Victoria’s Consumer Protection Framework for Building Construction

Tabled: 28 May 2015

4 Domestic building insurance

At a glance

Background

Domestic building insurance (DBI) is mandatory for domestic building works over $16 000. DBI is 'last resort' protection for the consumer because it only protects them when a builder fails to complete works to a satisfactory standard and the builder dies, disappears or becomes insolvent. The withdrawal of private insurers from the DBI market during 2009 and 2010 prompted government to direct the Victorian Managed Insurance Authority (VMIA) to provide DBI from the end of March 2010.

Conclusion

DBI provides only limited protection for consumers, is significantly more costly for builders and consumers than it needs to be and is widely misunderstood. Government intervention in 2010 was effective in addressing risks associated with the withdrawal of insurers from the market, but did not improve the level of protection for consumers and added to the costs of providing the insurance.

Findings

  • There was no comprehensive implementation plan in place before the government intervened in the DBI market in 2010, despite the apparent risks.
  • This led to a higher cost DBI delivery model being put in place that remains nearly five years later due to ongoing uncertainty about VMIA's future role in DBI.
  • Consumers have ultimately borne the additional costs of this model, estimated at around $21 million between July 2011 and July 2015, for little, if any, tangible benefit.
  • VMIA generally manages DBI effectively but should gain greater assurance on their agent's performance.

Recommendations

  • That the Department of Treasury and Finance works with VMIA to review the adequacy and cost of the current DBI scheme and provide advice to government on options to lower premiums and/or enhance coverage for consumers.
  • That VMIA obtains certainty about its ongoing role in DBI provision and implements the most efficient delivery model.
  • That VMIA alters the DBI policy certificate to show the base premium amount.

4.1 Introduction

Domestic building insurance (DBI) forms part of the domestic building consumer protection framework. The Building Act 1993 (the Act) requires building practitioners to have DBI cover when undertaking domestic building works costing over $16 000.

DBI is a 'last resort' consumer protection because it is only available when a builder fails to complete works to a satisfactory standard and has died, disappeared or become insolvent within six years of completion. DBI covers homeowners for:

  • structural defects, for up to six years, and non-structural defects, for up to two years, from the time the home or renovation is completed
  • non-completion of building work—this cover may be limited to 20 per cent of the original contract amount
  • a maximum claim payment of $300 000—this was $200 000 up until July 2014.

DBI schemes and coverage levels in other jurisdictions vary but are almost all 'last resort' in nature. Only Queensland has a 'first resort' scheme where consumers can also make a claim if a builder fails to rectify defects identified in a rectification order from the building regulator.

In Victoria, between the commencement of the DBI scheme in 2002 and 30 June 2014, 5 598 DBI claims were lodged in relation to registered builders and 3 943 of these claims were accepted. The estimated cost of payments to claimants for claims on registered builders in this period was $153.1 million. The average claim cost was around $33 000, with by far the most common trigger for claims being insolvency.

In 2014, the number of DBI policies issued rose to over 60 000 with an average premium cost of around $987. The average premium for DBI reached its lowest point in 2008 and has risen since as most private sector insurers withdrew from the market in 2009 and 2010. Since 2010, the average DBI premium for works undertaken by a registered builder has increased by around 55 per cent. Consumers often pay more than the premium, due to additional charges by brokers and builders.

The government directed the Victorian Managed Insurance Authority (VMIA) to provide DBI from the end of March 2010 following the withdrawal of private insurers from the DBI market. VMIA issues around 95 per cent of cover and is the only insurer of registered builders. The only private insurer offers DBI solely to owner-builders.

4.2 Conclusion

DBI provides only limited protection for consumers, is significantly more costly for builders and consumers than it needs to be, and is widely misunderstood.

Government intervention in 2010 to direct VMIA to provide DBI addressed the risks to the building industry and economy associated with the withdrawal of insurers from the market, but did not improve the level of protection for consumers and added to the costs of providing the insurance.

The model for delivering DBI adopted by VMIA in 2010 was driven by the very short time frame available to implement government's direction. VMIA had to appoint an agent to undertake almost all activities except claims management. While this largely mitigated the risk of implementation failure, it maintained a broker driven delivery model and added further to the cost of DBI for builders and consumers.

VMIA has maintained this higher cost model for almost five years due to ongoing uncertainty about its future role in DBI. While VMIA's actions have been reasonable in the circumstances and it has progressively reduced the commission paid to its agent, this delivery model will have cost consumers an estimated additional $21 million between July 2011 and July 2015 and needs to be addressed.

VMIA needs certainty on its future role in DBI to enable delivery costs to be effectively addressed. An alternative delivery model would enable consumers to benefit from lower premiums and/or better coverage. The Department of Treasury and Finance (DTF) and VMIA need to provide comprehensive advice to government on opportunities to improve the cost efficiency and consumer protection offered by DBI, or any replacement scheme.

4.3 Government intervention in the DBI market

The government decision in March 2010 to intervene in the DBI market addressed a risk that consumers would be left without insurance coverage. However, this decision was not informed by timely or sufficiently comprehensive advice and announcement of the intervention without an implementation plan in place carried significant risks.

DTF had monitored the withdrawal of insurers from the DBI market during 2009 and was aware from November 2009 that the largest insurer would withdraw from July 2010. A better outcome could have been achieved if advice to government and a decision on the preferred intervention approach had been made earlier.

VMIA could not implement the government direction that it provides DBI from the end of March 2010. It did not have the necessary staff, processes and systems in place and it was concerned about its legal capacity to issue DBI policies in its own name. VMIA relied on cooperation from existing DBI insurers and had to appoint an existing insurer as its agent to ensure ongoing availability of DBI cover.

4.3.1 Managing risks in the DBI market

DTF has monitored the DBI market since the late 1990's due to a history of private insurers entering and leaving the market and the risks this created for the availability of what is mandatory insurance. In September 2008, DTF advised the Minister for Finance that there were seven insurers in the DBI market and while it considered the risk of insurers leaving the DBI market as low in the short term, it would be problematic if a major insurer left.

