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Wladimir Kruythoff

Founder & CEO Infinite Observations

Disaster, Adaptation, Mitigation and Resilience Part 3: Insurance: A Cost-Effective Coping And Adaptation Tool

Evidence suggests that increasing anthropogenic emissions have significant effects on climate-related events, thus becoming more frequent over the long term. At the same time, population growth and urbanization combined with these climate-related extreme events impose substantial human and economic losses on coastal communities, port cities and urban areas. The need to assist developing countries, particularly small island developing states
in the Caribbean, a region prone to hurricane disaster, has become more urgent given climate-change negotiations. Developed countries acknowledge that their greenhouse gas emissions, industrial soot from the burning of coal and sulfates, among other examples, can lead to increased duration, frequency and intensity of weather-related extreme events in the developing countries. As a result, climate negotiators seek innovative, sustainable means and methods to help these affected nations cope and adapt. The United Nations Framework Convention on Climate Change (UNFCCC) and the Paris Agreement calls upon developed countries, notably North American and European nations, to take the necessary actions and to assume responsibilities to confront the effects of climate change by reducing their greenhouse gas (GHG) emissions as well as support efforts of developing countries that are disproportionately impacted by extreme climate events.

Disaster loss can be diminished by implementing natural disaster prevention measures and damage mitigation, i.e. early warning systems, improved prediction, emergency services response, land use, planning controls, building regulations, and post-disaster humanitarian aid for emergency relief and recovery. Post-disaster aid for emergency relief, reconstruction and rehabilitation, although important from a humanitarian perspective, arrives (sometimes
months) after the disaster, falls short when its comes to reducing the disaster risk exposure, gives little incentive to invest in prevention because of the associated moral hazard and ensuring sufficient financial reserves for governments and individuals in developing countries to finance projects in the immediate aftermath and during the recovery phase. Post-disaster humanitarian aid can be complimented with pre-disaster support of risk-management programs
that combine prevention and risk transfer. Developing countries cannot solely rely on humanitarian aid and economic pledges from donor countries, which is usually a fraction of disaster losses and not always forthcoming. Instead, risk-management programs in SIDS, should be supported by contributions from developed countries, that promote disaster
adaptation and mitigation. Along these lines national natural disaster insurance programs and the private insurance market can also be employed as a disaster mitigation measure, to meet private post-event costs.

Economic costs of disasters can be separated into two categories: (1) pre-event, preventative or risk management costs that are usually not included in the total insured losses, which are generally incurred by individuals, households, and the state over a long period time prior to an event. These investment costs, for measures implemented to prevent or minimize damage, i.e. establishing building standards, managing approvals of (mitigation) constructions
in high-risk areas are difficult to measure and it is challenging to verify whether these costs are justified in offsetting any future losses from natural disasters, and (2) post-event costs also known as direct and indirect losses, which are often a measurable outcome of the natural disaster, and in most cases it is simple to identify an entity (private or public, individual, household, business, or government) that has incurred the loss. Post-event costs are well suited to insurance because insurable risks are unexpected and random, but the losses associated with them are determinable, quantitative and commensurate to insurance premiums, which must be high enough to cover any losses, but the policies must be affordable to be available to the population of a developing country and have risk pool of adequate size.

Furthermore, insurance is based on the probabilistic nature of disaster losses. Physical disaster losses can be insured because there is some probability that this type of loss will occur in a certain period (general insurance) or when a loss, human capital, is certain to occur and occurs (as in life insurance). The primary advantage of insurance
is its ability to reduce the overall level of risk to society using different tools, specifically through combining individual risks, the segregation of individual risks, and the control of moral hazard.

Government And Disaster Insurance

The essential role for government when it comes to insurance is funding the financial impacts of a natural disaster. The advantages of this framework is that it generally guarantees coverage (able to spread the cost of risk for all occurrences and all households, which is basically democratic), affordability (across different risk categories to ensure affordable coverage), and devoid of under-insurance (no limited funding and the affected are restored to the pre-disaster state). There are, however, a number of disservices associated with this system, which include risk disincentives (cross-subsidization, which is a consequence of blanket affordable coverage reduces the control of the moral hazard issue through price incentive for risk reduction, thus increase the aggregate societal risk), efficiency (the private insurance market is more efficient), and financing risk (government credit ratings can come under threat from excessive disaster liability). Governments as risk managers can be fundamentally at odds with the basic principles of an economy that operates by voluntary exchange in a free market (a capitalistic economy) that is not planned or controlled by a central authority (government).

