Super Typhoon Haiyan satellite image.

Droughts, floods, heat waves, and tropical cyclones are on the rise. According to the UK Met Office, climate related hazards affected over 220 million people on average every year in the period 2000-2009. Extreme events destroy livelihoods and undermine the capacity of communities to adapt to even moderate shocks.

Financial disaster risk management (FDRM) reduces the cost and consequences of disasters. On the macro level, economies with deep insurance and financial markets recover faster (Pollner, 2012). Moreover, uninsured losses have been shown to drive the economic cost of disasters (Von Peter, von Dahlen, and Saxena, 2012). As we have highlighted in a previous post, the most vulnerable are least likely to be insured. Low insurance penetration coupled with high vulnerability stunts economic activity and reduces resilience to disaster shocks.

Disaster risk alters investment and production decisions and leads to higher cost of both equity and debt capital. In the absence of suitable risk management alternatives:

• Small and medium enterprises (SMEs) engage in low risk, low return strategies;
• Lenders ration credit in vulnerable regions and economic sectors;
• Some firms simply chose not to locate in vulnerable regions;
• International investors limit the supply of capital to vulnerable regions and sectors.

Consequently, many investments are not funded or those that are funded are more likely to be undercapitalized when disaster risks are present. This dynamic has profound implications for development and poverty alleviation.

Traditional insurance markets (e.g., property insurance, agricultural insurance) have limited reach in low income and emerging economies due to a long list of market and structural failures. Technological and capital market advancements create new opportunities for FDRM innovations that are better suited for conditions prevalent in lower income countries. However, commercial providers of these products (i.e., insurers and reinsurers) are reluctant to focus on lower income countries due to free rider problems, uncertainty about market potential, legal and other barriers. Consequently, innovations in FDRM are largely financed through donor interventions. Yet, donor intervention in this space thus far has not scaled largely because limited pilot projects do not address these barriers and market failures. Efforts to extend index insurance to vulnerable regions, for example, have met with limited success because:

• Risk assessment and product pricing is difficult in data sparse environments and insurers and reinsurers respond to this uncertainty by pricing products too high;
• Legal and regulatory frameworks are typically underdeveloped and institutional capacity for supervising these products is deficient;
• Clients require extensive capacity building to fully appreciate the value of insurance; and the list goes on.

In the next post, we will examine the effect of disaster risk on financial inclusiveness of SMEs and implications for economic growth and resilience building.

References:

Pollner, J. D. “Financial and Fiscal Instruments for Catastrophe Risk Management: Addressing Losses From Flood Hazards In Central Europe.” A World Bank Study 70911, The World Bank, Washington, DC, DOI: 10.1596/978-0-8213-9579-0, January, 2012.
von Peter, G., S. parental locks von Dahlen, and S. C. Saxena. “Unmitigated Disasters? New Evidence on the Macroeconomic Cost of Natural Catastrophes.” Working Papers 394, Bank for International Settlements (BIS), Basel, Switzerland, December, 2012.

The typhoon-ravaged Philippines are a powerful reminder of the high toll of disaster risk. Vulnerability to climate shocks and natural disasters in general continues to grow, particularly among the least equipped to withstand and rebound from this risk. The graphic below paints a telling picture. The first map is a Climate Demography Vulnerability Index (CDVI), developed by Sampson, et al. (2011); the second gives an overview of property insurance penetration. High vulnerability plus the lack of financial protection means even slower economic growth and more poverty in the future.

The good news is we have the technological and scientific wherewithal to model disaster risks which can significantly improve capacity to manage them. For example, the UK Met Office uses more than 10 million weather observations a day, an advanced atmospheric model and a high performance supercomputer to create some of the world’s most accurate forecasts. These forecasts can be used to model climate risks in Africa, Asia, South America and other regions where traditional insurance markets have failed to flourish. Climate models, in turn, can feed into the design of potent financial disaster risk management products.

We have capacity in the international risk markets to hold this growing risk. For example, the reinsurance industry capital now stands at USD 510 billion. According to Aon Benfield, insurers and reinsurers will benefit from additional USD 100 billion of alternative capital in the next five years.

Lastly, we have the goodwill to find working solutions. Development organizations have entrusted millions of dollars with practitioners, such as us, to test the potential of financial innovation in fighting poverty and building resilience at scale. The parts are there. How can we unlock this existing potential to deepen risk transfer markets in lower income countries?