Disaster Risk Insurance

Abstract

Disaster risk insurance schemes cover-against a premium-the costs incurred by the insured entity from extreme weather and natural disasters (such as earthquakes or floods). If the event occurs, the insurer refunds a percentage of the costs incurred. Insurance schemes are widely used to increase the resilience of individuals, companies and public entities to external shocks and reduce their future expenditures in case of a disaster. Damaged production facilities, shattered transportation infrastructure and business interruption produce direct losses and indirect costs in the form of foregone output (http://www.bis.org/publ/work394.htm). This is what natural disasters produce. In 2015 the number of natural catastrophes surpassed the 1,000 threshold for the first time, with an estimated loss of over US$90 billion out of which only 30 percent was insured. Losses have risen significantly over the last three decades as a result of economic development, population growth, urbanization, and a higher concentration of assets in areas exposed to climate change. Climate change is expected to continue to exacerbate both the impact and the number of calamities, reducing agricultural productivity, making access to water difficult, and causing energy stress and higher incidences of disease. This review focuses on the provision of disaster risk insurance products as a cost-saving and risk-managment strategy. Disaster risk insurance triggers a pay-out by the insurer when a disaster occurs, e.g. when a tsunami hits or rainfall falls below a certain threshold. At its most basic level, insurance commits an individual or entity to pay a fixed amount at regular intervals (premium) into a common fund (the scheme), from which money is retrieved (pay-out) to compensate for losses arising from a predefined event (coverage). The pay-out helps to moderate the financial impact of external shocks, so that the livelihood and business of the insured are not jeopardized by the occurrence of an extreme natural event. As well as property and industrial and agricultural assets, natural capital assets, such as natural forests, coral reefs and mangroves, can potentially be insured. Disaster risk insurance covers hazards arising from geological, meteorological, hydrological, climatological, oceanic, biological, and technological/man-made events, or a combination of them. Natural hazards include earthquakes, floods, storms, tsunamis, droughts and freezes. Man-made hazards can also be insured against, including air/water/soil pollution, nuclear radiation, toxic waste, dam failures, transport accidents, factory explosions, fires, and chemical spills. Insurance schemes can be private or public, mandatory or voluntary, direct or indirect. The government-the insurer of last resort in the event of natural disasters-can rely on the private sector for insurance schemes or establish public social security schemes on its own or in partnership with other governments. The coverage of losses arising from natural disasters remains limited even in developed countries: Hurricane Sandy produced more than US$68 billion losses in the East Coast of the USA in 2011, of which only around 40 percent were insured. More than 6.5 million US homes (http://www.ceres.org/resources/reports/insurer-climate-risk-disclosure-survey-report-scorecard-2014-findings-recommendations/view) are estimated to be at risk of storm surge damage, with a potential damage (i.e. cost of reconstruction) of US$1.5 trillion. The Great East Japan earthquake and tsunami generated losses estimated at US$210 billion, of which only 17 percent were insured. In developed countries the insurance market is dominated by private companies offering commercial products. The market is composed of insurance companies (that sell insurance to consumers) and re-insurance companies (that buy, pool together and eventually securitize insurance portfolios across, time, geography and risk categories). Even in private-sector-dominated markets access to disaster risk insurance schemes is often incentivized, for example through tax deductions. The availability of disaster risk insurance schemes in the developing world is growing. Property catastrophe insurance programmes for homeowners have emerged in middle-income countries such as Turkey with the Catastrophe Insurance Pool (http://siteresources.worldbank.org/FINANCIALSECTOR/Resources/CATRISKbook.pdf) established in the aftermath of the Marmara earthquake. More recently, the ClimateWise Compendium (https://www.cisl.cam.ac.uk/business-action/sustainable-finance/climatewise/pdfs/climatewise-compendium-of-disaster-risk-transfer.xlsm/view) profiled over 120 related programmes in developing countries: one third made up of agricultural indemnity-based schemes; one