Disaster Risk Insurance to Promote Resilience
For those trying to find solutions that bridge the humanitarian and development divide, it is critical to identify interventions that have been rigorously evaluated and can be scaled up. Statistics on the increasing severity and frequency of natural disasters are well known. According to the United Nation’s 2015 global assessment report on disaster risk reduction, 25.4 million people have been displaced every year since 2007 due to natural disasters and climate-related events. This has caused upwards of $250 billion to $300 billion lost in assets annually due to disruptions in local markets and livelihoods. Increasing population density and climate change-related pressures raise these possible costs, particularly in urban areas.
The economic and social impact of natural disasters is magnified for poor individuals. As outlined in Stéphane Hallegatte’s report Unbreakable, poor people have fewer assets to support their livelihoods, consume close to subsistence levels, and often cannot rely on savings to ensure health and education outcomes are maintained during periods of crisis.
Evaluations demonstrate that disaster insurance (contractual instruments that transfer the financial risk of natural disasters to market actors such as insurance companies, reinsurance companies, banks, and investors) can have positive effects on consumption, asset protection, and recovery of small businesses. A randomized field experiment conducted in 2017 by the International Food Policy Research Institute showed that, in drought-prone areas of Senegal and Burkina Faso, farmers who purchased insurance invested more in inputs and had greater yields. Programmatic evaluations of the World Food Programme’s R4 Rural Resilience Initiative, which aims to improve resource management through asset creation, livelihood diversification, and financial services, found that insured farmers in Ethiopia saved twice as much as those without insurance and invested more in key agricultural inputs (seeds, fertilizers, plough oxen). The program had important empowerment effects on women through investing in labor and improved tools for planting.
While these results are encouraging, operational and design complexities can make implementing disaster risk insurance challenging. Broad challenges to implementing effective disaster risk insurance markets include:
Economics and incentives. Insurable risks can be managed by financial services providers generally only when they are spread across time. Disaster insurance challenges these conditions because of the severity and cataclysmic nature of disasters. Imbalances between the high costs of destruction and the need to keep insurance affordable make it challenging to effectively deploy disaster risk insurance products. Rolling out effective disaster insurance products is further complicated by issues of moral hazard, adverse selection, and information asymmetry. Parametric disaster insurance (whereby pay outs are not explicitly linked to actual losses but rather ex ante upon occurrence of a triggering event) can help reduce transaction costs and address some of these issues.
Existing tools and technology. Effective business and risk modelling, as well as disaster risk assessments, are needed to generate accurate estimates on how much to pay out in order for disaster risk products to perform well. As outlined in the OECD’s Global Survey on Disaster Risk Financing, very few economies, including in advanced jurisdictions, have adequately implemented these tools. Thus there is a need to build capacity related to risk assessments and related data modelling techniques.
Regulation. Regulation ensures the rules of the game are well laid out and guides the development of the insurance sector, balancing access, affordability, and risk. Regulation ensures the performance of legal institutions during periods of disaster and enforces rights and responsibilities under insurance contracts. Regulation also addresses operational issues of market players (for example, tax treatment of risk-transfer reserves).
Building demand. Well-functioning insurance markets require adequate levels of awareness and appropriately designed products to stimulate demand. In Italy, despite earthquakes causing severe social and financial impact, low penetration of insurance was due to inadequate risk awareness, high insurance premiums, and lack of clarity surrounding the role of the state in providing post-earthquake compensation.
Operations. Operational challenges include efficient claim management, pricing, and pay-out processes and effectively targeting vulnerable populations. An empirical cross-country assessment of the impact of disaster microinsurance in South Asia found that while people were willing to pay for disaster microinsurance products, operational challenges were causing them to borrow funds via informal mechanisms such as friends and money lenders. The assessment also found that, in certain instances, microinsurance products were excluding the poorer segments they aimed to reach.
Role of government. When insurance markets do not offer disaster insurance, governments can provide direct assistance through reserve funds, contingent credit arrangements, and risk transfer mechanisms such as catastrophe bonds. To ensure a broad range of coverage against disaster risk, governments may require private insurance providers to bundle compulsory insurance into existing policies. Or they can publicly mandate the purchase of certain types of insurance to promote participation and coverage. In some other cases, tax incentives, subsidies, and various forms of compulsion can be used to ensure adequate coverage. What is critical is that governments have the capacity and sectoral strategy to facilitate the overarching development of an affordable and sustainable insurance market.
Looking ahead, it is clear that disaster insurance plays an important role in reducing vulnerability during periods of natural disasters and related humanitarian crisis. It should be considered when scaling up responses to humanitarian crises. Close attention, however, should be given to business and risk modeling, operational considerations, and product design to ensure programs are responding to the needs of vulnerable clients in an efficient and sustainable manner. Disaster risk insurance should also be considered to complement a package of resilience-building policies that includes financial inclusion, access to health and non-health insurance, and stronger social protection shields, as discussed in detail in Unbreakable. Given the enormity of these challenges, bold vision, efficient resource deployment, and strong monitoring and evaluation should underpin any strategy to scale up disaster risk insurance.