The Essential Services Commission (ESC) reported to government in March 2009 on the performance of Victoria's DBI scheme. The ESC found that DBI insurers had made reasonable profits by industry standards between 2005 and 2008, but the future profitability of the scheme was expected to decline due to increasing claims and the impact of a slowing economy on builder insolvency rates.

Subsequent ESC reports on the DBI scheme indicated that premium discounting between 2006 and 2009 coincided with an increase in claims, resulting in declining DBI profitability. This led to the exit of private insurers from the DBI market. In June 2009, there were five insurers operating in the Victorian DBI market. Two of these insurers, with an estimated combined market share of around 25 per cent, withdrew from the market during July 2009.

DTF advised government of the withdrawal of these insurers in August 2009 and indicated that while the three remaining insurers were willing to take on new builders, they were likely to tighten their eligibility criteria for DBI given the ongoing downturn in financial markets and economic conditions.

The government agreed to the further development of a contingency plan to support the existing market, including proposals to enhance consumer protection. DTF developed a contingency plan during the second half of 2009 and early 2010 in consultation with other relevant government departments and agencies, including VMIA.

The plan examined five options ranging from the introduction of a voluntary insurance model to a model under which government would underwrite and provide the insurance using agents, and manage claims internally. DTF preferred to maintain the 'last resort' nature of DBI and favoured options that minimised avoidable government involvement in the market given the risks associated with DBI.

In early November 2009, the NSW government announced that it was taking over the NSW DBI market from July 2010. DTF was concerned that NSW's decision would prompt remaining insurers to view the Victorian DBI market as commercially unviable and withdraw from it.

In November 2009, VMIA asked DTF to confirm there were no legislative barriers to prevent or impair VMIA's entry into the DBI market. DTF responded that its legal advice was that a Ministerial direction under the Victorian Managed Insurance Authority Act 1996 (the VMIA Act) could be used for VMIA to be either the insurer of 'last resort', or the monopoly insurer with no need for immediate legislative change.

At the same time, VMIA advised DTF that it would not be capable of responding to a direction from government to provide DBI from either December 2009 or January 2010, and that any government announcement needed to allow sufficient time for this capability to be established.

DTF advised the Minister for Finance in late November 2009 that:

  • the largest insurer in the DBI market would be withdrawing from July 2010
  • a government monopoly insurer model could be implemented in the short term without any legislative change, but DTF favoured a staged intervention approach
  • VMIA had advised that it would need several months to establish the necessary infrastructure to step into the DBI market and would need to rely on cooperation and assistance from private insurers for both personnel and systems
  • the continued use of brokers to deliver DBI was an option under a statutory monopoly, but this was arguably unnecessary if there was only one provider in the market.

However, DTF did not provide advice to government on options to ensure the continued availability of DBI until March 2010. This was despite risks to market stability posed by the largest insurer's announced withdrawal, and the significant operational and potential legal issues involved in ensuring a timely and effective response.

4.3.2 Informing the government decision to intervene

In early February 2010, the largest insurer in the Victorian DBI market formally advised the government that it was withdrawing from the market and would cease providing DBI from 1 July 2010. This announcement meant there would be only two insurers left in the DBI market.

The government received advice on this development in March 2010 from:

  • the Ministers for Finance and Planning who recommended that the government intervene to take over the DBI market from 1 July 2010
  • DTF and the Department of Premier and Cabinet that did not support the intervention recommended by the ministers. Instead, both departments recommended a staged intervention model where the state would monitor DBI availability and pricing and consider intervening as an insurer of 'last resort' on a temporary basis if builders could not obtain insurance.

The advice to government from ministers and the departments was focused on addressing an immediate and pressing risk that builders would be unable to access mandatory DBI and therefore would not be able to undertake domestic building work. It outlined the events prompting the need to consider action, the available response options and some associated issues and risks.

The ministers recommended that the government direct VMIA to act as a statutory monopoly provider for DBI on the grounds that this model had the best chance of providing ongoing stability to the DBI market. The recommended model assumed that brokers would be retained and would deal with VMIA as the sole insurer.

The main reasons the departments opposed a statutory monopoly model were that:

  • there was limited evidence of builders being unable to access DBI
  • a statutory monopoly model would remove any scope for competition in the market place and would risk becoming less efficient and innovative
  • the government would have difficulty exiting the market in the future
  • the government may be exposed to legal action from remaining market participants seeking compensation for loss of business
  • the risks involved in providing DBI meant the highest risk builders would be concentrated on VMIA's, and therefore the state's, balance sheet
  • the state may be subject to criticism if VMIA ruled some builders as not eligible for insurance as a result of applying the same standards as commercial insurers
  • there would be potential pressure on government to expand the scope of DBI, resulting in increased risk and costs.

The departments advised that the two insurers remaining in the DBI market had both indicated a willingness to continue to participate but may seek to leverage the situation to gain further support from the state. At the time, the government had a commitment to cover private insurers for losses above $10 million from claims relating to individual builders.

The two departments recommended a staged intervention model on the grounds that this would provide an opportunity for new insurers to enter the market and enable government to monitor the market while reserving the option to take it over.

The government considered the advice and on 22 March 2010 decided that it would intervene to take over the DBI market and implement the statutory monopoly model.

Image of construction site

The advice relied on by government when making this decision was not sufficiently comprehensive. The advice did not adequately highlight the legal, operational and timing issues, and risks associated with the options under consideration. Specifically, the advice did not:

  • comprehensively address legal issues with VMIA's ability to provide DBI
  • adequately reflect advice from VMIA that it would need several months to establish the capability to deliver DBI, and would need to rely on the cooperation and assistance of private insurers for both personnel and systems
  • propose a strategy to mitigate the risk that remaining DBI insurers would withdraw at short notice following announcement of government intervention or make unreasonable demands to secure their continued participation in DBI
  • comprehensively cost intervention options and models because all models and options presented assumed the ongoing use of brokers and did not include payments to an agent required by VMIA to facilitate delivery of the product.

4.3.3 VMIA's establishment of DBI arrangements

There was no comprehensive implementation plan in place before the government announced its intervention in the DBI market.

The Minister for Finance's announcement on 29 March 2010 indicated that the government would introduce a statutory monopoly for DBI provision, and that VMIA would provide DBI on a commercial basis from the end of March 2010 and work with private insurers to ensure their orderly exit from the market.

