Part 4: Local authority exposure to liabilities from leaky home claims
Summary
4.1
Provisions amounting to $201.1 million have been included in the 2008/09 financial statements of the six local authorities most significantly affected by the leaky homes issue. This is an increase of $33.2 million, or 20%, on the amount disclosed a year earlier.
4.2
The six most affected local authorities are getting better at reporting their leaky home liabilities. We are continuing to see small improvements that indicate an overall refinement in the information that local authorities disclose, and in the information on which the disclosures have been based. However, the uncertainties associated with assessing the future liabilities for leaky home claims remain high.
4.3
Overall, the amount that these six local authorities have disclosed as contingent liabilities in their 2008/09 financial statements – $378.2 million – has decreased from last year. This has led to increased provisions recognised in the financial statements. It is clear that leaky home liabilities remain a significant issue for these six local authorities in particular, and for the local government sector as a whole.
4.4
It is important to note that the amounts disclosed as provisions ($201.1 million) and as contingent liabilities ($378.2 million) are not the complete future liability for these six local authorities, because three of them have still not quantified and disclosed in their financial statements an estimate for claims yet to be made. The extent of liability recognised by the local authorities is already significant. The full extent of the liability for the local government sector is potentially much greater.
4.5
The situation is now worse because RiskPool50 no longer provides insurance cover for this type of claim. From June 2009, no insurance companies are providing cover to local authorities for their leaky home liabilities. Insurance cover had been progressively reducing during the last three years. The lack of any cover adds to the significance and financial effect of the leaky homes issue for the sector.
Background
4.6
In 2007, we considered the annual reporting requirements of local authorities in accounting for liabilities from leaky home claims. We issued guidance to our auditors to help them assess leaky home liabilities for each stage of the claims process. The principles included in our guidance were given to local authorities by their appointed auditor.
4.7
In our reports, Local government: Results of the 2006/07 audits51 and Local government: Results of the 2007/08 audits,52 we considered the disclosures made by the six most significantly affected local authorities and assessed how well their disclosures were aligned with the guidance we had issued. Here, we update our findings from the disclosures included in the 2008/09 financial statements.
4.8
In 2007, when we started monitoring the leaky home liability issue, the six most significantly affected local authorities were Auckland City Council, Christchurch City Council, North Shore City Council, Rodney District Council, Waitakere City Council, and Wellington City Council. Four of these local authorities will be incorporated within the boundaries of the new Auckland "super city".
4.9
Manukau City Council and Tauranga City Council now also face a high level of claims.53 Other local authorities have some claims against them, but the number and value of these claims is much lower. However, to compare disclosures with our previous years of analysis, we have reviewed the same six local authorities we originally identified in 2007.
4.10
If we included Manukau City Council and Tauranga City Council, this would add $1.1 million to the total amount accounted for as provisions by the six local authorities that we focus on here. In their 2008/09 financial statements, neither Manukau City Council nor Tauranga City Council accounted for future liabilities from leaky homes, either as provisions or as quantified contingent liabilities.
Provisions and contingent liabilities
4.11
Simply put, in the interests of transparent reporting and accountability, there is an important difference between recording a leaky home liability as a provision and recording it as a contingent liability. Provisions are included within the balance sheet of the financial statements. Contingent liabilities are included in the Notes to the financial statements – they are less obvious to the reader, and may not be quantified. The assumptions and estimation methods for provisions and any contingent liabilities are supposed to be clearly explained, so that readers of the financial statements can understand how accurate the amounts might be.
Categories of claims facing local authorities
4.12
We identified three categories of claims that local authorities need to consider when assessing their current and future exposure to liability for leaky homes. Each category represents a progressively increasing level of uncertainty about the extent of a local authority's financial obligations:
- category one – claims that have been investigated and reviewed, and the amount of the total claim and the local authority's share has been confirmed;
- category two – claims that are still being investigated and confirmed, which includes work to assess whether other available parties will share the liability and work to assess the costs; and
- category three – claims that might be made against local authorities between now and the end of the statutory limitation period but that have not yet been lodged, which includes issues that might not yet have been identified by the home owner.
