Each year, the World Economic Forum (WEF) works with insurers and risk management professionals to come up with a report which highlights the main global risks the world will face in the coming year. The 2011 report has been published recently. For this report the WEF worked with Swiss Re, Marsh & McLennan, Wharton Center for Risk Management, University of Pennsylvania and Zurich Financial Services.
According to the report, the global economy is in no position to face any major new shocks, the financial crisis has left the world in a vulnerable economic state and society’s ability to deal with the major risks has been damaged. However, the report highlights that the world faces growing risks and the prospect of rapid contagion through increasingly connected societies and systems. It highlights economic disparity and global governance failures as two factors that influence risks and inhibit the worlds ability to deal with them.
The report identifies three important clusters of risks. The global economy including macroeconomic imbalances, currency volatility, asset price collapse and fiscal crises. The illegal economy driven by crime, corruption and illicit trade. And the growing demand for food and water combined with the unsustainable pressure on resources.
Five risks to watch were also highlighted: cyber security, demographic challenges which add to fiscal pressures, security of global resources, retrenchment from globalization and weapons of mass destruction.
It’s pleasing to see the report state that effective response to these risks is not just about proactively reducing the downside associated with global risks but also about seizing opportunities for innovation and growth that arise.
The report identifies the role that re/insurance and risk transfer has to play in managing these risks and alternative risk transfer gets a mention along with catastrophe bonds as potential tools to transfer risk away from nations, to insurers and ultimately the capital markets.
Catastrophe financing: the use of alternative risk transfer instruments
The most common form of risk transfer, insurance, shifts exposure to insurers in a exchange for a premium. However this depends on insurers being able to profitably pool and absorb a range of risks through diversification over time and geography. This is becoming more difficult as disasters are increasingly regionally and temporally concentrated, thanks in part to development in hazard-prone areas. Of the 25 most costly insured catastrophes in the past 40 years, two-thirds have occurred since 2001.
The World Economic Forum’s Global Agenda Council on the Mitigation of Natural Disasters produced an analysis* of new forms of risk transfer which involve shifting parts of catastrophe risk exposure directly to financial markets. Alternative risk transfer (ART) instruments offer innovative financial solutions to meet the growing needs of financial coverage of catastrophic risks and permit investors to play a more direct role in that sphere.
One example of such instruments is a catastrophe bond which enables a company, international organization or a government to issue bonds to protect them against predefined risks. Over 160 “cat bonds” have been issued to date around the world to protect against pandemics, terrorism and natural disasters. Another promising financial innovation is weather-index based micro-insurance for subsistence farmers in countries where traditional insurance is unavailable or unaffordable.
With proper regulation and transparency, such alternative risk transfer instruments can provide additional capital and offer new ways to hedge catastrophe risks, protect individuals and reduce the systemic impact of future disasters.
* Michel-Kerjan, Erwann “Hedging Against Tomorrow’s Catastrophes”, in Learning from Catastrophes, Kunreuther and Useem (Eds), Wharton School Publishing, 2010
It’s good to see the recognition that risk transfer gets in this report.
Interestingly, the website Investment & Pensions Europe who were at the launch of the report, said that some of the representatives of re/insurers at the launch highlighted longevity risks as one of the stand-out risks the world is facing. These spokespeople highlighted the need for the capital markets to help governments and insurers absorb longevity risk.
Read the full report online here.