Planning for the worst

IFR IMF / World Bank 2009
8 min read

Governments around the world have earmarked funds to deal with the damage that catastrophes and extreme forms of weather can have upon livelihoods, and multilateral agencies such as the World Bank do their share in providing financial assistance. Yet having an affordable insurance solution in place before a crisis hits is, experts believe, the optimal solution for managing natural disaster risk, ensuring it doesn’t drain emerging economies by increasing their debt burden.

Insurers and reinsurers in the emerging markets, unlike those in OECD countries, still have enough capacity to take on natural disaster risk directly. However, both private sector and public sector entities believe the use of weather and catastrophic insurance, structured as capital markets instruments, will gain ground in emerging market countries going forward. Since 2007, the World Bank has been making progress in this area. It is involving global insurance companies in a number of transactions aimed at easing the financial burden upon countries in the event of a natural disaster by transferring the risk to the capital markets.

“Various studies over the past years have shown that countries waiting for donors to give them funds after a catastrophic event is just not a good enough option,” said Martin Reto Buehler, principal insurance officer at the International Finance Corp in Washington, D.C., the private sector arm of the World Bank. Like other agencies, it is keen to see increased use of catastrophe and weather-related insurance in emerging economies.

“It took, for example, 18 to 24 months for countries hit by the Tsunami to get their money, and governments just cannot deal with the double whammy of a catastrophe and rebuilding a shattered economy,” said Reto Buehler. “There is plenty a country can do before a disaster happens and insurance is the best tool.”

Private sector insurers have traditionally focused mainly on catastrophic risks in OECD countries. But over the past few years, several have been developing innovative financial risk transfer products aimed at helping emerging market governments leverage their available funds through the use of affordable capital markets instruments. This will enable them to protect their budgets in a low cost manner, and avail of more ample and immediately available funding when disaster hits.

First signs of life

Swiss Re, for example, launched in 2007 the GlobeCat securitisation, which used financial instruments with a trigger mechanism to transfer Central American earthquake risks to the capital markets. It provides a payout to the countries based on the size of a population exposed to a specific earthquake. The company also created the Cat-Mex bond in 2006 to help the Mexican government cover earthquake risk, and has worked in partnership with both multilateral agencies and non-governmental organizations on transactions to cover extreme drought in countries like Kenya, Ethiopia and Malawi, said Sandeep Ramachandran, director, ECM area at Swiss Re.

“The big advantage of these kinds of transactions is that countries make a small premium payment upfront and they don’t need to wait and file a claim after a disaster occurs to get paid a large sum of money,” Ramachandran said.

In the Malawi case, for example – which was structured to protect farmers against extreme drought and its impact upon the country’s maize output – the World Bank took historical weather data and matched it with data on maize production to come up with a weather hedge. It was structured so that Malawi would receive maximum payment if maize production dropped below the historical average. The risk was transferred to the private sector via Swiss Re and provided an affordable and workable solution for farmers, whose livelihood depends on the successful production of maize.

Over the past years, Swiss Re has been working to come up with other kinds of index-based transactions for dealing with extreme weather impacts in emerging markets countries. It is continually refining and fine-tuning these over time to come up with increasingly optimal solutions. These kinds of deals are interesting to the insurance giant, Ramachandran said, because they allow for portfolio diversification.

“Most of our risk is in developed countries, so to the extent that we can extend this to emerging countries does help us diversify and fits in well with areas that we want to grow,” he said.

They need somebody to lean on

However, for greater capital markets usage in the weather and catastrophe-linked areas, companies like Swiss Re must be able to rely on stable and dependable partnerships. Swiss Re looks to form alliances with the World Bank, the World Food Program, microfinance institutions and on-the-ground NGOs, Ramachandran said, to develop products tailored to the needs of specific countries. But it also expects individual governments to step up to the plate, get involved and look at the different types of insurance products they require. “There is an educational component involved and that is something that we as well as numerous NGOs continue to work on,” Ramachandran said.

According to Nikhil da Victoria Lobo, vice president of public sector business development at Swiss Re, many emerging market countries have shown both a willingness and eagerness to learn about how they can make use of weather derivatives and catastrophe insurance to mitigate and transfer risk. Most governments are dedicated to this endeavor, and many make stable and dependable partners. However, the greatest challenge in this field is actually sorting through and identifying the various risks that need to be covered, da Victoria Lobo said. This is where governments need to provide more assistance.

“Many sovereign governments are yet to properly identify the risks their countries face, so the first question clients ask is ‘what is my exposure?’” he said. “We work with countries to clearly identify and centralise risk, breaking it down into specific perils and using financial instruments to manage, mitigate and transfer risk.”

Indeed, a bond or a derivative works best when the risk it mitigates is homogenous, said Reto Buehler. One of the greatest obstacles to promoting the use of insurance products in the emerging market world is the lack of specific defined risk. “Insurance companies are only truly interested in applying solutions to a diversified portfolio of risks that are clearly defined and make sense,” he said.

While some emerging market regions – South Asia, Latin and Central America, for example – are more advanced in the science of risk identification, there is still a great deal of work that needs to be done at the local level, Reto Buehler said. The IFC is working to improve the technical skills in different countries, and also working with local insurance companies to get them up to speed on the details of weather and catastrophic risk management, he said. “We believe that there is a chance for emerging markets to step up, develop these same tools and deal with risks on their own, even as the distance between Wall Street and Malawi is shortened.”

From a global insurer’s viewpoint, the emerging markets represent great potential, given the overcapacity in OECD countries. However, Reto Buehler also believes that developing a local market is essential for the future of these countries.

“I can easily foresee a future 20-25 years from now where insurance penetration in emerging markets is equal to the OECD countries,” Reto Buehler said. “It’s clear, however, that whether one chooses to build local capacity or believes that insurance is best dealt with in a global way, it is the best tool to use to manage and mitigate risk resulting from weather fluctuations and natural catastrophes.”