Soaring home and contents insurance premiums are a “blind spot” for banks, exposing mortgage lenders to hundreds of millions of dollars in risk, S&P Global Ratings says.

The ratings agency warns underinsurance could lead to about $200 million of credit losses for the banking sector after a major natural disaster.

Banks have limited ability to ensure borrowers stay insured, as required by the terms of their loans, it adds.

“Coverage gaps have not in the past been a source of credit losses for banks, but this could change,” S&P says in a report called Australia's Home Underinsurance Could Spread Risks.

“Australian banks don’t closely monitor whether their customers have the right levels of property insurance. This could become a blind spot, in our view.

“If a catastrophe event caused property damage to a whole town, suburb or city that was underinsured, credit losses could be sizable and, in general, widening insurance gaps will exacerbate these types of fat-tail risks.”

The Actuaries Institute estimates 15% of Australian households – or 1.61 million – experienced affordability stress around home and contents cover as of March last year. About one-third of them have a mortgage.

“We expect a good proportion of these households to lower or drop insurance cover. For example, flood cover,” the report says.

S&P analyst Angela Zhou says higher premiums accurately reflect risks but may stifle new policy growth and lead to worse underinsurance.

“Australian insurers will likely keep raising home and contents premiums to improve margins and cover higher weather-related claims,” she said.

“We think Australian homeowners could reduce or discontinue their insurance coverage to meet other necessary spending obligations. Underinsurance is especially likely in higher-risk locales, where insurance costs are multiple times higher.”  

S&P says the Australian property and casualty insurance sector’s operating performance will remain strong, with returns on equity staying at 10%-15%, underpinned by good risk selection and pricing trends that support profitability.

Australia has no avenues or agreements for information to be shared between banks and insurers, and banks cannot verify if a homeowner holds adequate cover without a direct request to them.  

Ms Zhou says the federal government may choose to aid in underwriting or guaranteeing coverage, but such schemes can create “a false sense of protection”.  

“Deviating from risk-based pricing masks the underlying risks of living in a high-risk location,” she said. “The international evidence suggests that over the long run, government insurers of last resort may add to moral hazard by subsidising homeowners in high-risk areas and leaving taxpayers (rather than policyholders) to foot the bill after a disaster.”

S&P analysts will discuss the implications of Australia’s widening home insurance gap at a webinar on Wednesday. Register here.