Risk Wise

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Clearly, there is significant value in shifting the tradi-

tional ‘disaster relief’ approach – raising scarce funds after

the event hits – to an approach that accumulates funds

and funding sources before a disaster occurs. The financial

and insurance markets can play a key role in preparing for

the impact of extreme natural events and can also help to

spread risks. Pre-event risk financing instruments include

setting up financial reserves, contingent debt agreements,

insurance and alternative risk transfer solutions.

A new generation of financial risk transfer solutions

Risk avoidance and mitigation strategies must be the

first priority in managing natural disasters, in order to

reduce the extent of any loss and thus the required

funding. However, no organization or country can fully

insulate itself against extreme events. Transferring cata-

strophic risk has to be a key element in the financial

strategy of every disaster-prone country or region in

order to enable and sustain growth – just as corpora-

tions and individuals pass on peak risks to insurers in

order to reduce financial volatility and avoid potential

ruin from events that exceed their resources.

This is where the insurance industry can offer its exper-

tise in developing innovative solutions. A new generation

of sovereign insurance (or ‘macro-insurance’) instruments

can make it easier for local and national governments to

cope with disasters. In parallel, innovative ‘micro-solu-

tions’ can protect previously uninsured individuals and

small enterprises from the catastrophic financial conse-

quences of weather-related risks. Such products can help

governments and individuals in a number of ways, by:

• Ensuring that funds are in place for recovery and

rebuilding efforts as well as to compensate victims

of catastrophic events, particularly in developing

countries or in rural areas of developed countries

with no insurance access

• Protecting their budgets and reducing financial volatil-

ity, with potentially positive implications on debt levels,

sovereign ratings and foreign exchange fluctuations

• Reducing income volatility for individuals in devel-

oping countries, thus providing greater financial

security in the face of changing economic circum-

stances, reducing distress and conflict, and

providing access to credit for farmers with little

income diversification (by allowing them to borrow

against insurance as collateral).

Innovative solutions already in place

One way of securing access to disaster funds is through

reinsurance solutions and insurance-linked securities. In

recent years, several innovative private sector schemes have

provided models for both the public sector and NGOs:

• In May 2006, Swiss Re structured, placed and rein-

sured parametric earthquake coverage for FONDEN,

the Mexican Government’s natural catastrophe fund.

The transaction combined securitization and rein-

surance instruments

• In September 2007, Swiss Re launched the Climate

Adaptation Development Programme, which

increased the likelihood of business interruptions following a flood

or a storm.

In 2005, economic losses from natural catastrophes hit a record

high, with direct financial losses of about USD230 billion. This repre-

sents 0.5 per cent of total worldwide gross domestic product (GDP).

Despite a record insurance payout of more than USD83 billion world-

wide, uninsured direct losses of USD150 billion had to be carried by

individuals, companies and – last but not least – the public sector.

In 2007, a total of 335 natural catastrophes led to overall economic

losses of USD64 billion across the globe, of which USD40 billion

were uninsured.

Europe was hit particularly hard, with winter storm

Kyrill causing an insured loss of USD6.1 billion – making it the third

most expensive winter storm on record – while the UK was hit twice

by extreme rains and flooding resulting in a total insured loss of

USD4.8 billion. In terms of fatalities, however, Asia suffered the great-

est impact, with 4,140 persons dead or missing in Bangladesh

following Cyclone Sidr in November. In the Korean peninsula, heavy

rainfalls and resulting flooding left 610 dead or missing.

Financial impact on governments

Natural disasters have a significant financial impact on private indi-

viduals, business and insurers. However, events such as strong

flooding, severe storms or heat waves also place a huge burden on the

public sector, which not only shoulders the cost of relief efforts, but

is also responsible for rebuilding public infrastructure. This is inten-

sified by the fact that public entities consciously decide to retain risk

by not insuring their infrastructure. Depending on the level of insur-

ance penetration, governments may also be expected to support private

rebuilding efforts. The overall impact on the public sector varies greatly.

In smaller and developing countries with less financial resources, a

catastrophic event can result in higher public deficits and debt.

The burden of natural catastrophes on the national economy varies

greatly by region. Although developed countries typically account

for the majority of economic losses, the burden in terms of GDP is

dramatically higher in developing countries and emerging markets.

For example, in Turkey an earthquake in 1999 caused an economic

loss of 11 per cent of GDP, while a 1986 earthquake in El Salvador

cost as much as 37 per cent of GDP. In Jamaica, the possible loss

from a hurricane scenario with a return period of 250 years has been

estimated to exceed 200 per cent of GDP.

In the absence of wide-

spread insurance coverage, economic losses of this magnitude can

only be addressed with significant public sector funding by govern-

ments or relief organizations.

Shifting from post-event to pre-event financing

Traditionally, the public sector has adopted a post-event approach

to disaster funding. This includes increasing taxes, reallocating funds

from other budget items, accessing domestic and international credit,

and borrowing from multilateral finance institutions. Many devel-

oping countries also rely on assistance from international aid.

Pursuing a post-disaster financing strategy has several disadvan-

tages. Diverting funds from key development projects to pay for

emergency relief and recovery efforts entails significant opportunity

costs. It may also be costly to raise new domestic debt in an expen-

sive post-event capital market, which can significantly raise the cost

of servicing the country’s debt. Finally, raising taxes following a disas-

ter may further weaken an already impaired economy and provide a

disincentive to new private investments that are important for a

speedy and sustainable recovery.