Climate change and the massive growth of population density in urban areas have led to an increase in the frequency and severity of natural disasters and therefore in the resulting costs. In fact, such catastrophic events have a significant negative impact on public finances as governments are called upon to cover the costs of relief and rebuilding efforts, undermining the country’s economy.
One example can be Hurricane Matthew that hit Haiti in October 2016. It was estimated by the United Nations a direct damage of $2.7bn which is approximately 32% of their GDP. Despite the high damages and costs caused by such catastrophic events, there is still a gap between economic and insured losses particularly in high-risk areas. In 2016, natural disasters caused approximately $210bn of economic loss worldwide, as reported by Aon Benfield, and only 24% of the total amount was insured.
The consequences of the so-called ‘protection gap’ are extremely severe, especially in emerging economies due to the high exposure and unpreparedness to face natural catastrophes. Governments must acknowledge this breach and work towards finding innovative insurance solutions, without excluding a cooperation with the private sector in order to reduce their contingent liability from such events that can jeopardise their budgets.
Under-Insured Countries Are at Risk
In a report released by Swiss Re emerged that in the last 10 years only 30% on average of catastrophe losses were covered by insurance; the remaining 70% caused $1.3trn in damage for individuals, firms and governments.
The main issue after a natural disaster is not only linked to the magnitude of economic losses caused, but also to the essential role that insurance coverage plays in protecting the GDP, as countries are more or less vulnerable proportionally to their capacity of absorbing the losses deriving from such events.
As a matter of fact, natural hazards take a deeper toll in underdeveloped and under-insured countries where a devastating catastrophe, in terms of economic impact, may be more severe than in insurance-penetrated countries.
In those situations a catastrophe insurance coverage that narrows the protection gap is what makes the difference for the country’s financial resilience, minimising the negative financial impact and helping countries recover more quickly.
Ways of Closing the Gap
Potential credit events linked to a natural catastrophe can be prevented by governments by using specific risk transfer solutions, but in certain circumstances, access to risk financing strategies is limited or has high costs.
Nowadays there exist a variety of innovative risk-transfer solutions that can act as a model for other countries, for example by exploiting the capacity provided by international capital markets, that have up to $100trn in assets. To benefit from this capacity, various financial instruments have been developed, including catastrophe bonds.
As some countries do not have the means to access such technically complex and expensive instruments, the World Bank has developed a catastrophe bond issuance platform called the MultiCat Program that allows governments to use a standard framework to buy insurance on affordable terms by issuing ILS.
Mexico being very exposed to natural hazards has been in the last years very proactive to approach disaster risk financing. The Mexican government to this cause created FONDEN a fund for natural disasters in 1996, and in October 2009 was the first country to issue a multi-peril, multi-region cat bond using the World Bank’s MultiCat Program.
Another example is Turkey, frequently subjected to damaging earthquakes, has founded in 2000 TCIP (Turkish Catastrophe Insurance Pool) that provides risk-based disaster insurance for nearly 7m homeowners and has become one of the largest catastrophe insurance pools in the world, followed in 2007 by the Caribbean Catastrophe Risk Insurance Facility (CCRIF SPC) a multi-country risk pool utilizing parametric insurance.
Pre-event financing solutions help to lighten the financial load on governments, to this end is fundamental that they support a correct functioning insurance market that is able to absorb a part of the losses suffered by individuals and businesses after a catastrophic event. In this framework, a partnership between public and private sectors is essential to finance disaster risks.
As illustrated, innovative risk solutions to narrow the protection gap have already been developed and tested in the recent years, and can be used as a source for other countries to emulate.