but should investigate purchasing additional retrocession capacity for the scheme with the funds that would otherwise have been used to pay the maintenance fee for the line of credit. ARPC should also continue to monitor its overall liquidity position and the need for a line of credit or other liquidity source in light of market retrocession capacity and pricing and any other relevant factors.
  • Residential property (high rise buildings) — ARPC examine the effects of extending the scheme to mixed use high rise buildings that are not predominantly for commercial use, having regard to the need to maintain, to the greatest extent possible, private sector provision of terrorism insurance, and allow the re-emergence of commercial markets for terrorism risk cover. ARPC should report to the Minister with findings and recommendations by 30 September 2010.13
  • Residential property (defence force and student accommodation) — property that is wholly for residential use, including defence force and student accommodation involving commercial property financing, continue to be excluded from the scheme.
  • Postcode allocation — Treasury, with the assistance of an outside contractor, update the allocation of individual postcodes to particular tiers to ensure that all postcodes are allocated to the correct tier. As part of this process, ARPC model the impact of any reallocation of postcodes to different tiers and advise the Government of its findings. Subject to the recommendation being accepted, there should be a sufficient transitional period to allow insurers and policyholders to adjust to any reallocation of postcodes.14

All recommendations were accepted by Government. Premium and retention levels remain unchanged. The line of credit was not renewed on expiry. Residential property continues to be excluded from the scheme.

This report presents the results of ARPC’s examination of the effects of extending the scheme to mixed used high rise buildings that are not predominantly for commercial use. In conducting its enquiry ARPC has had regard to the need to maintain, to the greatest extent possible, private sector provision of terrorism insurance, and allow the re-emergence of commercial markets for terrorism risk cover.

Background to the treatment of mixed use high rise buildings

Exclusion of residential property from the scheme

As noted above, residential property is excluded from the scheme. The widespread withdrawal of terrorism cover from commercial insurance policies made it difficult for developers to obtain finance for large construction projects. This, in turn, had the potential to cause a decline in construction which would eventually lead to a downturn in the property sector, with negative flow-on effects for the wider economy.

The scheme was designed to protect the commercial property sector and was never intended to protect the residential property sector.

The Regulations exclude home buildings and contents of a residential building within the meaning given to those phrases by regulations 7.1.12 and 7.1.13 of the Corporations Regulations 2001. Under regulation 7.1.12 buildings under constructions are excluded from the definition of “home building”. Consequently, buildings under construction fall within the scheme regardless of whether the property is ultimately for residential or commercial use.

The structure of the scheme has meant that the withdrawal of terrorism insurance has not affected the availability of finance for the construction of high rise buildings, regardless of their end use.

Review of the exclusion of residential high rise buildings

The reviews of the Act conducted in 2006 and 2009 reconsidered the exclusion of residential property from the scheme.

The 2006 review did not support the extension of the scheme to include predominantly or wholly residential high rise buildings. It concluded that there was no evidence to suggest that either the willingness of lenders to provide finance for residential developments, or sales of residential apartments in high rise buildings, had reduced due to the withdrawal of terrorism insurance. The review also concluded that the increased transfer of cost and risk from property owners to the Government would substantially increase the costs of the scheme while producing limited benefits.

The 2009 review affirmed the findings of the 2006 review in relation to the exclusion of residential high rise buildings from the scheme. It also analysed movements in lending and construction activity. There is data to indicate a downturn in dwelling unit commencements in the March 2009 quarter. The review concluded, however, that the downturn was due the economic slowdown and the reduced availability of credit, not the lack of terrorism insurance.

Including only high rise residential buildings, rather than all residential buildings, would mean that ARPC would not be diversifying the additional risk it was assuming. It is also inconsistent with the scheme’s treatment of commercial property. The report concluded that the inclusion of single use residential high rise buildings would increase the overall risk assumed by the scheme and possibly impact on its sustainability.

The review noted that there was an emerging market for terrorism insurance for residential high rise buildings.

The review also noted that the price of commercially available terrorism insurance and whether some residential high rise property owners choose to purchase terrorism insurance from overseas markets are not necessarily issues for the scheme to address. This is particularly so where these issues are not having a negative impact on the broader Australian economy or placing the Australian financial system at risk.

For these reasons, the review did not support extending the scheme to include single use residential high rise buildings.

