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May 2019

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The Geneva Association - Sovereign Risk Financing and Risk Transfer Schemes: A critical component of a comprehensive disaster risk management strategy

Source: Asia Insurance Review | Aug 2017

The Geneva Association, in collaboration with the Insurance Development Forum (IDF), has developed a document to provide governments with a framework for development of sovereign risk financing and risk transfer programmes as critical components of a comprehensive approach to disaster risk management. The document also offers a checklist for conducting the underpinning risk analysis to guide the design of such programmes. This effort is a response to a request from the United Nations Office for Disaster Risk Reduction (UNISDR) and is part of the document “Words into Action: Guideline on National Disaster Risk Assessment – Governance System, Methodologies, and Use of Result.” Here is an excerpt taken from a Geneva Association/IDF publication. 
 
 
When a disaster strikes, it can lead to significant financial burdens which can be felt by several stakeholders ie by governments, businesses, and individuals, whether directly or indirectly (World Bank, 2014).
 
Financial costs of disasters
A region’s economic vulnerability to extreme events will depend on a range of factors, linked to: (i) increasing exposure and vulnerabilities such as higher concentrations of people and property in cities in exposed coastal regions, poor development planning, complex inter-dependent supply chains and trade patterns, cascading failure effects of critical infrastructure, and inter-linkages of natural and man-made catastrophes; and, (ii) increasing incidence and severity of hazards such as extreme weather events due to climate change. These factors are contributing to the rising financial impacts of disasters. 
 
   In absolute terms, the financial costs of disasters are highest for high-income countries. However, in relative terms, the financial effects of extreme events are much more devastating for middle- and low-income countries, when analysed in relation to their average GDP. Recurring disasters present a significant challenge to socio-economic development and poverty reduction efforts in those countries. As is too often the case, the poorest communities are the most vulnerable. 
 
A comprehensive risk management strategy is required 
A comprehensive risk management strategy should consider several options to reduce and prevent economic losses. Preventive measures such as land-use planning, enforcement of appropriate building codes, retrofitting of homes, commercial building and critical infrastructure, better construction practices, and investment in the natural infrastructure (eg, wetlands) are critical for reducing and preventing economic losses associated with disasters. 
 
   Several studies indicate that these ex-ante preventive risk-management measures are more cost-effective than post-disaster response and reconstruction crisis-management approaches.
 
   These can be combined with emergency preparedness and response procedures linked to early warnings, to further reduce the risks. Well-coordinated early warning and emergency preparedness systems primarily lead to reduction in loss of lives and in some cases reduction of some damages to homes, if the public has the incentives and knows what measures to take (Golnaraghi, 2012). Early warnings are also proving useful to (re)insurance companies to design contingency plans that could expedite claims management processes, following a disaster. 
 
   Despite such risk reduction or preventive efforts, some residual economic risk will always remain. Risk financing and risk transfer measures (such as insurance) provide protection cover and can distribute or pool the residual economic risk. 
 
   A number of recent studies indicate that, following a major disaster, countries with lower levels of insurance penetration experience larger declines in economic output and more considerable losses in fiscal strain than those with higher level of insurance penetration (Von Peter et al., 2012). 
 
   Finally, these can be complemented by effective reconstruction plans (that may also consider re-zoning) that aim to reduce future disaster risks and build resilience, after any major event. 
 
   Direct and indirect financial impacts on governments, businesses and individuals.
 
   The direct impact of a disaster on a government’s budget could include: (i) emergency relief and response expenditures, (ii) relocation of affected and/or at-risk citizens, (iii) reconstruction or improvements of non-insured or partially-insured public infrastructure and low-income-family dwellings, (iv) costs of social and economic programmes for rehabilitation and recovery, and (v) contingent liabilities for state-owned and other enterprises that are critical to economic recovery. 
 
   Governments will also sustain indirect impacts: (i) decreased tax revenues associated with business interruption and decline in GDP growth, (ii) opportunity cost of diverting funds from intended development plans to reconstruction and recovery programmes, (iii) additional expenditures related to effectiveness of social recovery programmes, (iv) increased borrowing costs and potential negative impacts on the sovereign credit rating; and, (v) migration of population due to loss of livelihoods. 
 
   Disaster risks will impact businesses and individuals directly through (i) cost of reconstruction of uninsured or partially-insured assets, (ii) cost of replacement or repairs of uninsured or partially-insured assets, (iii) health care, (iv) loss of sources of livelihood, (v) decline in property value due to destruction of surrounding infrastructure. The indirect impacts could include (i) loss of income due to business interruption, unemployment, death or economic decline, (ii) increased borrowing costs; and, (iii) additional costs such as relocation and alternative housing and long-term disability. 
 
   At a sectoral level, the economic consequences of some disaster risks could be felt across an entire supply chain and can affect economic output by interruption of supply chain and market accessibility. On the other hand, in countries with limited economic diversity, a single catastrophe can lead to profound economic impacts. For low-income nations, these types of economic shocks, can deepen poverty levels and can lead to complex emergencies, requiring significant humanitarian and relief interventions. 
 
   Post-disaster financial needs are often defined by three phases: (i) immediate relief and rescue response, (ii) early recovery; and, (iii) the reconstruction phase. The funding needs will differ in each phase and are required on different timescales. Delays in receiving funding can hamper each phase, negatively impacting the population and the economy. 
 
Sovereign risk financing and risk transfer measures offer a variety of solutions 
Sovereign risk transfer can take several forms, each with different trigger mechanisms, payout conditions and timescales. The suitability of this approach will differ depending on each government’s budget and risk contexts (World Bank, 2014; OECD, 2015; Golnaraghi, et al., 2016). 
 
   An important distinction is between indemnity-based and parametric insurance. With the former, claim payments are linked to the actual losses incurred by the insured. Under indemnity covers, all claims need to be individually checked, which may lead to significant transaction costs. 
 
   On the other hand, parametric trigger-based insurance contracts make a payout if a physical loss parameter (eg wind speed or amount of precipitation) is reached – and not on the basis of actual losses incurred by the insured. 
 
   Compared with indemnity-based insurance, loss parameters used in risk transfer schemes with parametric triggers are available immediately, after the event causing losses. The most significant disadvantage of parametric triggers is basis risk, ie the difference between the actual loss incurred by the insured and the payout. 
 
   Since the 1990s, a number of ‘alternative risk transfer’ (ART) capital market instruments have been developed to complement the more traditional (re)insurance solutions. These insurance-linked securities (ILS) (eg, catastrophe bonds) provide substantially more reinsurance capital to cover catastrophe losses, by transferring risks to the capital markets.
 
Risk assessment a critical step
To determine the required scope and type of risk financing or risk transfer in a country, a government should first understand the risk context, for example, the potential impacts of disasters on their population, infrastructure and economy. 
 
   Probabilistic catastrophe models provide a systematic and rigorous approach to pricing, underwriting and managing complex risk portfolios. An important question in the risk assessment stage is to define the goals of the risk assessment, and identify who can and should do the risk assessment. 
 
   For some countries and perils, several models exist and each is likely to provide different estimates of risk. A common question is ‘which model is right?’ Parametric options may be considered when exposure and vulnerability information is lacking or unreliable. 
 
   Finally, the development of a successful risk financing and risk transfer programme requires the collaboration of multiple stakeholders and information providers. A checklist for conducting risk assessment for design of sovereign risk financing and risk transfer programmes is also provided in the report. A 
 
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Dr Maryam Golnaraghi, Director, Extreme Events and Climate Risks, The Geneva Association
Visit www.genevaassociation.org for more information.
 
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