It is the task of innovative policy-makers to design programs that use the leverage of governments in risk pooling and segregation, at the same time limiting the consequences of moral hazard. To pursue this responsibility the role of government can be categorize as, (1) Insurer: in this role the government uses the administrative capacity of the private insurance market to assist in programs that are fundamentally directed and paid for by government
itself. (2) Reinsurer: the government uses its financial capacity to provide support to the private insurance industry. (3) Underwriter: in this character the government sets of rules and regulations, i.e. measure the risk exposure and determine the premium that needs to be charged to insure certain risks, that enables the private market to function without direct governmental economic support.

Government As Insurer

Creating government-sponsored insurance programs involves a system that have all the attributes of private insurance market but is neither regulated by general insurance principles nor financed primarily by an established insurance financial institution with reserves, see figure 5.85. In a comparable market substituting system insurance programs essentially disperse disaster costs over the population basically without any incentives for moral hazard
reduction. These types of insurance premiums can be distinguished from private market insurance premiums in this regard, that the value of premiums are not correlate to the assumed risk. Overall, a government-sponsored insurance programs are supervised by centralized decision-making and depend upon conclusive and standardized insurance
premiums. Additionally this type of market is defined by fixed amounts of claim payments irrespective of the extent of incurred losses. The dissimilarity of a government-sponsored insurance system and that of official aid (OA) is that the establishment accumulates reserves as a result of paid premiums based on participation of the inhabitants in programs available through the system prior to the onset of a natural disaster before it is redistributed to account
for losses in the aftermath of a natural occurrence, while in the case of OA, there is no system for the collecting of funds prior to a catastrophic event. A government sanctioned insurance system is very advantageous when the desire is to disperse risks over the population. Nonetheless, they are infamously inefficient in limiting moral hazard. Government as insurer scarcely implement any measures to control moral hazard. Government programs can
incorporate techniques used in the private market, i.e. deductibles, coinsurance, and policy limits, to control moral hazard, but they rarely do so to the extent of the private market, because voter interest in benefits is unlikely to permit the government to control moral hazard to the same extent as the private market.

Government As Re-Insurer

In this market-enhancing approach to government policy, as it known in the literature, the establishment in contrast to the market substituting view, through executive policy of government re-insurance programs, has the jurisdiction to access the treasury of the state in the event of a natural disaster and, depletion of all other financial resources, facilitate the private insurance sector in order for it to fulfill its responsibility and be more productive and efficient, see figure 5.85. The fundamental disparity between the market substituting system and the market-enhancing approach is that government in the role of re-insurer requires the private insurance market to retain some portion of the risk while the state assumes the legally responsibility for the most costly risks. If no risk has been retained by the private insurance sector, then it is a government sanctioned insurance program with the state as insurer. The establishment pays a fee and depends on the administrative capacity of the private insurance market to execute indispensable services in the form of, i.e. marketing, premium collection, policy issuance, and claims handling. This approach as the aggregate of risk-spreading by the state and the effectiveness of moral hazard functions of the private market.