On 30 March 2010, the Minister for Finance used powers under the VMIA Act to direct VMIA to provide DBI from 31 March 2010—the next day. However, VMIA was not able to provide DBI from that date because it:

  • was not a 'designated insurer' under the Act
  • had not been given sufficient time to put in place the necessary resources, systems and processes to deliver DBI.

The VMIA Act requires the Minister to consult with VMIA before issuing a direction. VMIA advised that there was very limited consultation with it immediately before this direction. Adequate consultation with VMIA could have identified the legal and operational issues constraining its capacity to implement the government decision, before it was announced, and enabled a more strategic response to these issues and a smoother, less costly transition.

Because these issues were not adequately addressed before the government announcement, VMIA had no option but to make arrangements with an existing insurer to ensure the continued availability of DBI.

Initial contact with remaining domestic building insurance insurers

VMIA's inability to immediately step in and take over the DBI market meant the state's intervention approach carried a significant risk if the two remaining insurers decided to withdraw from the market at short notice.

This risk was mitigated by a history of DBI insurers providing reasonable notice of withdrawal and cooperating to facilitate the transition of clients to other insurers. However, the government decision was effectively closing the market and this could have precipitated a less cooperative approach from insurers.

The two remaining DBI insurers wrote to the government on 31 March 2010 advising that they were reconsidering their immediate and ongoing provision of DBI in Victoria, with one indicating that it would suspend DBI operations from 7 April 2010. Both insurers made it clear they knew that VMIA could not immediately step in and take over the entire DBI market.

The insurers offered to continue providing DBI if the government would underwrite all new DBI policies and pay them a commission on premiums of between 44 and 65 per cent. In effect, the insurers were proposing to transfer the risks associated with all new DBI policies to the state for a significant fee that would ultimately be passed on to DBI consumers or taxpayers.

This placed the state in a difficult position because VMIA was not operationally ready to immediately take over the market and had also identified a legal issue with its capacity to offer DBI.

Legal issues with VMIA providing DBI

In November 2009, DTF advised VMIA that there were no legislative barriers to its entry into the DBI market and that a Ministerial direction could be used in the short term for VMIA to be either the insurer of 'last resort' or the statutory monopoly insurer.

VMIA obtained legal advice on implementing the Ministerial direction on 6 April 2010. This advice confirmed that the while the direction gave VMIA authority to provide DBI, VMIA was not a designated insurer under the Act and that any builder relying on DBI provided by VMIA may be committing an offence under that Act. VMIA raised this issue with DTF on the day it received the advice and action was initiated immediately to amend the Act to identify VMIA as a designated insurer.

Advice to government on the proposed amendment indicated that VMIA was entering into a commercial arrangement with one of the existing private designated insurers as a temporary measure to remove the risk of legal challenge to its ability to provide DBI and that this would add considerably to DBI's cost. The government approved the amendment and legislation was passed through Parliament in mid-2010.

VMIA decided that it would not issue DBI policies in its own name until it was confirmed as a designated insurer under the Act. To cover the intervening period, VMIA reached agreement with the major remaining DBI insurer which involved reinsuring the liability for DBI policies issued by that insurer from 31 May 2010 until VMIA was confirmed as a designated insurer in mid-July 2010.

Appointment of existing DBI insurer as VMIA's agent

VMIA's ability to negotiate a commercial arrangement with an existing insurer to implement the government decision was made more difficult because it was seeking to do so after the decision had been publicly announced and there were few insurers remaining in the DBI market:

  • The first and largest insurer in the market would not negotiate given it had previously announced its intention to withdraw from the market.
  • The second and smallest insurer in the market sought a commission of 65 per cent of DBI premiums and a further $340 000 for services to be provided to VMIA.
  • The third insurer sought a commission in the range of 44 to 48 per cent of premiums on the basis that it would pay broker commissions and meet its own operational costs from this commission.

VMIA obtained commercial advice that a commission between 35 and 40 per cent was reasonable and that anything above 50 per cent would be excessive. VMIA announced the appointment of the third insurer as its agent for DBI delivery on 13 May 2010.

The commencement date for the relationship with the agent was 7 May 2010. Under the agreement, the insurer offered DBI in its own name and at its own risk until 30 May 2010, and in its own name but totally underwritten by VMIA, between 31 May 2010 and 16 July 2010. From 17 July 2010 onwards, the insurer acted as VMIA's agent and issued DBI policies in VMIA's name.

The agent manages almost all aspects of DBI provision on VMIA's behalf, including managing the interface with brokers, assessing DBI applications against underwriting criteria and maintaining a system to record details of all DBI policies issued. VMIA directly manages claims and decisions to decline DBI cover.

The initial commission paid to the agent on DBI premiums collected in 2010–11 was 45 per cent. VMIA advised that this was towards the upper end of what was commercially reasonable at the time but reflected what was thought to be the short‑term nature of the arrangement. VMIA subsequently negotiated lower commission rates and succeeded in making part of the agent's commission dependent on meeting agreed key performance indicators from July 2013.

The commission paid to the agent has declined since the establishment of the arrangement in mid-2010 as follows:

  • 45 per cent from 31 May 2010 to 31 October 2010
  • 42.5 per cent from 1 November 2010 until 30 June 2011
  • 38 per cent from 1 July 2011 to 30 June 2013
  • a maximum of 32.5 per cent from 1 July 2013, comprising base commission of 22.5 per cent with access to up to a further 10 per cent if all key performance indicators are met.

Payments to the agent between mid-2010 and 31 December 2014 totalled over $80 million, including GST. Assuming a broker commission rate of 15 per cent of premiums collected, the agent paid broker commissions of around $30 million from this amount.

VMIA achieved a reasonable outcome in difficult circumstances. By appointing an agent to provide DBI, VMIA accessed the agent's established systems and processes and largely mitigated the risk of failing to implement the government direction. However, VMIA was required to provide DBI on a break-even basis and the need to introduce another intermediary added to the costs to DBI consumers. These costs could have been at least partly avoided with earlier and more comprehensive advice, and a more strategic approach to the government's intervention.