4.13
Categories two and three are of greatest concern to local authorities because of the associated high level of uncertainty. These categories reflect the "tail" of the leaky home liability facing the country.
Accounting treatment
4.14
The accounting standard that applies to accounting for leaky home liabilities is New Zealand Equivalent to International Accounting Standard 37: Provisions, Contingent Liabilities and Contingent Assets (NZ IAS 37). This standard provides the definitions and criteria to identify whether a liability should be accounted for as a provision or disclosed as a contingency. The most relevant element of the criteria for leaky home liabilities is the assessment of whether a liability, which needs to be estimated, can be calculated with enough reliability to meet the definition of a provision.
4.15
Our guidance to auditors on the appropriate accounting treatment based on the categories of claims was:
- category one – a provision for the confirmed amount should be recorded in the financial statements;
- category two – a provision for the estimated amount should be recorded in the financial statements; and
- category three – a provision should be recorded in the financial statements if an actuarial assessment has been obtained and is reliable; otherwise it should be disclosed as a contingent liability.
4.16
In practice, identifying category two and category three claims has proved more complex than we anticipated when we wrote our guidance. In our guidance, we assumed that an actuarial assessment, particularly if carried out by professional actuaries, would be enough to meet the requirements of NZ IAS 37 and facilitate accounting for the liability within the financial statements. However, the estimation processes used to assess category two and category three liabilities, whether done in-house or by a professional actuary, have, in many cases, not been reliable enough to enable the resulting estimation to be accounted for as a provision in the financial statements. The estimation processes are not reliable enough because there are too many variables that apply to each individual leaky home case.
Approach taken by local authorities
4.17
The six local authorities made few changes to the disclosures in their 2008/09 financial statements compared with those in their 2006/07 and 2007/08 financial statements, other than the reassessment. In all cases, the local authorities were facing increases in the amount of leaky home liabilities.
Accounting for category one claims
4.18
All six local authorities continued, as they did in 2007/08 and earlier years, to appropriately provide for notified and confirmed claims.
Accounting for category two claims
4.19
For category two claims, all six local authorities increased the amount from that provided in the 2007/08 financial statements. One local authority improved its approach to accounting for leaky home liabilities by making provisions for category one and two claims, where it had previously provided only for category one claims and treated the remainder of the liabilities as contingencies. Another local authority made the same change in 2007/08. These changes reflect an ongoing improvement in the quality of the information disclosed in the local authorities' financial statements. We are pleased to see this trend.
4.20
As we noted in the previous two years, the six local authorities continue to vary in how they treat claims that have been notified but not yet investigated and confirmed. In many instances, based on the information disclosed in the financial statements, it is not clear what approach the local authorities have taken to account for this category of claims. In some instances, the local authority has divided category two claims into two parts. The part where a higher level of certainty has been obtained has been accounted for as a provision, while the remainder has been treated as a contingent liability. None of the local authorities following this approach included in their disclosures an explanation of the basis that they had used to make such a distinction.
4.21
We observed last year that the six local authorities were using actuaries and other professional expertise to assess leaky home liabilities, but the reliability of the estimate can be uncertain even when an actuarial assessment has been completed. This situation continues and, in many instances, still prevents the local authority from meeting the requirements of the accounting standard. NZ IAS 37 requires the estimate to be reliable. The disclosure of the assumptions and uncertainties surrounding the estimate should enable the liability to be treated as a provision and not a contingent liability.
4.22
Because of this, three of the six local authorities have continued to disclose category two claims as contingent liabilities rather than account for them as provisions in the balance sheet.
4.23
In our view, there is also considerable scope for local authorities that have accounted for category two claims as provisions in the financial statements to provide clearer and more descriptive explanations of the assumptions and uncertainties on which the provision is based.