Review of the exclusion of mixed use high rise buildings

While the 2009 review did not support extending the scheme to include single use residential high rise buildings, it noted that different considerations might apply to mixed use high rise buildings. During the course of the review representations were made that mixed use high rise buildings are:

  • becoming more prevalent, particularly in central business districts;
  • perceived as a higher risk than wholly commercial use buildings located outside central business districts.

Some stakeholders also raised the appropriateness of the test ARPC uses to determine whether a mixed use building is commercial or residential. Currently, ARPC uses the “predominance” test to ascertain whether a mixed used high rise building is commercial or residential using the percentage of the floor area devoted to each use. It was suggested that the 50:50 ratio could be relaxed or that alternative methods of measuring the commercial and residential compositions of high rise buildings could be investigated.

The review considered that the extension of the scheme to mixed use high rise buildings that are not predominantly for commercial use could be examined in terms of the perceived anomaly between their exclusion from the scheme compared to similar buildings that are not excluded from the scheme. This examination must have regard to the policy objectives of the scheme.

Enquiry strategy

ARPC consulted with a variety of stakeholders, including industry associations, industry participants (insurers and reinsurers), brokers and legal advisers.15

ARPC engaged Finity Consulting Limited (a leading firm of actuaries) to assist it in estimating the additional risk to ARPC by including mixed use buildings alongside commercial risks already covered by the scheme. Due to limitations of time and resources, Finity was asked to limit its examination to Tier A postcodes in Sydney and Melbourne.16

Outcomes

Availability of commercial terrorism insurance

The insurance capacity of commercial insurers is based on the terms of their reinsurance treaties and the underwriting guidelines set by management.

Some Australian insurers have automatic terrorism reinsurance capacity for policies which cover residential strata buildings that are valued at less than $50 million. Automatic cover is not available where a residential building is valued at more than $50 million. To obtain cover in these cases, insurers must approach the facultative market for additional reinsurance capacity. Stakeholders advised ARPC that stand alone terrorism cover is available in the market. Few Australian companies offer the product but there is some capacity, particularly from Lloyd’s syndicates and foreign owned insurers.

It appears, however, that the capacity is limited and what is available is expensive relative to the price of fire and perils covers. One Australian company advised that it had $50 million in capacity Australia wide that it offered on a first loss cover basis at a cost of an additional 7% of the fire and perils premium. Other insurers advised that the premium for terrorism cover could be almost as much as the fire and perils premium. It appears that cover is rarely taken up because of the limited capacity, expense and the perception of there being a low risk of loss.

To determine whether a mixed use high rise building is residential or commercial, insurers use a floor area test. The test ranges from 10% to 20% of floor area devoted to commercial use. Two of the largest companies which operate in this area use an 80:20 ratio as the test. That is, if the building is 80% residential and 20% commercial, the building is considered to be residential and is insured through the residential portfolio.

If the building is more than 20% commercial the cover is offered through the commercial portfolio which excludes terrorism cover. The companies then review the building again to determine whether it meets ARPC’s predominance test. If it does not, the policy is not an eligible insurance contract for the purposes of the Act and premium is not ceded to ARPC.

As a result:

  • mixed used high rise residential buildings valued under $50 million with up to 20% of floor area devoted to commercial use benefit from the cover offered by the market;
  • mixed use high rise buildings valued under $50 million with between 20%-50% of floor area devoted to commercial use do not benefit from the cover by the market or that offered by ARPC;
  • mixed used high rise residential buildings valued over $50 million with less than 50% of floor area devoted to commercial use do not benefit from the cover offered by the market or that offered by ARPC.

Figure 1 below shows the current availability of terrorism cover by building type and value.

Figure 1 – Current availability of terrorism cover (“Asset Value” vs “% of Commercial Floor Area”)17

Current availability of terrorism cover by building type and value

As noted above, many insurance companies can offer terrorism insurance through their residential portfolio provided the value of the building is less than $50 million. The $50 million limit on the insurance capacity for residential buildings is driven by the availability of reinsurance. ARPC spoke to two of the largest reinsurers in the Australian market. Neither is contemplating raising the $50 million limit on the reinsurance cover they offer because:

  • most residential buildings with a value above $50 million are located in CBD areas and are considered to be higher risk; and
  • the number of these buildings is small and offering terrorism cover would result in an unbalanced portfolio with higher risk exposures and a small premium pool.