In June 2010, DTF provided evidence to the Legislative Council's Standing Committee on Finance and Public Administration's Inquiry into Builders Warranty Insurance that the arrangements established for DBI had been designed to ensure that it would be available at 'the least cost that it should be available for'. This advice to the committee appears to have been inconsistent with DTF's knowledge at the time that VMIA's use of an agent would add to the costs of DBI.

4.4 DBI delivery model and costs

Consumers ultimately pay for DBI, as the premium and any related costs are passed on by builders. The amount consumers pay partly depends on how many intermediaries are involved in the delivery model.

The DBI delivery model established by VMIA in mid-2010 retained brokers and added to delivery costs because the agent was an additional intermediary. While this model was intended to be temporary, it has been retained for nearly five years as government has considered reforms to the framework for domestic building consumer protection.

We estimate that this DBI delivery model will have cost an additional $21 million between July 2011 and July 2015 compared to a model where VMIA might insource DBI delivery and dispense with brokers and an agent. These costs have been passed on to consumers through higher DBI premiums for little, if any, tangible benefit. An alternative lower cost DBI delivery model, such as VMIA directly providing DBI without brokers or agents, could have delivered the same benefits to builders and consumers, including improved stability and claim handling times.

Appointment of the agent was largely unavoidable. However, the need to retain brokers beyond an initial transition period was questionable because DBI is a mandatory product with standard cover and there was to be only one provider of insurance. In a typical competitive insurance market with a variety of insurers and products on offer brokers have a role acting for their clients by providing advice and sourcing lower cost, or better cover.

This audit has established that the two largest DBI brokers are associated with the two major building industry associations, the Master Builders Association of Victoria and the Housing Industry Association. The Legislative Council's Standing Committee on Finance and Public Administration's October 2010 report on its Inquiry into Builders Warranty Insurance recommended that government and VMIA review the role of insurance brokers under Victoria's new DBI arrangements. The government did not formally respond to the committee's recommendations. In early 2011, around 50 per cent of brokerage commissions were being paid to these two entities.

The cost of DBI to consumers can also include fees imposed by brokers and/or builders over and above the premium charged by VMIA. These fees are not transparently disclosed to consumers or subject to scrutiny by VMIA or the ESC.

VMIA has provided advice to DTF and the Minister for Finance on a number of occasions since late 2010 on the additional costs of the DBI delivery model and the capacity to eliminate commissions by eliminating brokers and the agent. However, the interim model has been retained due to ongoing uncertainty about VMIA's future role in providing DBI.

This uncertainty has constrained VMIA from investing in the internal capability needed to deliver DBI without an agent and/or brokers. While this was understandable, it is a lost opportunity to generate savings and pass the benefits on to consumers in the form of lower premiums and/or enhanced cover.

DTF advised that changes in government and the consequent changes in policy direction have meant that reform efforts have prioritised redesign of the domestic building consumer protection framework ahead of making arrangements for the delivery of DBI more efficient and cost effective.

DTF advised that it and VMIA are currently examining ways to reduce the costs of DBI. However, VMIA requires certainty about its continued involvement in the provision of DBI to enable it to more cost-effectively deliver DBI.

4.4.1 Analysis and advice on the DBI delivery model

VMIA advised its board in October 2010 that the interim DBI delivery model involved high distribution costs and was significantly more expensive than if VMIA eliminated agents and brokers and dealt directly with builders. VMIA's modelling showed the total cost of maintaining the interim arrangement for 2011–12 was around $11 million higher than a model with no agent or brokers.

The board was advised that the optimal pricing and distribution model for DBI involved a single agency dealing direct with builders to eliminate or substantially reduce commissions and loadings. VMIA identified that this model would deliver improved outcomes for consumers through lower premiums and/or increased access to cover.

VMIA advised DTF in December 2010 that one of the risks of delaying the statutory monopoly for DBI provision was that commission and transaction costs paid by consumers and builders, which could be reduced or eliminated under a statutory monopoly, would continue to be incurred.

The optimum DBI delivery model identified by VMIA was not implemented as there was a change in government in late 2010 and a decision was made by the new government not to implement the statutory monopoly model while broader reforms to the domestic building consumer protection framework were considered.

DTF advice to the Minister for Finance in March 2011 on deferral of the statutory monopoly model and VMIA's decision to increase DBI premiums from 1 July 2011 did not provide information on the additional costs associated with the interim arrangement for DBI delivery, or the relative costs of alternative DBI delivery models.

Advice on DBI delivery costs in 2012

In March 2012 the Minister for Finance requested advice on options that could reduce DBI agent fees within the current model but not undermine the broader reform possibilities under consideration at the time.

DTF advised that given ongoing consideration of reforms, temporarily retaining current arrangements with VMIA using a single agent but seeking to negotiate a lower commission when rolling over the agreement with the agent was the best option. DTF preferred this approach due to the uncertainty, complexity, cost and risks of alternative options and because it had no financial impact on the state and was unlikely to draw criticism from building industry associations.

The DTF advice indicated that a DBI delivery model where VMIA offered DBI direct to builders, with no agent or broker involvement would:

  • remove the 38 per cent commission currently paid and streamline DBI oversight
  • involve once-off start-up costs of around $4.6 million and an increase in VMIA's ongoing annual costs estimated at $8.8 million
  • translate into a decrease of 17 per cent for the average premium, based on the net savings under this model and recouping the start-up costs over two years.

DTF also advised the minister that in addition to the DBI premium, the cost of insurance for consumers is inflated by additional costs, such as extra fees charged by brokers direct to builders to arrange coverage, plus builders' own insurance surcharges—often around 10 per cent. DTF advised that these charges can inflate a DBI premium of $850 into an end cost to the consumer of around $1 200.

These additional fees imposed by brokers and/or builders are not subject to scrutiny by VMIA or the ESC and are not transparently disclosed to consumers. The ESC monitors the DBI market and reviews the validity of VMIA's premiums but its work does not extend to providing information on the full costs of DBI to builders and consumers. No agency monitors the total costs of the insurance scheme.

