Catastrophic risk insurance: Willingness and ability to pay

Catastrophic risk insurance assumes specific importance when we talk about disaster risk reduction or climate change adaptation or sustainable development since  risk insurance has been advocated and effectively used in small scale to achieve these broad goals in most instances. However, the spread or uptake of risk insurance in the Asia-Pacific region and  elsewhere remained negligible (compared to sales of Coke or cell phones?) due to several bottlenecks arising from policy and information imperfections. While part of the problem can be attributed to policy level imperfections, it is surprising to see that a subject that can greatly benefit corporate sector (really?) also seems to suffer same limitations that many other public policies face and the so called efficient and effective private sector seems to be oblivious to this fact that they are not able to reach out to a section of society that needs them most. The intriguing question here is, how come the same corporate sector that is extremely successful in selling a sugared drink (such as Coke or Pepsi) which in most opinion is useless and probably has least intrinsic value of whatsoever is failing to sell a very useful product such as risk insurance to the very same masses!

"If I could convince my son to ride bicycle without fear by wearing a helmet, I am sure our marketing agents are more than intelligent and can very well communicate the risk to adult population they are targeting!!!"

I am sure several people have already talked and written on this subject very extensively but I feel that there is definitely more than that meets the eye. In a quest to get even with this, I have been brainstorming (and writing) on this issue for quite some time and this is what I could come up with to summarize what may be limiting the spread of risk insurance in most cases:

1) Affordability: The issue of affordability could be put at the top of all the bottlenecks limiting the spread of risk insurance in the developing Asia-Pacific. Though insurance premiums in most of the developing Asia-Pacific region are lower than that of those in the developed countries, the annual insurance premium costs are still not affordable for most of the income groups in the developing countries. Part of the high insurance premium costs emerge from the high residual risks and low spread in terms of number of insured (i.e. poor development of the insurance portfolio). 

But, mind you, the cost of premium cannot be brought down beyond a point since the premium should meet lot of other expenses of the insurance company as well. Can we think about subsidizing the premium? Though this option appears to be most lucrative proposition for most policy makers, as they tend to go towards populistic measures, there are several others that go against this option. The argument here is sending proper price signal is important to make the insured feel the importance of [not]indulging in reckless risk taking behavior! Then the question is how do we bring down the price to an affordable level?

The price issue has two components, one is ability to pay and the second is willingness to pay. I think there is not much research on these points, if the success in uptake is achieved by targeting more on willingness to pay than on ability to pay.  I would be very happy to see an approach that targets both these components of price rather than getting lost in some kind of obscurity. 

2) Residual risks: High residual risks are one of the major causes for the poor risk insurance coverage in the region. The high residual risks are due to poor disaster risk mitigation mechanisms, lack of or poor enforcement of laws and codes such as building bylaws, structural codes, and laws pertaining to land use planning.

3) Presence of insurers and reinsurers: One of the reasons behind poor penetration of insurance and insurance prices above affordability is limited presence of private insurers and reinsurers. Reinsurers play an important role of providing shock absorbing capacity to the insurers. To date, very few national (e.g. General Insurance Corporation in India, China Reinsurance Company in China, Zenkyoren or Zenkoku Kyousai Seikatsukyoudoukumiai Rengou Kai in Japan) and international (e.g. Munich Re, Swiss Re, Toa Re, Axis Re) reinsurers operate in the region. Hence, there is a very high potential for the expansion of the reinsurance sector. Insurers and reinsurers cannot afford to operate in the region unless there is sufficient enabling environment including efforts to reduce the residual risks.

4) High premium costs: The high residual risks, lack of optimum number of insurers, low competition, and low number of insured population all lead to the higher premium costs than what they could be in the Asia-Pacific region.

5) Policy environment: Though risk insurance is a ‘market instrument’, its dynamics are determined or governed by the principles of an open market, government policies and regulatory guidelines act as precursors for flourishing of the sector and ensures the effectiveness of the instrument. Hence, the role of government in promoting the culture of risk mitigation by promoting awareness generation, and designing and implementing structural and non-structural disaster risk mitigation codes and laws including institutional mechanisms and regulations for promoting risk insurance is paramount.

Though there has already been significant improvement in terms of policy support to insurance sector, as observed from the high growth rates of insurance sector in the region, the support is still not comprehensive enough. For example, currently, most developing countries in the Asia-Pacific region are at the nascent stages of formulating national disaster risk mitigation plans and policies and haven’t fully utilized the potential of risk insurance in promoting risk reduction. Traditionally, strong emphasis of most governments on disaster response over mitigation is known to hinder the public participation in risk insurance schemes. Limited financing is the major reason behind the poor emphasis on disaster risk mitigation in the region.

6) Cultural and perceptional issues: General lack of awareness and misplaced perceptions about dealing with the risk in general and about the risk insurance in particular among the common people and business sector also serves as a bottleneck. Sociological research has indicated the existence of behavioral situation that can be characterized as ‘lethal attitude’ which suggests that things will happen whatever is done and that things are beyond ones’ control, which limit the risk mitigation behavior of individuals.

7) Lack of data: Infrastructure for collecting and managing the systematic and comparable data on past risks, vulnerabilities, disasters, and the nature of disaster losses provides important information for designing risk insurance schemes which is either not fully developed nor readily available and accessible to the risk insurance industry and for the general public in most of the developing nations in the Asia-Pacific region.