third agricultural index-based schemes, followed by disaster micro-insurance and sovereign risk transfers. The majority of schemes are either national (35 percent) or local (24 percent). Despite the emergence of innovative programmes, growth is still limited by the size of the insurance market and by the ability to pay premiums. The coverage is as a result often limited: Typhoon Mirinae in 2009 triggered losses of around US$280 million in Vietnam (http://media.swissre.com/documents/Flood_focus_Vietnam_en_factsheet_FINAL.pdf) of which only 3.6 percent were covered. There is a potential market (https://www.lloyds.com/~/media/lloyds/reports/360/360%20other/insuranceindevelopingcountries.pdf) in developing economies estimated at between 1.5 and 3 billion policies. An insurance scheme is "direct" or "traditional" when the insured entity-an individual or a company-signs a contract with the insurance provider, i.e. without intermediation. These are typical insurance products offered by private companies, where the insured party receives a pay-out directly from the insurer (e.g. a farmer from an insurance company) upon the occurrence of an event (e.g. a drought). The periodical payment of an insurance premium is required. The premium might, however, be unaffordable to the average worker, household or company in a developing country. Nevertheless, similarly to micro-credit, financial products can be optimized for less wealthy clients. Microinsurance has expanded the reach of insurance products to lower-income individuals and informal businesses, including crop and livestock insurance (e.g. Philippines Corp Insurance (http://pcic.gov.ph/) and Mongolian Index Based Livestock Insurance (http://www.worldbank.org/en/news/feature/2009/09/23/index-based-livestock-insurance-project)). The insurance scheme is "indirect" or "mutual/cooperative" when the contractual arrangement between the insured entity and the insurer is intermediated by a third party. The intermediary can be a government (e.g. through regional risk insurance pools) or an institution that has negotiated insurance cover for its clients (e.g. credit unions, microfinance institutions, savings clubs, etc.). Pooling schemes often offer better terms. For developing countries, the establishment of regional risk facilities (e.g. the Pacific Catastrophic Risk Assessment and Financing Initiative (http://www.spc.int/), Caribbean Catastrophic Risk Insurance Facility (http://www.ccrif.org/) and African Risk Capacity (http://www.africanriskcapacity.org/c/document_library/get_file?uuid=9fb04f73-f7c4-47ea-940f-ebe275f55767&groupId=350251) programme is a relatively recent phenomenon. Countries that become members can receive pay-outs to be invested in public rehabilitation programmes (public buildings and assets like roads, maintaining police forces, keeping ministries running following a major catastrophe). African governments pay a premium to join African Risk Capacity (http://www.africanriskcapacity.org/home), a continent-wide pooled risk mechanism which has also been supported by development partners. When rainfall in a participating country falls below a certain threshold, this triggers a speedy pay-out-within 2-4 weeks of the end of the rainfall season-allowing the government to start taking action almost immediately to protect and assist its citizens. Innovations in technology, including weather reporting/forecasting and satellite imagery, have increased the number of options available to determine the trigger for the insurance payment. Parametric insurance schemes, for example, are defined on the basis of a predetermined amount and a specific parameter, e.g. wind speed, strength of a hurricane, rainfall amounts, and the magnitude of an earthquake. The pay-out from the Caribbean Catastrophe Risk Insurance Facility (http://www.ccrif.org/) to the government of Haiti after the earthquake is an example of the use of a parametric insurance scheme. The same facility financed rescue and relief operations after the 2017 hurricane season in Antigua and Barbuda, St Kitts and Nevis and Anguilla (https://www.economist.com/news/americas/21729003-too-little-not-too-late-caribbeans-pioneering-form-disaster-insurance). By providing predictable financial relief, disaster risk insurance improves the resilience of government balance sheets and those affected by natural disasters, as well as incentivizing risk mitigation actions through the use of premium discounts (lower premiums to reward risk-reducing behaviour). The discounts can be further enhanced with capacity-development provisions on risk awareness for households and/or farmers. In the case of sovereign pooling mechanisms, premiums can be lowered to governments that retrofit their public infrastructure against disaster risks, for example.