The terrorism cover offered on high rise residential buildings is not offered as a sub-limit. That is, if the building is valued above $50 million, no cover is offered. The insured does not have the choice to purchase terrorism insurance up to $50 million on a building valued at, say, $75 million.

ARPC understands that this terrorism reinsurance capacity has been available in the market for only two years. It may be appropriate to give the market some time to assess whether this capacity is appropriate or whether additional capacity can be made available.

Another issue raised by insurers is “value creep”. As property values rise, buildings begin to exceed the $50 million value at which terrorism cover cuts out. One major home unit insurer advised that the percentage of buildings coming within its $50 million limit is decreasing. If mixed use high rise residential buildings are included in the scheme the increasing valuations would result in more buildings being covered by the scheme, thus increasing ARPC’s accumulations.

Recommendation 1

That the existing test of predominance be retained, thus continuing to exclude mixed use buildings in accordance with the existing protocol.

Appropriate ratio of commercial to residential use

This issue was a matter of some discussion at the time of the scheme’s introduction. ARPC and the Insurance Council of Australia (and their respective legal advisers) developed a protocol to assist insurers to determine whether or not a building is a residential building and, consequently, excluded from the scheme.

The protocol recognises that it is difficult to have a hard and fast rule in respect of what is, and is not, a residential building. However, it draws on applicable legal principles and outlines a methodology based on the area of usage or intended usage. If the residential component is more than 50% the building is to be treated as residential unless other factors lead to a contrary conclusion. The protocol then outlines what factors may be considered if further analysis is required to determine whether the building meets the definition of home building as defined in Regulation 7.1.12 of Corporations Regulations 2001. That is, is the building used, or intended to be used, principally and primarily as a place of residence.

The protocol recognises that a degree of flexibility is required, particularly when the commercial use is closer to 40% than 50%. It also suggests that insurers to have regard to the overall character of the building and the pattern of occupancy.

The Act defines eligible insurance contracts. The Regulations exclude from the definition of that term contracts of insurance providing cover to home building within the meaning given by Regulation 7.1.12 of the Corporations Regulations 2001. That regulation defines a home building as a building used, or intended to be used, principally and primarily as a place of residence. The protocol was developed having regard to the meaning given to the phrase “principally and primarily” by case law. By applying a different test, ARPC might be knowingly accepting premium for a contract of insurance which a court could hold is not an eligible insurance contract. Any change to the test currently applied by ARPC would probably require a change to the Regulations.

The current availability of reinsurance for residential mixed use high rise buildings is a direct result of the exclusion of residential buildings from the scheme. Because of the availability of reinsurance, many insurers are including automatic terrorism cover in their residential property portfolio for buildings valued at less than $50 million, including those with up to 20% commercial usage. Extending the scheme to other than predominantly commercial property may restrict the introduction of insurance industry solutions to the unavailability of terrorism insurance. This is unlikely to promote the Government’s objective of operating the scheme only while terrorism insurance cover is unavailable commercially on reasonable terms.

Recommendation 2

That ARPC conduct an education campaign with it cedants to raise awareness of the protocol contained in the Insurance Council of Australia General Circular No G1573.

Appropriate measures to determine the ratio of commercial to residential use

The review was asked to examine whether there is a more appropriate measure to determine, or assist in determining, the ratio of commercial to residential use in mixed use high rise buildings. Two measures mooted were asset values and contributions to strata title levies.

Asset values

Using asset values as the determinant factor could introduce uncertainty to the scheme. Asset values fluctuate from time to time during the economic cycle. This could mean that an eligible insurance contract one year would not meet that definition the next year because of a change in the value of the asset it is insuring. There is also a difference between the asset value and the insurable value, the latter being largely determined by replacement costs. Introducing uncertainty to the scheme might create difficulty for insurers in managing their exposures.

To use asset values could mean the inclusion in the scheme of purely residential buildings. As mentioned above, the scheme was designed to protect the commercial property sector, not the residential property sector. The 2006 and 2009 reviews did not support the extension of the scheme to predominantly or wholly residential high rise buildings.

