Real Risk

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OLLOWING THE

NITED

Nations year of microcredit in

2005, there is growing interest in microfinance solutions

to help alleviate poverty in developing countries.

Furthermore, with the international community placing more

emphasis on disaster prevention, the potential of risk transfer as

part of an effective disaster risk management strategy is being

explored.

Whereas microcredit and to a lesser extent microinsurance for

life and health risks are now widely established, microinsurance

to indemnify losses from severe and catastrophic natural disaster

risks is only emerging, a major constraint being the nature of

disaster losses, which can affect whole communities and risk

pools at the same time (so-called covariant risks). Due to the

limited experience and specific challenges with such schemes,

the ProVention Consortium has been collaborating with the

International Institute of Applied Systems Analysis (IIASA) on a

microinsurance research initiative.

A first outcome of this initia-

tive is an independent review of the potential benefits, viability

and limitations of microinsurance as an instrument for transfer-

ring risk in developing countries.

Insurance is an established instrument for transferring natural

disaster risks by providing indemnification against losses from a

disaster event in exchange for a premium payment. Yet govern-

ments, households and businesses in poor countries cannot easily

afford commercial insurance to cover their risks, or they lack

access to such services. Instead of insurance, they rely on family

and public support, which is not always forthcoming for cata-

strophes that affect people throughout a region or country at the

same time.

Without support, disasters worsen poverty as victims take out

high-interest loans (or default on existing loans), sell assets and

livestock, or engage in low-risk, low-yield farming to lessen expo-

sure to extreme events. Many poor people in low-income

countries have two or more sources of livelihood, and often they

encourage their children to take on jobs in and out of the region

to hedge against family disasters. When all else fails, the poor

rely on their governments and the ad hoc generosity of interna-

tional donors, which in the past (with the notable exception of the

Indian Ocean tsunami) has often been woefully inadequate to

assure timely assistance.

The objective of disaster microinsurance is to provide low-

income households and businesses with easily accessible and

affordable insurance for loss of life, health expenses, loss of small-

scale assets, livestock and crops in the event of a flood, typhoon

or other natural disaster. Microinsurance for unexpectedly severe

disasters can provide low-income households, farmers and busi-

nesses with access to affordable means to spread losses, which

will secure their livelihoods and improve their creditworthiness.

Also, for many, an insurance contract is a more dignified means

of coping with disasters than relying on (or begging for) the

generosity of donors after a disaster strikes.

In India for example, microinsurance for sudden-onset disas-

ter risks is offered by non-governmental organizations (NGOs)

in conjunction with insurance companies. These schemes build

on microinsurance arrangements for independent risks such as

unemployment, fire and accidents by extending cover to loss of

life, property or livestock due to natural disaster events. Coverage

for property losses due to floods, earthquakes, cyclone and other

natural calamities is offered to groups such as women with a

minimum group size of 250, or to community groups established

to manage the impacts of disasters post-event.

Microinsurance can also take the form of index-based weather

derivatives. Such pilot schemes have been implemented in India,

Malawi and the Ukraine, with other pilot projects underway glob-

ally, providing financial protection to farmers against weather

risks such as drought. Contracts are written against a physical

trigger, such as severe rainfall measured at a regional weather

station. Contracts are designed by insurance companies and sold

by rural development banks, farm cooperatives or microfinance

organizations. Since payouts are not coupled with individual loss

experience, farmers have an incentive to engage in loss-reduction

measures such as switching to a more robust crop variant. A phys-

ical trigger also means that claims are not always fully correlated

with the actual losses experienced, but this ‘basis risk’ may be

offset by the reduction of moral hazard and the elimination of

long and expensive claims settling.

The review of disaster microinsurance programmes undertaken

within the ProVention/IIASA initiative demonstrates the poten-

tial of microinsurance schemes for protecting the poor against

the consequences of natural disaster shocks, and also reveals

significant challenges in making this protection viable.

Microinsurance programmes are already providing post-disaster

liquidity to poor households, and thus helping to secure liveli-

hoods and facilitate disaster recovery and reconstruction. Yet the

long-term viability of these programmes in the face of large, covari-

ant losses and the overarching need to reduce the immediate

Microinsurance for natural disaster risks?

Insights from a ProVention/IIASA

research initiative

Reinhard Mechler, Joanne Linnerooth-Bayer, International Institute of Applied Systems Analysis

David Peppiatt, ProVention