Advice on DBI delivery costs in 2013

In February 2013, VMIA again highlighted the potential to significantly reduce the costs of the DBI scheme by removing agents and brokers, in advice provided to DTF and the Minister for Finance. After considering this issue, VMIA opted to retain the existing DBI delivery model given the ongoing uncertainty around proposed reforms.

In May 2013, the ESC raised VMIA's pricing of DBI with the Minister for Finance. The ESC noted that while VMIA's arrangement with the agent was reasonable in the circumstances, there was scope for savings under other delivery models.

In May 2013, the government released the Domestic Building Consumer Protection Reform Strategy which committed to broadening the triggers for accessing DBI beyond the existing narrow triggers and which stated that the insurance would continue to be provided by an open market, with VMIA remaining in the market to avoid supply problems.

In June 2013, DTF responded to a request from the Minister for Finance for advice on the advantages and disadvantages of terminating the agency arrangement for DBI delivery and having VMIA bring DBI operations in-house. DTF's advice clearly acknowledged that eliminating intermediaries would significantly reduce the costs of DBI and provide VMIA with more control over its delivery. Despite this, DTF recommended that the status quo be maintained until 1 July 2015 to provide sufficient time for VMIA to implement the new DBI arrangements outlined in the government's reform strategy. While this advice was appropriate in the circumstances, it meant retention of the higher-cost delivery model.

In July and September 2013, DTF provided advice to government on a proposal to replace the DBI scheme component of the previously announced reform strategy with a domestic building consumer protection fund to be administered by the Victorian Building Authority (VBA). DTF's advice indicated that an advantage of this proposal was that it would avoid the broker and agent costs under the current scheme.

In April 2014, the government announced the new approach to DBI delivery. This involved introducing a domestic building consumer protection fund to be managed by VBA. This fund was to replace DBI which was to be phased out by 30 June 2015. This reform was not progressed in 2014.

4.4.2 Possible savings under different delivery models

VMIA could have delivered DBI for less than the costs incurred under the delivery model established in 2010.

In October 2010, VMIA estimated that the total cost of the interim DBI delivery model in 2011–12 was likely to be around $11 million higher than a model with no agents or brokers, based on premium income of $40 million. However, this estimate did not include an allowance for the significant start-up costs that would have been incurred for VMIA to deliver DBI totally in-house.

Figure 4A shows the estimated costs for the two DBI delivery models between 1 July 2011 and 30 June 2015. The first is the current model, involving brokers and an agent assisting VMIA. The second model does not involve any intermediaries and assumes VMIA deals directly with builders. This was identified as the optimum delivery model by VMIA in late 2010.

Figure 4A
DBI delivery costs and potential savings ($ millions)

Distribution model

2011–12

2012–13

2013–14

2014–15

Total

Current model

Payments to intermediaries

16.3

17.4

16.7

19.6

70.0

VMIA expenses

2.0

2.0

3.1

3.5

10.6

Delivery costs (before claims)

18.3

19.4

19.8

23.1

80.6

Model without intermediaries

Payments to intermediaries

VMIA start-up costs

13.2

N/A

N/A

N/A

13.2

VMIA annual operating costs

11.0

11.3

11.6

11.9

45.8

Delivery costs (before claims)

24.2

11.3

11.6

11.9

59.0

Savings with no intermediaries

-5.9

8.1

8.2

11.2

21.6

Source: Victorian Auditor-General's Office based on information from VMIA.

Implementation of the lower cost model from 1 July 2011 would have resulted in an estimated saving of around $21 million to 30 June 2015. The savings foregone by not adopting a lower cost delivery model could have benefited consumers through lower DBI premiums or enhanced cover. The current DBI delivery model will be in place until at least the end of 2015.

4.5 VMIA's management of DBI

VMIA is managing its responsibilities for providing DBI robustly. It has:

  • established adequate DBI governance, management and staffing arrangements
  • recognised DBI in strategic planning and priority setting for the organisation
  • put in place management information and performance measurement systems
  • successfully reduced the commission payable to its agent and linked part of this commission to performance
  • significantly reduced the average time taken to manage DBI claims to completion
  • communicated with stakeholders—including DTF, the ESC, Consumer Affairs Victoria, VBA and the Building Practitioners Board.

While VMIA's processes for the day-to-day management of the DBI agency arrangement are robust, it could improve the indicators used to measure the agent's performance and could improve the level of assurance obtained on the adequacy of the agent's systems and performance.

4.5.1 Implementation actions

The government direction in March 2010 put VMIA in a position where it had to maintain DBI cover for more than 15 000 builders who had been assessed and accepted by private insurers, as well as assessing new applications for DBI cover.

VMIA moved to establish the governance, management and staffing arrangements required to implement the government decision. It:

  • assigned responsibility for implementation to senior officers
  • established a steering committee including representatives from DTF
  • obtained legal, actuarial and other relevant advice to inform its actions
  • negotiated an agreement with an existing DBI insurer to quickly access established systems and processes
  • obtained communications advice and developed a stakeholder engagement plan
  • communicated with stakeholders including insurers, industry bodies and brokers and developed a website to provide information to builders and consumers
  • engaged or reassigned staff to deliver DBI
  • investigated and established appropriate ICT systems and capability.

The government provided VMIA with start-up funding of $3.6 million and a capital contribution of $13.9 million to support its implementation of the direction to provide DBI. This funding contribution was set out in an agreement between DTF and VMIA in mid-2011. The start-up funding was fully repaid by the end of 2013. The capital contribution is only repayable if VMIA's DBI arrangements are wound up.

Initial assessment of builders

A builder cannot be registered as a building practitioner under the Act without showing proof of eligibility for insurance. The insurer typically sets a turnover limit when granting eligibility for insurance which limits how much a builder can trade.

The government direction presented a range of challenges because VMIA needed to obtain the relevant information and records of all builders eligible for DBI cover at the time of the direction and was exposed to risks for those builders it had not assessed.

Of the initial 15 000 builders, VMIA's agent had around 4 480 active builders on its DBI policy book at the end of May 2010. Records relating to the remaining builders were transferred from other insurers to the agent during 2010.

