But only $1.1 million will be returned to overcharged customers, with the rest going to emergency services organisations due to the administrative costs of making individual refunds below $30 and finding former policyholders.

The error has been revealed by Professor Allan Fels, who has been appointed the NSW Emergency Services Levy Insurance Monitor.

Professor Fels' role is to ensure insurers pass on savings to customers when the emergency services levy (ESL) on contracts is scrapped from July next year and replaced with a levy on all properties.

NSW Treasurer Gladys Berejiklian has estimated the property levy will be about $160 a year.

But she says insurance premiums should drop by an annual average of $200, for a net saving to insurance policyholders of $40 a year.

Potential penalties of $10 million apply to companies who breach the rules.

IAG told the monitor about the overcharging after an internal review of ESL collections in preparation for the change. It occurred in 2013, before the July 2014 start date of Professor Fels' powers.

Instead, the Australian Securities and Investments Commission has agreed to IAG refunding $1.1 million to more than 27,000 NRMA insurance customers.

IAG will pay a further $5.7 million to emergency services organisations including the NSW Rural Fire Service, St John's Ambulance, SES and National Parks & Wildlife Service.

Tracy Green, IAG executive general manager for customer and underwriting, said the ESL funds an essential community service but the collection process is "complicated and difficult to administer".

"On deciding the refund threshold [of $30] we take into account a number of factors, which include customer feedback, the cost of refunding customers as well locating those who may no longer be with us," she said.

Refunds will apply to people who had home insurance with NRMA between December 22, 2012, and June 30, 2013.

Professor Fels said it was "highly unlikely" the overcharging error would have been detected "had the removal of the ESL not been introduced, with strong consumer protection laws surrounding it".

In another case, IAG subsidiary Swann Insurance will repay $17,000 to 3000 car and motorcycle policyholders after failing to reduce their premiums as required following early removal of the levy.

The company says it will refund customers where the amount involved is over $5, and donate the rest to Lifeline.

"I am surprised that such a basic error in pricing was made after all the measures we have taken to make insurers are aware of their obligations under the law," Professor Fels said.

"It's vitally important that insurance companies' systems are properly geared to fully removing ESL and passing on the benefit fully to consumers."