Government As Underwriter

The term “underwriting” originates from the Lloyd’s of London insurance market, who in the past would would accept to some extent a certain risk on a given endeavour and guarantee their liability on this venture by literally writing their names under (or at the bottom of) the risk information slip (or page). In this role, state involvement is limited to making arrangements to facilitate the private insurance market whereby they (the government) guarantee payment
(the insurer is liable, will pay) in the event of damage or financial loss (losses of a client) due to natural disaster and accept the financial risk for liability arising from such guarantees, see figure 5.85. (Underwriting also include services provided by some large specialist financial institutions, such as banks, insurance or investment houses that raise investment capital from investors on behalf of corporations and governments that are issuing either equity (= assets
– liabilities) or debt securities. Thus, the primary function of an underwriter is to make a market for (debt) securities (debt instrument, such as bonds) to sell to investors to accumulate reserves (funds) in the event of a disaster.) For many man-made or human risks (as oppose to natural hazards), the role of the government is to make underwriting arrangements (set the terms of liability, conditions or standards, in other words the government assesses risk exposure to a certain hazard and determine the premium that needs to be charged to insure that risk) so that risks become insurable. Two main aspect that are related to insurability of risks are: (1) identifying the risk and (2) setting premiums or classifying risks for each potential customer. Insurability is related to the potential size of a hazard. The private insurance market is capable of managing most man-made risks considering that they are usually independent, non-correlated hazards and by applying standards, underwriting arrangement set by the government. In contrast, natural catastrophes can have significant social, environmental and economic impacts, simultaneously effecting many people, covariant risk. Under these circumstances the government must play a very
important role by more narrowly defining moral hazard (appropriate behaviour) and limiting liability (by implementing building codes, zoning, research, developing methods and tools to monitor situations and predict future developments, etc). Government as underwriter directly enhances the ability of the private insurance market to manage, notably natural disaster, risk by making underwriting arrangements.

Markets And Disaster Insurance

In this case insurance cover would only be available from existing private insurers, the market determines the height of the insurance premiums and risk borne by a private insurer, see figure Overview of an insurance-reinsurance system. This approach comes with a number of complications, namely affordability (high-risk events or areas may require considerable premiums), market failure (no insurance service will be provide for an event or area that is assumed un-insurable by the insurer), and under-insurance (post-event losses have been underestimated by the insurers and the insured).

Private insurers, however, are able to control moral hazard, thus reducing overall societal risk, but lack the financial capacity to bear disaster risk and maintain disaster insurance at reasonable cost and coverage.

The insurance industry in particular has been identified as a mechanism for channelling finance to countries recovering from disaster in a climate of diminishing aid payments. Careful reform is needed in the insurance and reinsurance sectors and perhaps a greater role for government to encourage insurers not to pull out of areas that appear to be becoming increasingly disaster prone as a result of global climate change and continuing uneven global development. The insurance industry is in the curious position of being a major shareholder in many of the industries that are contributing to global climate change whilst also being the biggest potential private-sector loser should catastrophic natural disaster related to climate change increase in frequency and severity

Overview of an insurance-reinsurance system, Goda et al.

Public-Private Partnerships And Government Insurance And Re-Insurance Programmes

Developing nations are beginning to take the initiative and introduce public-private insurance systems and formal government reinsurance programs similar to those in other developed countries, for example France, National Disaster Compensation Scheme (CAT NAT) backed by the state-guaranteed public reinsurance program known as the Caisse Centrale de Réassusrance (CCR), and Fonds National de Garantie des Calamites Agricoles; United States, National Flood Insurance Program (NFIP); Japan, The Japanese Earthquake Reinsurance Company (ERC); New Zealand, Earthquake Commission (EQC); Iceland, Catastrophe Insurance (ICI) ; Norway, Norsk Naturskadepool (Norwegian Natural Perils Pool); Spain, Consorcio de Compensacion de Seguros (CCS); Brazil, Instituto de Resseguros; Australia,
Natural Disaster Relief and Recovery Arrangements (NDRRA); Taiwan, Residential Earthquake Insurance Program (REIP); United Kingdom, Association of British Insurers (ABI). Providing assistance to affordable public-private risk-transfer programs in a middle income (small island) developing countries such as those in Turkey, Turkish Catastrophe Insurance Pool (TCIP); Mexico, reinsurance national catastrophe relief and reconstruction reconstruction fund (FONDEN) catastrophe bond and Ethiopia, is an innovative option to consider these first of their kind initiatives to deal with the reduction of financial, and in turn hazard, vulnerability.

The capacity of developing countries, particularly Caribbean nations, to individually absorb an exogenous shock is limited due to various constraints ranging from: (1) geographically, their size is an impediment for risk diversification. (2) economically, budgetary constraints and small scaled fiscal revenues hamper the accumulation of financial reserves and reallocating resources in the immediate aftermath of a disaster. (3) government debt and insufficient depth of domestic capital markets is a disadvantage to the procurement of international credit. (4) donor assistance and humanitarian aid to support relief and recovery often comes with a delay.