Recognising these issues, VMIA initiated:

  • integrity checks on data transferred from private insurers on builders—this identified inaccuracies in records for around 10 per cent of builders
  • a financial and solvency assessment on all builders
  • an actuarial review of the DBI market to assess risk and premium adequacy
  • a program of builder underwriting reviews by its agent to ensure that builders were accurately risk rated and classified for premium purposes.
Assessment of premium adequacy

When VMIA entered the DBI market in mid-2010 the average premium was around $636. Average DBI premiums have risen since the withdrawal of most private sector insurers in 2009. The average premium for a registered builder has increased by around 55 per cent since 2010.

The most recent ESC report on the performance of DBI indicates that average premiums reached their lowest point in 2008 due to strong competition between insurers. The ESC noted that a lack of information about DBI claim costs could have driven premiums below cost-reflective levels at that time.

VMIA initially adopted the premium rates used by its agent and was instructed to keep premiums fixed for 12 months from June 2010. It was also directed to provide DBI on a break-even basis and has regularly assessed the adequacy of premiums to meet the long-term costs of the scheme.

VMIA's initial actuarial advice in 2010 indicated that the DBI scheme was 15 to 20 per cent underpriced, meaning premiums were lower than required to meet expected future claims costs. This work also identified a practice where some high‑volume builders were only paying around 50 per cent of the applicable premium under discount arrangements with insurers. VMIA addressed the inequities in premium levels in 2011 by eliminating premium discounts.

VMIA increased DBI premiums in July 2011 and July 2013 to match the costs of providing DBI, including the emerging and expected future DBI claims costs identified by actuarial assessments. Figure 4B shows average premiums for registered builders from 2005–06 to 2013–14. Higher than necessary DBI distribution costs have contributed to, but are not the predominant cause of, increased premiums since 2010.

Figure 4B
Average DBI premiums for registered builders

Figure 4B shows average premiums for registered builders from 2005–06 to 2013–14

Source: Victorian Auditor-General's Office based on information from the ESC.

The Minister for Finance instructed the ESC to review the adequacy and validity of VMIA's DBI premiums every two years. The initial review was finalised in May 2013 and found that VMIA's premiums were sufficient for it to break even on DBI business and were not excessive.

The most recent ESC review of VMIA's DBI premiums was released in April 2015 and concluded that the average premiums for 2012–13 and 2013–14 and VMIA's approach to DBI underwriting were reasonable. The review also concluded that VMIA's decision to increase the capital charge applied to the 2013–14 premiums means that capital to support the DBI portfolio will be collected faster than it was previously. This was prudent given the uncertainty surrounding the duration for which VMIA would be underwriting DBI and the 'long-tail' nature of the product—where the full cost of claims is not known for several years after the policy is issued.

Consideration of alternative delivery models

VMIA's mandate from government in 2010 was to implement a statutory monopoly for DBI. This changed in early 2011 under a new government which decided not to close the DBI market while broader consumer protection reforms were considered.

Recognising the high cost of the operating arrangement established in 2010, VMIA has periodically examined a range of different delivery models. This analysis has identified that other delivery models would have benefits including lower operating costs. However, VMIA has determined not to implement an alternative model given the ongoing uncertainty about its ongoing role in the DBI market.

4.5.2 Management of DBI agent

VMIA negotiated an agreement with an existing DBI insurer in mid-2010 to enable it to implement the government direction to provide DBI.

The agent manages almost all aspects of the provision of DBI on VMIA's behalf including the interface with brokers, assessing applications for DBI against underwriting criteria and periodically reviewing the financial strength of builders. The agent maintains an IT system which records details of all DBI policies issued. The VMIA manages claims and decisions to decline DBI cover directly.

VMIA has been generally effective in managing the agent appointed to support delivery of its DBI responsibilities. It has established:

  • access and reporting requirements and arrangements
  • monitoring and review mechanisms and processes
  • payment approval mechanisms.

Opportunities for improvement include broadening the indicators used to measure its agent's performance and improving the level of assurance obtained on the adequacy of its systems and performance.

Agreements with DBI agent

VMIA's relationship with the agent commenced in May 2010 and it entered into an initial Heads of Agreement in June 2010. A more detailed service-level agreement was subsequently established to specify operational details including service response times and reporting and quality assurance requirements.

The initial agreements did not include any performance indicators to measure how effectively and efficiently the agent performed its obligations. As a result, its remuneration was not linked to its performance. The initial agreement expired on 30 June 2013. A new agreement was negotiated and commenced on 1 July 2013.

In negotiating the new agreement VMIA was successful in reducing the commission payable to the agent from 38 per cent to a maximum of 32.5 per cent per month. Under the new agreement the base commission was reduced to 22.5 per cent and the agent is entitled to additional commission of up to 10 per cent, depending on its performance against a set of indicators.

These performance indicators relate to the completeness and timeliness of the agents performance of its responsibilities and reporting on these to VMIA. The indicators could be improved by introducing some dealing with the quality of performance in key areas such as assessing the financial strength of applicants for DBI eligibility, given that insolvency is by far the most common trigger for DBI claims.

VMIA's decision not to invite tenders for the agent role in the lead up to the expiry of the initial agreement was reasonable given the uncertainty around the reform process.

Adequacy of assurance obtained on agent performance

VMIA demonstrated active and robust engagement and oversight of the agent. Regular monitoring activity includes:

  • weekly analysis of data sourced direct from the agent's DBI system on eligibilities, insurance certificates and policies and amendments
  • examination of the results of reviews undertaken by the agent on the performance of brokers and the status of builders against the underwriting criteria
  • weekly meetings with the agent to discuss performance and address issues arising from VMIA's review and analysis of the agent's data and other information.

This regular monitoring enables VMIA to maintain a strong position in directing the agent on delivery of its obligations under the agreement.

The agent is also required to provide an annual attestation that it has established and maintained adequate controls over the ICT and other systems used to discharge its obligations to VMIA. This attestation is required to be complemented by an audit on whether relevant controls have operated as intended. The agent's attestations and audits have consistently confirmed adequate controls.

VMIA agreed to allow the agent to use its internal auditors to undertake these annual audits. This was initially agreed because the agent had insufficient time to appoint an external auditor. The internal auditor provides a detailed schedule on controls addressed and work performed but does not provide an audit opinion.