Accounting for category three claims
4.24
The approach to disclosing contingent liabilities continues to vary. With future leaky home claims, all six local authorities included some disclosure in their financial statements acknowledging a contingent liability. Two of the six included a quantified contingent liability for future leaky home claims in their 2008/09 financial statements. The remaining four local authorities have all recorded the issue as part of their contingent liability disclosures, but without quantifying the estimated future cost to the local authority.
4.25
There is room for all six local authorities to improve the clarity of their explanations of their contingent liability disclosures. One of the six local authorities has included an estimate of the total liability for all parties involved, not just the local authority's specific share of potential costs. Two of the six local authorities have disclosed their use of an actuarial assessment to gain an understanding of the extent of the liability they might face in the future. Other local authorities imply the use of actuarial assessments, but this is not clearly stated.
Total amounts disclosed as contingent liabilities
4.26
This year, there has been a decrease in the total amount the six local authorities have disclosed as contingent liabilities. The main reason for the overall decrease is Auckland City Council's decrease of $77 million. Auckland City Council improved the accuracy of its assessments, allowing it to reduce its contingent liabilities and increase its provisions for leaky home claims.
4.27
Also, home owners are filing increasingly more accurate claims and actuaries are able to refine their estimation process because of the acquired knowledge from the increasing number of settled claims. However, for the sector as a whole, much uncertainty remains despite the professional expertise that actuaries are able to contribute to the estimation process.
4.28
We accept that the uncertainties linked with the assumptions that an actuary is required to make do not provide the desired level of clarity. Nevertheless, the increased involvement of actuaries in the assessment of these liabilities has contributed to improved disclosure in the financial statements of the six local authorities in the past three years. The decreased liability recorded by Auckland City Council for the 2008/09 year is particularly strong evidence of the refinement of these liabilities that is occurring.
Reduced insurance cover for leaky home claims
4.29
Local Government Mutual Funds Trustee Limited (RiskPool), a mutual fund created by local authorities to provide liability protection, is the main insurer for local authorities. Because of the extremely high value of the claims related to leaky homes, RiskPool has progressively reduced the extent of insurance cover for leaky home claims during the last three years. Until June 2009, this was reflected in annual limits for insurance cover for those local authorities with a great many or particularly costly claims. From June 2009, RiskPool has completely excluded leaky home claims from its insurance cover. This leaves local authorities with no insurance cover for this already very costly type of liability.
4.30
In June 2009, RiskPool had to make a call for capital funding from its members54 because of high deficits in the fund. RiskPool expects to make further calls for funding during 2009/10. RiskPool was not fully reinsured for all years of the fund because full reinsurance for leaky homes was not available.55
4.31
The costs of the June 2009 call for funding, and expected future calls, combined with the withdrawal of insurance cover, contribute to the substantial burden that leaky home claims are placing on local authorities.
2010 Budget announcement
4.32
In May 2010, the Government announced a proposed financial assistance package for homeowners with leaky homes. If a homeowner opts to take up the financial assistance package, the proposal would see the Government providing funds to meet 25% of an eligible homeowner's repair costs. Local authorities would be required to contribute 25% of the repair costs, and the homeowner would pay the remaining 50%.
4.33
It is unclear at this time whether this proposal will have any effect on the extent of the liability faced by local authorities.
50: More information about RiskPool is available on the Civic Assurance website – www.civicassurance.co.nz.
51: Published in June 2008, and available on our website at www.oag.govt.nz.
52: Published in June 2009, and available on our website at www.oag.govt.nz.
53: In 2007, Manukau City Council and Tauranga City Council had claim levels that were significantly below the six most affected local authorities. Now, they have claims levels higher than those of Rodney District Council.
54: Membership of RiskPool is open to all local authorities.
55: RiskPool (June 2009), Annual Report, pages 2-4.