The Caribbean Catastrophe Risk Insurance Facility (CCRIF), established in May 2007 as an independent, not-for-profit risk pooling legal entity based in the Cayman Islands, has the objective to pool catastrophe risks and offer the members and associate members of the Caribbean Community (CARICOM) insurance at affordable rates and provide a rapid infusion of short-term liquidity in the event of a natural catastrophe (hurricane or earthquake) exceeds a given disaster magnitude (, a proxy relationship or parametric insurance policy that is triggered dependant on velocity, geographical location, and intensity). The sixteen island nation members of the Facility are: Anguilla, Antigua & Barbuda, Bahamas, Barbados, Belize, Bermuda, Cayman Islands, Dominica, Grenada, Haiti, Jamaica, St. Kitts & Nevis, St. Lucia, St. Vincent & the Grenadines, Trinidad & Tobago and Turks & Caicos Islands. The Facility to estimate the losses using data from the National Hurricane Centre (NHC) in the event of hurricanes and the United States Geological Survey (USGS) in the case of earthquakes. CCRIF was established at the request of the CARICOM Heads of Government for World Bank (International Bank for Reconstruction and Development, IBRD) assistance in devising and creating a structure to address the constraints described above, improving access to catastrophe insurance by providing them with access to affordable insurance coverage and protection against potential revenue loss as well as economic growth. The idea of the facility was prompted by the devastation caused by hurricane Ivan in 2004, which
amounted to billions of dollars of losses throughout the West indies. In close collaboration with the governments in the West Indies, CARICOM, the Caribbean Development Bank (CDB) and other key donor partners, the World Bank, and external experts The Caribbean Catastrophe Risk Insurance Facility Project for a disaster risk management strategy and recovery was initiated. Funding was provided by the issuance of a catastrophe bond (“cat bond”). The issuance of the bond, yielding interest rates of about 15 percent, is a highly successful transaction for transferring earthquake and hurricane risk to the re-insurance market. Investors are benefited if a hurricane seasons is very mild, contrary to expert
predictions. In the event the impact of an extreme natural occurrence is extensive, all the investment, including the capital, can go back to the re-insurers to help absorb the payouts,which can be of substantial proportions, and to cover the cost in the immediate aftermath of the disaster.

Table: Hypothetical Payouts(US $ millions)

A three-year US$ 30 million transaction was the first of a newly created Capital-at-Risk Notes Program of the World Bank. The bond is linked to earthquake and tropical cyclone risk in the sixteen Caribbean countries. By issuing the bond, the World Bank was able to provide re-insurance to CCRIF. CCRIF provides rapid natural disaster financial liquidity when a policy is triggered. CCRIF was developed under the technical leadership of the World Bank and with a grant from the Government of Japan. It was financed (underwritten), through contributions to a multi-donor Trust Fund by the Government of Canada, the European Union, the World Bank, the governments of the United Kingdom and France, the Caribbean Development Bank and the governments of Ireland and Bermuda, as well as through membership fees paid by participating Caribbean governments. The Facility functions by combining the benefits of pooled reserves from participating nations with the international financial capacity of re-insurance markets. CCRIF retains some of the risk transferred by the participating countries and the remainder of the risk is transferred to
international re-insurance markets, namely, Munich Re, Swiss Re, Paris Re, Partner Re and Lloyd’s of London syndicate Hiscox. CCRIF is now expanding to include several Central American countries with the support of the governments of Canada, the United States, Mexico and potentially other donors. Since the inception of CCRIF in 2007, this not-for-profit risk pooling facility has made eight payouts totalling US$32,179,470 to seven member governments, notably Haiti received, in 2010, a payment of US$7.75M fourteen days after being affected by the catastrophic 7.0 magnitude earthquake. All payouts were transferred to the respective governments of the affected nations within two weeks following each disaster, see .

Table: Loss Probabilities for 2009-2010

This article is the third part in the series “Disaster, Adaptation, Mitigation and Resilience” by Infinite Observations.

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