VMIA could enhance the level of assurance gained on the agent's performance by seeking its agreement to appoint an external auditor to perform and provide an opinion on this work. VMIA could also exercise its other rights under the agreement to directly review the agent's performance.

4.5.3 Assessment of applications for DBI

VMIA's mandate is to provide DBI on commercial terms. It assesses applications from builders for DBI cover eligibility using underwriting criteria which examine the level of risk posed by the applicant in terms of future claims.

VMIA's underwriting activity has significant implications for builders because DBI is mandatory for building projects above the threshold and builders have to demonstrate eligibility for DBI when seeking registration with the Building Practitioners Board. Inability to obtain DBI effectively means a builder cannot operate in Victoria if undertaking works valued over $16 000. VMIA was the only insurer offering DBI to registered builders in Victoria from 1 January 2014.

In 2010 VMIA was directed to provide cover to all builders who held eligibility for DBI with existing insurers. This was done and VMIA progressively undertook financial and solvency assessments on builders transferred from other insurers. VMIA initially adopted the underwriting criteria used by its agent and has subsequently reviewed and changed the criteria in consultation with the agent. The agent undertakes underwriting assessments against the criteria and VMIA monitors how the criteria are applied.

The underwriting criteria are focused on financial strength and risk because the vast majority of DBI claims are triggered by builder insolvency. As part of the underwriting process builders are assigned risk ratings which impact on the premiums they pay. VMIA also assigns an annual turnover limit on builders which puts an upper limit on the value of contracts the builder can enter into, in order to limit VMIA's exposure to claims if a builder becomes insolvent.

VMIA may also impose security and/or indemnity conditions on builder DBI eligibilities. The percentage of builders with conditions attached fell from over 30 per cent prior to VMIA's involvement to around 6 per cent in the September 2010 quarter.

Declined applications

A decision by VMIA to decline eligibility for DBI to a builder has significant implications for the builder's capacity to be registered and trade. VMIA has established a robust process for declining access to DBI.

The Ministerial direction to VMIA in March 2010 provided for builders issued with an eligibility certificate in the previous 15 months to be provided with automatic cover by VMIA for at least 12 months. VMIA did not decline an application for DBI insurance until December 2011, around 19 months after it stepped into the DBI market.

While not declining an application for DBI in the 19-month period to December 2011, VMIA did withdraw cover from some builders with pre-existing eligibility for DBI coverage between 1 June 2011 and 30 November 2011 as a result of financial assessments of these builders.

Figure 4C shows the number of applications declined for the financial years 2010–11 to 2013–14. There was a steady increase in these numbers between 2010–11 and 2013–14.

Figure 4C
Declined applications, 2010–11 to 2013–14

Figure 4C shows the number of applications declined for the financial years 2010–11 to 2013–14

Source: Victorian Auditor-General's Office based on information from VMIA.

The most common reasons for VMIA declining a builder's eligibility for DBI are an adverse assessment of their financial position or the existence of an adverse corporate or disciplinary history.

There is no reliable data available on the number of applications declined prior to VMIA stepping into the DBI market in mid-2010. However, it was likely to have been lower than present given the capacity at that time of builders to approach a number of insurers to gain cover. Insurers did not share information on rejected applications for DBI and the ESC did not collect this information.

VMIA's internal auditor reviewed the design and operation of the processes in place around declining DBI applications in 2012–13 and found a strong control environment. We reviewed a sample of decisions where an application was declined and found that the process is consistently applied.

4.5.4 Claims management

VMIA undertakes claims management directly and has established a process and supporting procedures to guide this activity. It has significantly reduced the average time taken to manage a claim through to completion compared to other insurers.

The claims management process involves establishing whether the builder has died, disappeared or become insolvent and, if so, assessing whether the claimed defects or non-completion meet the time limits and exist. Where a claim is accepted the insurer obtains quotes to inform the claim payment. For non-completion of building work, the cover may be limited to 20 per cent of the original contract amount and the maximum payment for all claims is $300 000.

DBI is known as 'long-tail' insurance because the full cost of claims is not known for several years after the policy is issued. This is different to most consumer insurance products where the policy is renewed on an annual basis and the insurer will know its full claims liability with a high degree of certainty shortly after the anniversary date.

The long-tail nature of DBI cover means it is difficult to assess whether there have been changes in insurance claims history and management since VMIA's involvement from 2010. However, the available information suggests the following:

  • The timeliness of claims management has improved since VMIA's involvement—the average time between receiving a notification and a claim being finalised across all insurers since the DBI scheme began in 2002 was 345 days at June 2014. This was a significant improvement since 2012 when the average claim handling time was 545 days. VMIA's timeliness is better than the average across all insurers, with an average claims handling time of 129 days for 2013–14.
  • Builder insolvency continues to be by far the most significant reason for DBI claims—with this being the trigger for around 94 per cent of successful claims.
  • While DBI claims are relatively infrequent, there are signs that the number of claims is increasing—5 598 claims in relation to registered builders have been lodged and 3 943, or around 70 per cent, of these have been accepted since the DBI scheme commenced in 2002.
  • The most common reasons for denying claims are that the insurer does not accept that the reported fault is a defect or that the builder is insolvent.

There are opportunities to further improve the timeliness of claims handling and the level of consumer understanding of DBI claim triggers.

Claims data

The ESC has examined and publicly reported on the pricing and performance of DBI since 2009 under terms of reference from the Minister for Finance. The ESC collects quarterly data from relevant insurers and relies on these insurers providing accurate information because the data is not audited. While a number of insurers no longer offer DBI cover, they are responsible for managing claims on policies they have issued.

Figure 4D shows information from ESC reports on DBI policies, premiums and claims between 2002 and 2014. The ESC data assigns the number of claims and their costs to the year in which the DBI policy was issued. This enables an assessment of the insurers' loss on policies issued each year but the long-tail nature of the DBI scheme means that it is difficult to gain a complete understanding of this until at least six years after the policy issue date. This is why claims costs in Figure 4D for recent years are much lower than earlier years.