Contributions to strata title levies

Contributions levied by an owners’ corporation must be levied in respect of each lot in shares proportional to the unit entitlement of the lot. However, if the use to which a lot is put causes an insurance premium for the strata scheme to be greater than it would be if it were not put to that use, the contribution for a particular lot may, with the consent of the owner, be increased to reflect the extra amount of that insurance premium.

Depending on the level of the insurance premium, the application of these provisions of the Strata Schemes Management Act 1996 (NSW) could result in a higher percentage of levies being attributable to commercial units even though they form a smaller percentage of the overall units.

Floor area

All insurance companies consulted during the course of this enquiry use the ratio of floor area devoted to residential and commercial use to determine whether a building is residential or commercial. No stakeholder consulted during the enquiry suggested there is a more appropriate measure. Floor area is a measurable and objective test which is not easily manipulated.

Recommendation 3

That the existing floor area test be retained.

Transitional considerations in the event of changes to the scheme

Any changes to ARPC’s exposures and risk profiles would have to be notified to the market before the changes are introduced. At least 12 months notice would be required to enable insurers to understand their obligations under the reinsurance agreement and retrocessionaires to understand the exposure implications.

Consideration should be given to those insurance contracts in force at the time of the implementation of any decision to include in the scheme mixed use residential high rise buildings. Currently, those insurance contracts are not eligible insurance contracts for the purposes of the Act and insurance companies are neither collecting nor ceding terrorism insurance premiums in respect of those contracts. There may be a need to include transitional provisions so that there is no imposition of a terrorism liability and associated claims management costs on insurance companies for which they have not had the opportunity to collect appropriate premium from the insured.

Actuarial Analysis

Risk profile of mixed use high rise buildings

In its review, Finity mapped the location of all residential and mixed use buildings. This mapping shows that the buildings are evenly spread throughout the Sydney and Melbourne CBDs. The only discernible increase in concentration is located in the Pyrmont area of Sydney and the Docklands area in Melbourne. There are no major mixed use buildings located within ARPC’s peak exposure zones. Consequently, Finity’s analysis concludes that it is unlikely that the extension of the scheme to include mixed use high rise buildings will have an impact on ARPC’s maximum expected losses.

Finity’s analysis shows that the largest loss that would be incurred by extending the scheme to include mixed use high rise buildings with between 10-20% commercial area would occur at the World Square Centre in Sydney’s southern CBD region and would result in a $6.8 billion loss, which is lower than the $8.95 billion exposure at the corner Phillip and Bent Streets. In Melbourne the maximum loss scenario increases by 30% to $4.6 billion when mixed use high rise buildings are included. While the percentage increase is greater, the total exposure is still much lower than the Sydney scenario.

The tables below illustrate the increases in estimated losses in Sydney and Melbourne.

Table 1 – Increase in estimated loss at Sydney peak zones
20% to 50% Commercial 10% to 20% Commercial
Cluster Address Predominantly Commercial Building Sum Insured Total Increase Building Sum Insured Total Increase
1 Bent St / Phillip St 8,951 0 8,951 0% 0 8,951 0%
2 York St / Jamison St 4,331 0 4,331 0% 0 4,331 0%
3 George St / Bathurst St 2,980 0 2,980 0% 0 2,980 0%
4 Goulburn St / Pitt St 4,489 1,623 6,112 36% 663 6,776 15%
5 Pyrmont St / Jones Bay Rd 2,233 0 2,233 0% 173 2,406 8%

 

Table 2 – Increase in estimated loss at Melbourne peak zones
20% to 50% Commercial 10% to 20% Commercial
Cluster Address Predominantly Commercial Building Sum Insured Total Increase Building Sum Insured Total Increase
1 Russel St / Little Collins St $1,907 32 1,939 2% 36 1,974 2%
2 Queen St / Bourke St 1,258 87 1,939 2% 36 1,974 2%
3 Block enclosed by Kings way / Queensbridge St / Whiteman St 3,596 0 3,596 0% 250 3,846 1%
4 Southbank Bvd / Freshwater Pl 2,367 0 2,367 0% 2,282 4,648 96%

Impact of extending the scheme to mixed use high rise buildings

Additional exposure

Sydney

In its review Finity identified land parcels containing mixed use buildings with between 10-50% commercial usage. It identified 31 such parcels within Sydney’s CBD, 7 at Pyrmont and 4 at North Sydney, making a total of 42 in Sydney’s Tier A postcodes.