Another important challenge, which didn’t receive much attention in the region, that could undermine the implementation of an affective insurance facility is the liability challenge that insurers will have to deal with due to not reporting their climate related risks to their shareholders, and probability for high insurance payouts due to high potential for yield losses in a changing climate scenario. As a result of these limitations, most of the initiatives couldn’t be scaled-up to cover larger, and sometimes important geographic areas and socio-economic groups that could benefit from insurance related instruments.

For more information, write to me and I will be happy to send a full paper that I have been working on this subject. 

Risk insurance in the Asia Pacific Region: How the processes under UNFCCC can help?

This is not a full article. Read the full article available here.

Summary
Risk insurance can provide an effective means of catastrophic risk reduction and climate change adaptation in the developing countries. The ongoing discussions by the Conference of Parties to the United Nations Framework Convention on Climate Change are putting substantial efforts to promote climate change adaptation through international cooperation in the form of providing additional finances and technologies including proposals to promote a global or regional climate risk insurance facility. Case studies from within and outside the Asia-Pacific region provide valuable lessons which could be used for promoting risk insurance by the future climate regime (post-Kyoto Protocol beyond 2012). The analysis of these risk insurance proposals to the Convention and comparison of what they intend to achieve with that of the existing issues within the risk insurance sector in the developing Asia-Pacific indicate that these proposals address some of the major issues that are limiting the spread of risk insurance. However, no single proposal is comprehensive enough to address all the issues and all the proposals lack details in terms of how they can achieve what they intend to achieve. There is a need for the proposals to the Convention to give more thought on how they address the issues such as high base risks, lack of historical data required for designing risk insurance systems, limited awareness in the utility of insurance instruments, keeping the premium prices within affordable levels, encouraging the role of private sector, enabling greater access to reinsurers, and instituting enabling policies to create a proactive risk mitigation environment with an eye on sustainability. A convergence approach wherein the proposals incorporate lessons from on-the-ground experiences from regional, national and local initiatives could provide an effective model for promoting the risk insurance.

.........Not a full article......

The natural and man-made hazards have historically undermined the developmental gains across the world. The Asia-Pacific region is one of the most vulnerable regions to a range of primary hydro-meteorological natural hazards such as storms, floods, and droughts. The data from EM-DAT suggest that the number of hydro-meteorological natural disasters has been increasing at an average annual rate of 217% over the past 40 years in the Asia-Pacific region (EM-DAT, 2010).

 In the region, the total human lives lost due to disasters were 3729 with estimated damage costs of 11.54 billion USD in 2009. Similar increase in the number of catastrophic natural disasters and related losses was also reported by Munich Re according to which both the insured and uninsured losses have been increasing over the years.

Climate change has brought an additional dimension to disaster risks in the Asia-Pacific region as it is projected to exacerbate the intensity and magnitude of various natural hazards such as storms, high-intensity rainfall events, heat waves, floods and droughts. Especially, the projections suggest high probability for an increasing trend in the high-intensity and low probability events (IPCC, 2007; Kunreuther and Michel-Kerjan, 2007). These increased catastrophic risks will further undermine the developmental gains already made in the Asia-Pacific region.

Taking agricultural sector as an example, being one of the highly vulnerable sectors in the region, farming communities are in particular at greater risk due to weather related crop failures. Often, farmers borrow loans from local banks prior to the cropping season. However, farmers, banks, and governments are put at higher financial risk due to increasing frequency of crop failures, and often governments are forced to waive the loans. In case of India, estimates suggest that the government waived off crop loans worth 16 billion USD in 2008 alone (Srinivasan, 2008). Similar incidences are observed across other countries in the Asia-Pacific region (Sompo Japan Insurance Inc., 2010).

Hence, in order to address additional risks brought by the impact of climate change, there is a need to relook at and reframe the current risk reduction strategies especially in terms of development and utilization of risk spreading instruments within the Asia-Pacific region. This working paper reviews the current status of risk insurance and identifies emerging issues and experiences. These issues and experiences are applied to various risk insurance proposals made by the Conference of Parties (COP) to the UNFCCC for assessing the extent to which they consider experiences to address issues for promoting the risk insurance.

The concept of risk transfer or risk spreading entails that the individual (the insured) risks be reduced by spreading or transferring the risks from the insured to the insurance provider (the insurer) since the insurer is in a stronger financial position than the insured (Njegomir and Maksimovic, 2009). The insurance provider is able to insure the risks of the insured largely due to the fact that the insurer obtains premiums from a large number of insured who are at different levels of risks by making sure that the total amount of premiums collected are far greater than or exceeds the underwriting of risks (termed as law of large numbers). Insurance agencies in turn underwrite some of these risks with reinsurance firms that provides needed buffer against catastrophic event related losses. In sum, the risk insurance scheme functions as part of the social security net through risk transfer mechanism and thereby contribute to build the resilience of vulnerable societies.

Risk transfer has been widely advocated as one of the best means of risk mitigation across the world (Arnold, 2008; Siamwalla and Valdes, 1986; Swiss Re, 2010) due to several advantages it provides:

 

·         Promotes emphasis on risk mitigation compared to the current response-driven mechanisms.

·         Provides a cost-effective way of coping financial impacts of climate and weather induced hazard events.

·         Supports the climate change adaptation by covering the residual risks uncovered by the other risk reduction mechanisms.

·         Stabilizes rural incomes and hence reduce the adverse effects on income fluctuation and socio-economic development.

·         Provides opportunities for public-private partnerships.

·         Reduced burden on government resources for post-disaster relief and reconstruction.

·         Helps communities and individuals to quickly renew and restore the livelihood activity.

·         Depending on the way the insurance is designed, the insurance mechanism can address a wide variety of risks emanating from climatic and non-climatic sources.

Read full paper available here.