To Transfer Disaster Risk, Let’s Partner with the Insurance Sector

Aceh, Indonesia, 10 years after the Itsunami.
Aceh, Indonesia, 10 years after the Itsunami.

By Arup Kumar Chatterjee

The new Sendai framework for disaster risk reduction supports risk transfer and insurance to reduce the financial impact of disasters on governments and societies, especially in vulnerable developing countries.

Up to 88% of the people affected by natural disasters worldwide in the past 45 years live in the Asia and Pacific, where economic losses from catastrophes have jumped to around $75 billion per year.

Last week, I attended the 3rd International Conference on Disaster Risk Reduction (DRR) in Sendai, the Japanese city that bore the brunt of the 2011 earthquake and tsunami, where representatives from 187 UN member states agreed to adopt a new DRR framework for 2015-2030. The Sendai Framework, as it is popularly known, gives clear recognition about promoting disaster risk transfer and insurance to reduce the financial impact of disasters on governments and societies, both in urban and rural areas.

The working session I moderated on disaster risk transfer and insurance discussed why tackling disasters is much easier when DRR strategies are integrated with wider development, financial planning and poverty reduction strategies by linking investments with jobs, economic growth, security, health, and risk-sensitive development. This, unfortunately, is not happening at the scale we would desire. Part of the problem is that decision-makers are understandably wary of investing in an insurance product that can only be claimed in case of an “unlikely” event such as a typhoon or a drought – even if, for instance, we know that certain countries will surely suffer a number of catastrophes each year.

Value at risk

A growing proportion of the gross domestic product of Asian economies is highly vulnerable to disasters, and that risk has increased more than average regional GDP growth in the past three decades. For most small island developing states, disasters represent a significant contingent liability (legal obligations for governments to make payments) after each catastrophe.

The triggering event, the value at risk, and the amount of the budgetary outlay that could eventually be required are all so uncertain that governments may be required to provide financial support that far exceeds their legal obligations. Since all risks cannot be cost effectively reduced, Philippine Undersecretary of Finance Gil Beltran suggested that ministries of finance in disaster-prone nations identify, quantify, analyze, and manage this contingent liability risk, and development disaster risk financing (DRF) strategies to mobilize funds by protecting fiscal balances or transferring their residual risks.

Disasters disproportionately affect the poorest and most marginalized communities. They exacerbate vulnerabilities and social inequalities, destroy livelihoods and harm wellbeing. Besides imposing a massive financial burden on the state, they undermine both development and economic growth. Nelson Kuria, of the International Cooperatives and Mutual Insurers Federation, defended the use of new products like micro-insurance schemes offered by the mutuals and cooperatives to overcome the challenges of traditional insurance systems. Together with private insurance companies, they can help cope with the consequences of extreme weather events at the community level, under an enabling regulatory environment.

The characteristics of the risks associated with earthquakes requires the government's involvement absolutely necessary for the earthquake insurance system in Japan , shared Kengo Sakurada from the General Insurance Association of Japan. Despite its declared goal of restoring livelihoods and stimulating early recovery, as well as having been around for 16 years, though, the penetration rate of earthquake insurance is only 30% in Japan, so Sakurada called on insurers to promote wider uptake of earthquake insurance and offer “risk-based premiums” to incentivize "risk informed investment decisions and minimizing losses when the next disaster strikes.

Emphasizing the importance of the private sector in building back better, Gerry Brownlee, the New Zealand minister of defense who oversaw efforts to recover from the 2011 earthquake in Christchurch, noted how 80% of the buildings in the city were insured, and called for promoting DRR through risk-based preparedness and mitigation approaches as well as incentives in innovative DRF and insurance instruments.

Scaling up

Managing risk is core to the purpose of the insurance business and drives a significant proportion of the industry, which has put in place a tried and tested operational system for rationally allocating capital in relation to disaster risks, even extreme ones. It has also developed conditions and standards of behavior for its customers to reduce risk to the system and to encourage—and sometimes enforce—resilience as a requirement of access to the contingent capital that an insurance policy represents. This is why we should drive awareness and engagement around financial regulation, resilience standards, and investment. According to Michael Morrissey from the International Insurance Society, recognizing the unique role of this industry as risk manager, carrier, and investors is key to harnessing its full potential in disaster risk management.

Turkey is another case in point. In 2000, the government set up a national catastrophe insurance facility, the Turkish Catastrophe Insurance Pool, to reduce government fiscal exposure to major earthquakes by making liquidity readily available to insured homeowners through reinsurance. It also began collecting data to assess the exposure of its assets to losses from earthquakes and analyze the economic costs and benefits of investing public resources in two risk transfer instruments: insurance and catastrophe bonds or “cat bonds.” Cat bonds allow the investor to receive an above-market return when a specific catastrophe does not occur, but the investor must share the insurer’s or government’s losses by sacrificing interest or principal following a disaster event. Unlike reinsurance, post-event payments do not stem from insurance company reserves but from global capital markets. Finally, in 2013 the Turkish government decided to transfer part of its public sector earthquake risk to the international reinsurance and capital markets through the issuance of cat bonds .

To scale up innovative risk financing mechanisms such as cat bonds and index-based parametric insurance, the World Bank’s Zoubida Allaoua called for more support from governments, and especially private insurance companies. Moving forward, partnering with the private sector and harnessing its knowledge, expertise, and capital to form partnerships in disaster risk assessment and financing can encourage the use of catastrophe models for the public good, stimulate investment in risk reduction, and generate new risk-sharing arrangements for developing countries.