Table 3 – Number of mixed use buildings in Sydney CBD (10%-50% commercial floor area)
Classification Land Parcels
10-20% Commercial Usage 8
20-50% Commercial Usage 23
Total Sydney CBD 31
Pyrmont1 7
North Sydney1 4
Total Sydney (Tier A) 42

Source: RPData and Finity Consulting

1Assumed 15% Commercial Usage

Finity then analysed this information to produce a split by building usage and sum insured.

Table 4 – Sum insured profile split by number of buildings and commercial floor area in Sydney CBD
Number of buildings
Sum Insured Band ($ millions) 10% – 20% Commercial 20% – 50% Commercial Combined
0 – 10 12 12
10 – 20 1 1
20 – 30 0 0
30 – 50 2 2
50 – 100 10 3 13
100 – 500 9 4 13
500+ 0 1 1
Total 19 23 42
Commercial exposure 1935 1935 1935
Increased exposure 1954 1958 1977
Increased exposure (%) 1.00% 1.20% 2.20%
Table 5 – Sum insured profile split by aggregate sum insured and commercial floor area in Sydney CBD
Number of buildings
Sum Insured Band ($ millions) 10% – 20% Commercial 20% – 50% Commercial Combined %
0 – 10 42 42 1%
10 – 20 14 14 0%
20 – 30 0 0 0%
30 – 50 72 72 1%
50 – 100 698 170 868 17%
100 – 500 2,099 771 2870 56%
500+ 0 1,295 1,295 25%
Total 2,797 2,364 5,161
Commercial exposure 115,668 115,668 115,668
Increased exposure 118,466 118,032 120,829
Increased exposure (%) 2.4% 2.0% 4.5%
Melbourne

Finity conducted the same identification and analysis for Melbourne’s Tier A postcodes. It identified 51 such land parcels in Melbourne – 38 in the CBD, 8 in Southbank and 5 in Docklands.

Table 6 – Number of mixed use buildings in Melbourne CBD (10%-50% commercial floor area)
Classification Land Parcels
10-20% Commercial Usage 6
20-50% Commercial Usage 32
Total Melbourne CBD 38
Southbank1 8
Docklands1 5
Total Melbourne (Tier A) 51

Source: RPData and Finity Consulting

1Assumed 15% Commercial Usage

Again, Finity analysed this information to produce a split by building usage and sum insured.

Table 7 – Sum insured profile split by number of buildings and commercial floor area in Melbourne CBD
Number of buildings
Sum Insured Band 10% – 20% Commercial 20% – 50% Commercial Combined
0 – 10 23 23
10 – 20 3 3
20 – 30 2 2
30 – 50 0 0
50 – 100 8 3 1
100 – 500 9 0 9
500+ 2 1 3
Total 19 32 51
Commercial exposure 1865 1865 1865
Increased exposure 1884 1897 1916
Increased exposure (%) 1.0% 1.7% 2.7%
Table 8 – Sum insured profile split by aggregate sum insured and commercial floor area in Melbourne CBD
Number of buildings
Sum Insured Band ($ millions) 10% – 20% Commercial 20% – 50% Commercial Combined %
0 – 10 140 140 2%
10 – 20 37 37 1%
20 – 30 52 52 1%
30 – 50 0 0 0%
50 – 100 594 216 810 13%
100 – 500 2,004 0 2,004 33%
500+ 2,282 698 2,980 49%
Total 4,880 1,143 6,023
Commercial exposure 65,206 65,206 65,206
Increased exposure 70,086 66,349 71,229
Increased exposure (%) 7.54% 1.8% 9.2%

Analysis of the Sydney and Melbourne building profile by number indicates that 90% of residential buildings have at least 5% commercial floor area. The profiles also indicate that 87% of all CBD high rise buildings have at least 10% commercial floor area.

If the scheme was extended to include mixed use buildings with 20-50% commercial use, ARPC’s exposures would increase by 2% in Sydney Tier A postcodes and by 1.8% in Melbourne Tier A postcodes. If mixed use buildings with 10-50% commercial use are included, ARPC’s exposure would increase by 4.5% in Sydney Tier A postcodes and by 9.2% in Melbourne Tier A postcodes.