Figure 4D
DBI premium and claims 2002–14

Year

Number of DBI policies

Premium(a) ($'000)

Number of claims(b)

Net claims costs(c) ($'000)

Excess of premiums over claims costs

($'000)

2002

17 731

10 661

160

4 839

5 822

2003

40 305

27 521

402

12 043

15 478

2004

34 720

27 536

359

17 742

9 794

2005

46 975

31 986

549

18 661

13 325

2006

53 142

32 119

575

19 284

12 835

2007

54 690

30 574

772

20 320

10 254

2008

53 113

27 650

606

22 573

5 077

2009

61 555

34 251

519

25 332

8 919

2010

65 101

41 881

640

23 511

18 370

2011

61 355

44 330

562

15 316

29 014

2012

57 703

46 678

320

9 572

37 106

2013

61 219

54 925

129

3 472

51 453

2014 Jan-June

32 449

32 000

5

19

31 981

(a) This only shows premium charges. Additional fees or charges imposed by brokers and/or builders are not included. From mid-2010 onwards the premium charged by VMIA includes the commission payable to its agent from which the agent pays brokers.
(b) These claim numbers are for registered builders only. There have been a total of 377 claims in relation to owner-builders since 2002.
(c) Net claims costs include amounts paid to successful claimants and other costs associated with managing claims.
Note: This data covers both registered builders and owner-builders. The ESC assigns number of claims and net claims costs to the year the DBI policy was issued.
Source: Victorian Auditor-General's Office based on information from the ESC.

The expected cost of payments to claimants in relation to claims on registered builders between 2002 and 30 June 2014 was $153.1 million at 30 June 2014, with the average cost per claim of around $33 000.

Figure 4D shows a significant excess of premium income over claims costs. However, the long-tail nature of DBI explains this:

  • For the years up to 2006 the insurers' overall profit or loss on DBI can be determined with reasonable certainty because the period for lodging a claim can be assumed to have past for the vast majority of policies. The data shows that in the years 2002 to 2006 inclusive, insurers collected $57.2 million more in premiums than was paid out in claims. This amount would have been used to pay expenses including underwriting costs, broker commissions and claims handling costs.
  • For 2007 and beyond, the significant excess of premium income over claims costs will be reduced over time as claims are made and processed.

4.6 The case for broader DBI reforms

Since 2008, successive governments and stakeholders alike have widely accepted the need for broader review and reform of the level of consumer protection provided by DBI. Despite this, the insurance remains essentially unchanged while there continues to be consumer misunderstanding of the product and a lack of transparency about its costs.

DTF and VMIA need to provide comprehensive advice to government on options to improve the adequacy and cost-efficiency of the DBI scheme.

Progress on DBI improvements and reforms

Government intervention in the DBI market in 2010 enabled insurance to continue to be available but did not improve consumer protection because it did not change the limited, 'last resort', triggers for making a claim. Government intervention simply changed the underwriter, or bearer of risk, for DBI from the private sector to the state.

The Minister for Finance announced in March 2010 that while consumer protection under DBI would not be immediately enhanced, the government would discuss potential improvements to the level of protection offered to consumers with VMIA. Work commenced in early 2011 on developing reform options for the broader domestic building consumer protection framework, including DBI.

Potential improvements to DBI and details of consideration and action on them include:

  • Expanding the triggers for making a claim—the DBI scheme has been 'last resort' since 2002. The triggers for making a claim are limited to the death, disappearance or insolvency of the builder. Expanded triggers proposed by the previous government were not progressed.
  • Increasing the threshold for mandatory DBI and the maximum available payout—from 1 July 2014, the threshold for mandatory DBI was increased from $12 000 to $16 000 and the maximum cover from $200 000 to $300 000.
  • Replace DBI with a consumer protection fund—the previous government's proposed reforms included a proposal to replace DBI with a domestic building consumer protection fund to be administered by VBA. This reform was not progressed.
  • Improve consumer information and advice on the nature of DBI—VMIA identified a lack of consumer understanding of the DBI product early on in its involvement and has introduced a range of information materials to enhance consumer knowledge. This information is useful and readily accessible from VMIA's website for DBI.
  • Introduce a DBI policy database—this could act as a one-stop shop for home owners wanting information on their policy and the scheme in general. This database was initially suggested by the ESC in March 2009. The government approved implementation of a DBI policy database in August 2009. The database has not been established despite almost six years passing. VMIA advised that it is planning on implementing a DBI policy database during 2015.
Transparency of DBI costs to consumers

The cost of DBI to consumers can also include fees over and above the premium charged by VMIA. These additional fees may be imposed by brokers and/or builders but are not subject to scrutiny by VMIA or the ESC and are not transparently disclosed to consumers.

The ESC monitors the DBI market and reviews the validity of VMIA's premiums, but its work does not extend to providing information on the full costs of DBI to builders and consumers. No agency monitors the total costs of the insurance scheme.

DTF advice indicates that the final cost includes additional broker and other fees, which can range from 30 to 50 per cent on top of VMIA's base DBI premium. VMIA publishes its premium rates, but the actual premium charged is not currently disclosed on the DBI insurance certificate and is not usually separately disclosed in building contracts. This means that consumers have no way of identifying the extent of additional charges by brokers and/or builders.

This issue could be addressed without the need for legislative change.

Improvements requiring consideration

Opportunities to improve the delivery of, and consumer protection offered by, DBI or any replacement scheme should be considered as part of deliberations on future reforms and should address the following issues:

  • the most cost-efficient delivery model for DBI or any replacement scheme
  • expanding the triggers for making a claim beyond the current 'last resort' triggers
  • further improving consumer understanding of the nature and limitations of DBI, or any replacement scheme
  • providing consumers with more transparent information on the DBI premium cost for their building project.

DTF, with support from VMIA, needs to develop comprehensive advice including robust option analysis and costings to support government deliberations on these issues.

Recommendations

That the Department of Treasury and Finance:

  1. works with the Victorian Managed Insurance Authority to review the adequacy and cost of the current domestic building insurance scheme and provide advice to government on options to lower premiums and/or enhance coverage for consumers.

That the Victorian Managed Insurance Authority:

  1. obtains certainty about its ongoing role in domestic building insurance provision and implements the most efficient delivery model
  2. alters the domestic building insurance policy certificate to show the base premium amount
  3. enhances the performance indicators and level of assurance gained on its agent's performance.

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