Innovation can remove limits of catastrophe risk transfer strategies: GDI

by Artemis on November 21, 2016

Catastrophe risk insurance, risk pools and catastrophe bonds can all participate in closing the international protection gap, ultimately helping to better prepare and finance the world against climate and weather-related disasters.

But further innovation is required to address the varied nature of catastrophe events across the globe and respond to loss and damage, according to a discussion paper from the German Development Institute (GDI).

The discussion paper explores efforts and measures that are currently, and could further be implemented across the globe in response to loss and damage as a result of climate change, and also catastrophic weather-related events.

Like other studies surrounding the issue from organisations such as the World Bank and the UN, the GDI paper notes the influence and potential of risk transfer solutions to respond to loss and damage in both mature and emerging regions.

Catastrophe risk insurance, risk pooling schemes and catastrophe bonds all enable the transfer of risk related to extreme natural disaster and weather-related events, such as hurricanes, drought, severe storms, earthquakes and so on.

The GDI paper notes several advantages for each of the aforementioned approaches to responding and mitigating loss and damage as a result of catastrophe events, but for each individual mechanism the GDI also highlights current disadvantages, including an inability to cover slow onset events, which are most likely to be a result of climate change.

Catastrophe risk insurance and risk pooling approaches, which can be seen with the effective CCRIF SPC in the Caribbean and Africa’s African Risk Capacity (ARC) scheme, “provide opportunities to incentivise risk reduction, enhance finance leveraged through private-public partnerships, pool risks across wide areas, and provide rapid payouts after catastrophes,” says the GDI.

Catastrophe bonds, one of the largest sub-sectors of the insurance-linked securities (ILS) space, provide multiple advantages, says the GDI.

This includes low correlation with the wider financial markets, a reduction of “roll over” risk that reduces the possibility of refinancing debt, and the fact that they don’t require a mandatory reinstatement, explains the GDI. Furthermore, “The application of cat bonds could reduce reliance on traditional forms of insurance, thereby reducing the overall costs of a programme,” says the GDI.

As noted in the report, and also discussed at the time by Artemis, regional catastrophe risk financing pools such as ARC and the CCRIF SPC and the Turkish Catastrophe Insurance Pool (TCIP) have used, or are planning to use catastrophe bonds to support their risk transfer needs.

However, for these types of risk transfer techniques and approaches at responding to loss and damage, there are limitations, and the GDI notes a need to develop risk transfer solutions “without the limitations of conventional insurance.”

“For example, parametric insurance schemes can redefine triggers that would prompt a payout based on parameters that indicate slow onset events, such as mean annual temperature increase or sea level rise,” says the GDI.

Parametric trigger structures are a common feature of the ILS and catastrophe space, and facilitate rapid payout post-event and have such approaches have been used by ARC, the TCIP, and the CCRIF SPC.

The limitation that the GDI applied to all the catastrophe risk insurance strategies mentioned in this article, relates to an inability, currently, to cover slow onset events, as catastrophe bonds and alike are designed to cover sudden catastrophes.

Other limitations include potential high costs of issuing such instruments for poorer governments and organisations in more emerging parts of the world, and the need for high-quality risk modelling capabilities, which can also be expansive.

As technology continues to advance, alongside a heightened awareness around the globe of the need to close the protection gap and make affordable insurance solutions available to those that need it most, innovative approaches are starting to be developed.

ARC, for example, has developed the XCF in an effort to improve Africa’s climate resilience, and has underlined the potential for climate change catastrophe bonds in the future.

In order to expand the reach of ILS and more traditional forms of catastrophe risk insurance to adequately respond to loss and damage as a result of climate and weather-related events, further innovation is likely needed. But the influence the market already has and things it can already do shouldn’t be ignored.

With more and more global economies and public and private sector entities seemingly eager to improve global disaster resilience and mitigate the impacts of, and prevent future loss and damage, it’s likely that a concerted effort among all parties will be needed, and risk transfer solutions look set to play a vital part in achieving the goal.

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