In explaining the greater increase for Melbourne, Finity notes that there is a smaller sum insured for Melbourne’s commercial risks and that two Melbourne buildings with 10-20% commercial use (Eureka and Freshwater Place) both have sums insured of more than $1 billion. Building height limits have not allowed similar developments in Sydney.18 Building height limits in Sydney are unlikely to change because of the proximity of Sydney Airport.

Impact on policy holders’ premiums

Currently ARPC’s cedants pass on to policy holders the entire reinsurance premium charged by ARPC, together with a loading to fund their retentions and cover administrative costs (typically around 3%). It is likely that the same approach would be adopted for premiums charged in respect of mixed use residential high rise buildings which are not predominantly commercial.

Consequently, the impact on policy holders’ premiums is likely to be an increase of approximately 15% of their fire and industrial special risks policies covering properties located in Tier A postcodes.

Rate and structure of reinsurance premiums payable to ARPC

There is no evidence that the perceived threat to mixed use buildings is higher than for commercial buildings in the CBDs of Australian’s capital cities. Consequently, if the scheme were to be extended to mixed use buildings which are not predominantly commercial, there is no reason to apply a rate other than the existing tier rates of 12%, 4% and 2%.

Assuming that the existing rates are applied, Finity estimates that the additional premium from all mixed use buildings in all Tier A postcodes would total between $267,000 and $400,000 per annum.19 This represents an increase in overall Tier A premium of between 1.3%-2%.

Insurers’ retentions

Finity’s analysis suggests that the inclusion of mixed used buildings which are not predominantly for commercial use would result in an increase in ARPC’s overall exposure. However, the analysis also concludes that maximum loss scenarios across Australia will not be affected in a material manner.20

Insurers’ retentions would increase slightly if the existing method of applying 4% to their gross fire and industrial special risk premium is applied.

Adequacy of reserve for claims

ARPC has collected just over $600 million in premium since 2003. The resulting reserve for claims of $551.26 million (as at 30 June 2009) would cover losses from localised terrorist incidents only. The reserve for claims would not cover ARPC’s maximum exposure from a major event such as a large blast in Sydney’s CBD. However, the reserve for claims is supplemented by ARPC’s retrocession program and the Commonwealth guarantee, which together currently provide a capacity of $12.9 billion for the scheme.

This enquiry has found that the mixed use high rise buildings portfolio is relatively small and there are no concentrations of these risks located within ARPC’s existing major commercial loss footprints. Finity’s analysis indicates that the extension of the scheme to include mixed use high rise buildings which are not predominantly commercial would not increase ARPC’s maximum loss scenarios. 21

Consequently there would be no need to seek additional capacity for the scheme in order to extend the scheme to cover those buildings. It should be noted, however, that the scheme’s funds could be exhausted more quickly if losses from mixed use high rise buildings are covered by the scheme.

Table 1 on page 2 of this report shows a cluster analysis for Sydney that identifies the corner Goulbourn and Pitt Streets as the location with the highest impact on major losses in a CBD region.

Impact on retrocession program

At present, ARPC’s pays an annual premium of $80.098 million for its retrocession program of $2.6 billion excess of $300 million. Any inclusion of mixed use buildings in ARPC’s portfolio will increase its aggregate exposure. It is expected that this increased exposure will be reflected in the premium ARPC pays for its retrocession program. However, the number of large mixed use buildings is small and these buildings do not impact on ARPC’s probable maximum loss scenarios. Consequently, it is unlikely that there will be a significant increase in the cost of ARPC’s retrocession program. ARPC’s reinsurance broker, Guy Carpenter, estimates that any increase is unlikely to exceed 5% of current retrocession premiums.

Financial risk to the Commonwealth

The Commonwealth, and consequently the Australian taxpayers, is on risk when losses from a declared terrorist incident exceed $2.9 billion.

Our analysis indicates that the mixed use buildings in CBD areas are located mostly outside the blast footprints for ARPC’s maximum probable loss scenarios. The only location in Sydney where a mixed use building is within a major loss footprint is at the corner Goulburn and Pitt Streets (Sydney World Trade Centre) where the expected loss increases from $4.5 billion to $6.8 billion. This is materially less than ARPC’s probable maximum loss scenario for Sydney which is just under $9 billion at the corner of Phillip and Bent Streets.

