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The capital efficiency gap

Source: Asia Insurance Review | Dec 2017

Global Microinsurance Nat CAT Technology

Underinsurance is a problem, but not all of it represents a protection gap. Stakeholders need to take a more comprehensive approach to risk management to ensure losses are being absorbed in the most efficient way. Mr Greg Lowe at Aon and Mr George Attard at Aon Benfield Analytics International explain.
Minimising the social and economic costs of natural disasters is an economic and humanitarian challenge. Currently, many of these economic losses are being absorbed by the financial system and wider economy. The issue is whether these losses are being managed at the lowest cost to society in a capital efficient way. 
   Aon Benfield’s 2016 Annual Global Climate and Catastrophe Report highlights a familiar theme: Total economic losses continue to dwarf insured losses. This “protection gap” has received so much attention that in 2016, a new institution, the Insurance Development Forum, was established to develop partnerships and initiatives to address the issue. 
   Asia Pacific accounted for 22% of global insured losses, but 55% of global economic losses with a gap of almost 90%. However, even in the United States, which accounts for 56% of global insured losses but only 28% of global economic losses, the gap was nearly 50% in 2016.
Using TCOR to identify most cost-effective ways to manage risk
A total cost of risk (TCOR) approach - the sum of insurance premiums, administrative risk control costs, and retained losses - could be instrumental in combatting the protection gap by identifying the most cost-effective ways to manage and reduce risk. 
   TCOR is not a new concept, but it has yet to be widely applied to systemic problems. The 2017 Aon Global Risk Management Survey indicates that even for businesses with more than US$25 billion in revenue, just 57% use TCOR to guide their risk management and insurance decisions. By integrating TCOR into disaster risk and resilience, governments and businesses will be able to allocate capital more efficiently. 
Learning from chronic Nat CAT events
A look at chronic natural catastrophes highlights the use of insurance, as well as financial tools beyond insurance, such as development finance, derivatives, and sovereign debt, to help economies and societies mitigate the risks that natural disasters pose. A better understanding of these dynamics can help elected officials, finance managers, policy makers, and business executives take a more prudent approach to safeguarding their interests.
   Natural disasters tend to be seen as singular short-term events. Some catastrophes such as drought or extreme heat, however, take time to inflict losses. In this way, the impact of such events is chronic, not acute. 
   Drought is under-reported due to a lack of data and typically uninsured. Impact Forecasting’s Catastrophe Insight team captures loss data, and one notable trend is the increase in losses from chronic events such as drought. 
The absorption of losses by other financial means
This dynamic does not mean that the losses are not being absorbed by other financial instruments and economic players. 
   The University of California, Davis, estimated that the agriculture industry’s economic losses during the 2015 California drought totalled $2.7 billion, but less than $500 million was insured. Of the total, direct losses accounted for $1.8 billion, of which $1.25 billion was from sources such as crop yields and associated revenue losses that were insurable. 
   However, $590 million was incurred due to increased costs from pumping water and job losses, which were partially absorbed by rising food prices. While the increases were significant for certain crops, the US Department of Agriculture estimated total food price inflation at only 3.5% for the year. 
   Job losses would be partially absorbed by the state through unemployment claims and a drop in demand from employers. 
   Insurance would mitigate employment losses by helping farmers stay in business and keeping money in local economies. In agricultural markets where derivatives play a role, these products can also reduce the risk of price volatility through hedging.  
Looking at derivatives
With the protection gap at $156 billion in 2016, how do we assess the optimal role for insurance to play?
   For chronic risks, derivatives are good at mitigating high-probability, low-impact events at a market level, whereas insurance is effective for low-probability high-impact events for specific circumstances. TCOR can combine risk appetites with associated administrative costs of both insurance and other financial instruments to produce an efficient frontier.
An efficient frontier relating a chosen risk appetite to a risk transfer premium – example of TCOR approach
   The good news is that innovation in weather data and analytics is facilitating the deployment of insurance capital to chronic events by improving the ability of insurers to price and underwrite the risk. Satellite imaging and high-resolution weather data help assess the risk of drought and the impact of the loss when it occurs. Whether insurance, derivatives, or government programmes step in to absorb the economic losses, the underlying data and analytics are useful for all parties.
Parametric insurance 
Currently, many governments and development finance institutions (DFIs) can borrow at very low interest rates, often lower than the cost of insurance capital. However, government funds and/or foreign aid can be slow to materialise, sometimes taking up to six months, which delays vital redesign and reconstruction work. As parametric insurance continues to grow in sophistication and availability, these products can help speed the flow of funds and plug gaps for local and municipal governments.
Better engagement with FIs and govts
Underinsurance is a problem, but not all of it represents a protection gap. Better engagement with financial institutions and governments at every scale is needed, and the Insurance Development Forum is a good start. 
   Numerous other industry initiatives are underway, many in collaboration with governments, including the Singapore NatCatDAX Alliance led by the Institute of Catastrophe Risk Management (ICRM) at Nanyang Technological University (NTU Singapore) in partnership with Aon Benfield, Mitsui Sumitomo Insurance Group, RenaissanceRe, Risk Management Solutions and PERILS AG, with support from the Monetary Authority of Singapore. 
   The NatCatDAX initiative seeks improved data standards and the availability of data to enhance traditional reinsurance support for Asia-Pacific risk, and expand the market to alternative capital providers. NatCatDAX will initially focus on Indonesia, the Philippines, Taiwan and Thailand, but will expand to cover other countries in Asia.
   Technology and innovation are creating new ways of pricing and transferring risk, and analytics can help assess risk and determine where insurance makes sense. Only through innovation can economies and societies absorb the economic losses of disasters in an efficient way. Closing the capital efficiency gap is critical not only to our industry but also to the lives and livelihoods of the global population. A 
Mr Greg Lowe is Head of Resilience & Sustainability at Aon & Mr George Attard is Head of Aon Benfield Analytics International.
Aon Benfield is the 2017 winner for Reinsurance Broker of the Year at the 21st Asia Insurance Industry Awards.
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