Reinsurers face a future of ever-increasing catastrophe losses. The World Bank’s Eugene Gurenko discusses the industry’s role in an age of climate change.
The causes of rising global temperature and the increased frequency of extreme weather patterns remain the subject of ongoing scientific debate. Meanwhile, the insurance industry – particularly global reinsurers – face the undeniable consequences of climate change. Estimated insured losses caused by natural disasters have been on the rise worldwide. Economic losses over the last decade have increased by a factor of seven over the level of the 1960s, and insured losses caused by natural disasters went up by a factor of twenty-five. First 2004 and then 2005 have been the years with the highest-ever insured losses due to weather-related natural catastrophes. Insurance claims from natural disasters (and related economic losses) are likely to continue on their relentless upward trend.
Climate change means that natural disasters in disaster prone countries are becoming a way of life. As a result, governments are no longer capable of dealing with the economic consequences of natural disasters on their own by financing them out of annual recurrent budget revenues. Catastrophe insurance coverage for private assets, particularly private homes, remains rather scarce worldwide, not least because of the still prevailing (but now completely obsolete) model where governments view post-disaster reconstruction subsidies as a legitimate use of taxpayers funds.
Just a quick look at the statistics of catastrophe insurance coverage among homeowners in most disaster prone parts of the world reveals a staggering picture. In all but four countries (see figure 1) where catastrophe insurance is affordable and is compulsory by law, with an effective enforcement mechanism, most homeowners remain at the mercy of Mother Nature and their respective governments when it comes to post-disaster compensation. The penetration statistics also raise several pertinent questions relevant to the forging of a truly global public private partnership between governments of disaster prone countries and the global reinsurance industry.
First of all, there is the responsibility of governments and industry in dealing with climate change. Over the last few decades, mandatory motor third-party liability coverage (MTPL) has become a universally accepted legal norm endorsed by every nation on the planet, despite the fact that the issue at stake is coverage for private assets provided by private firms. The accepted common rationale for compulsory MTPL coverage is that everybody has a right to be compensated in case of becoming a victim of a car accident caused by a third party. A similar rationale certainly applies to victims of natural disasters, with the only difference that natural disasters often affect millions of people at once, giving the issue of individual compensation a new social and political dimension. Indeed, every victim of a natural disaster deserves to receive a minimum compensation essential to resume a normal life. The only question is how to best fund this compensation.
In a recent World Bank survey we discovered what we had long suspected: that governments simply do not have the financial resources to finance even medium-sized natural disasters. For instance, it would have taken 248 national annual emergency budget allocations in Romania to pay for the recent 2005 floods. Most other countries in the region did not fare any better.
Governments should do more to stimulate demand for catastrophe insurance coverage among their people. One way to proceed is to make catastrophe insurance compulsory for all homeowners who live in disaster prone areas, like MTPL insurance. This would guarantee a no-fault immediate compensation to affected homeowners without putting government finances at risk. To help the private market provide the needed coverage, governments should lift (or refrain from introducing) premium rate controls, which often make the delivery of catastrophe insurance unprofitable.
Governments should invest in raising public awareness of catastrophe insurance and incorporate commercial insurance mechanisms into the national disaster compensation system. They should also encourage catastrophe risk pooling solutions. These can act as national/regional aggregators of catastrophe risk and a platform from which to access global reinsurance and capital markets on efficient pricing terms.
“Governments are no longer capable of dealing with the economic consequences of natural disasters on their own
For governments to succeed in raising the demand for catastrophe insurance coverage in a meaningful way, these products should be made affordable, simple to understand, and easy to collect on in case of a disaster. It is no accident that in countries like France and New Zealand where catastrophe insurance coverage is included in fire policies, with premiums collected through a simple small surcharge on fire premiums, the take-up rate among homeowners is close to 100%. Unfortunately, in countries with less developed P&C markets where only few have a fire policy this mechanism is impractical. In this context, the ability of insurers to come up with new low cost catastrophe insurance products is simply crucial.
The industry has to innovate to find ways to reduce distribution and claims handling costs through simplified terms of coverage and claims verification and settlement processes. It must also find a way to share a larger part of the potential loss burden with governments and the insured through higher deductibles and lower limits. These actions should result in affordable pricing and simpler terms of coverage – the key prerequisites for developing the mass catastrophe insurance market.
Capital market capacity
The increased primary demand for catastrophe insurance products will translate into much higher needs for additional risk capital. Can the reinsurance industry meet these additional demands? We estimate that today somewhere between $100bn-$150bn of risk capital, including annual premium and risk capital in alternative risk markets is dedicated to catastrophe risk. Considering that Katrina cost $40bn alone, this amount of capacity does seem rather insignificant.
With further development of catastrophe risk securitisation techniques, the limited capacity of the reinsurance industry can be augmented many-fold by capacity available from the capital markets. This will benefit the capital markets by expanding its exposure to an asset class that bears little or no correlation to other investments. With the reduction in transaction costs involved in issuance of insurance-linked securities (ILS), securitisation of insurance risk should become no different from that of credit risk. With these developments in the ILS market, reinsurers will increasingly play the role of risk underwriters and conduits between insured and investors rather than that of risk warehouses.
In the age of climate change the industry also has a social responsibility to encourage more sustainable carbon emission habits among its clients as well as their commitment to disaster risk reduction. To reward sustainable energy consumption and prudent risk management on the part of the insured, the industry may consider a combination of pricing incentives. One idea to consider is the introduction of an universal insurance premium surcharge/credit (mandated by national insurance regulators) linked to the carbon footprint of the insured – the higher the emissions the higher the surcharge. The collected premium surcharge could then be used to reduce the premium for weather-related coverage (eg flood or wind) to insureds with the lowest carbon footprint.
The new age of climate change offers enormous business opportunities for the global insurance and reinsurance industry, due to the growing interest of the general public and governments in protecting themselves against the vagaries of weather. These business opportunities however may prove to be illusive in the absence of innovation and the ability of the industry to change along with the planet’s climate.
Eugene Gurenko is lead insurance and risk management specialist at the World Bank.
Catastrophe insurance penetration for homeowners in selected disaster prone countries
Country/region Disaster insurance coverage
(% of insurable homes)
Southeastern Europe <5%
New Zealand 90%