Finity’s view is that the inclusion of mixed use high rise buildings in the scheme would not materially increase the Commonwealth’s exposure in the event of a declared terrorist incident. 22

Appendices

Appendix A: Recommendation from the Terrorism Insurance Act Review 2009

The recommendation from the 2009 review of the need for the Act to continue in operation which is relevant to this report is contained in chapter 3 of the review report. 23 That recommendation is:

That:

  • the ARPC examine the effects of extending the scheme to mixed use high rise buildings that are not predominantly for commercial use, having regard to the need to maintain, to the greatest extent possible, private sector provision of terrorism insurance, and allow the re-emergence of commercial markets for terrorism risk cover;
  • the ARPC consult with relevant stakeholders to examine the issues, collect data and assess the impact of extending the scheme in this way, and have regard to:
    • the availability of commercial terrorism insurance for mixed use high rise buildings that are not covered by an ‘eligible insurance contract’;
    • an appropriate ratio of commercial to residential use in mixed use high rise buildings where residential use is greater than 50 per cent, subject to the availability and quality of data;
    • appropriate measures to determine or assist in determining the ratio of commercial to residential use in mixed use high rise buildings, for example, asset valuations or contributions to strata title levies; and
    • the risk profile of mixed use high rise buildings that are not predominantly for commercial use, including their location, concentration and proximity to buildings covered by an ‘eligible insurance contract’;
  • in assessing the impact of extending the scheme to mixed use high rise buildings that are not predominantly for commercial use, the ARPC examine the likely impacts on policy holders’ insurance premiums, the rate and structure of reinsurance premiums payable to the ARPC, insurers’ retentions, the adequacy and structure of the reserve for claims, the ARPC’s current and future retrocession purchases, the financial risk to the Commonwealth and consequently Australian taxpayers;
  • the ARPC consult with Treasury throughout the process of examining this issue; and
  • the ARPC report to the Minister with findings and recommendations by 30 September 2010.

Appendix B: Consultation with stakeholders

In conducting this enquiry ARPC consulted the following stakeholders:

  • Allens Arthur Robinson
  • Australian Bankers Association
  • Catlin Insurance
  • CGU (including Insurance Australia Group)
  • Chartis Insurance
  • CHU (including QBE Insurance)
  • Chubb Insurance
  • Clayton Utz
  • Finity Consulting Limited
  • Guy Carpenter
  • Insurance Council of Australia
  • Lloyds Australia
  • Munich Reinsurance
  • Property Council of Australia
  • Risk Frontiers
  • Strata Unit Underwriting
  • Swiss Re
  • Willis Re

Appendix C: Report from Finity Consulting Pty Limited

Appendix C is scanned and is only available for viewing in the PDF version:(PDF 8.9MB)

Appendix D: Insurance Council of Australia General Circular No G1573

Appendix D is scanned and is only available for viewing in the PDF version:(PDF 8.9MB)

  1. See Appendix A for the full text of the recommendation relating to mixed use high rise buildings from the 2009 review.
  2. See Appendix B for a full list of stakeholders consulted
  3. See Appendix C for Finity’s actuarial report.
  4. Terrorism Insurance Bill 2002, Revised Explanatory Memorandum, paragraph 3.15, p 6.
  5. Terrorism Insurance Act 2003, subsection 7(1).
  6. Section 3
  7. Regulation 4.
  8. Regulation 5.
  9. Section 3
  10. Terrorism Insurance Bill 2002, Revised Explanatory Memorandum, paragraph 1.8, p 2.
  11. Section 41.
  12. The report may be viewed at http://archive.treasury.gov.au/.
  13. See Appendix A for the full text of the recommendation relating to mixed use high rise buildings from the 2009 review.
  14. The full report may be viewed at http://www.treasury.gov.au/
  15. See Appendix B for a full list of stakeholders consulted for the purposes of this enquiry.
  16. See Appendix C for the full actuarial report.
  17. Appendix C, page 5
  18. Appendix C, pages 9 & 10.
  19. Appendix C, page 12
  20. Appendix C, page 11.
  21. Appendix C, page 13
  22. Appendix C, page 13
  23. Terrorism Insurance Act Review 2009, chapter 3, pp 64 & 65.