Risk transfer enables the amortizing, or spreading, of financial risk over time and across a pool of clients, thus limiting the exposure of individual people or organizations to catastrophic losses due to disaster events. As such it is a key component of disaster risk management, but one that must be balanced with other types of disaster risk reduction to ensure comprehensive protection from disaster events.
Households that already have insurance against disaster hazards should check their policies to be sure that they have comprehensive coverage for the full range of hazards to which their family and assets are exposed. Particularly with the changing patterns for climate risk, past experience is often not the best indicator for future risk scenarios. National meteorological agencies typically provide a range of useful information products that can help inform individual and household decision-making.
For households that do not have insurance, it is important to research what insurance or other risk transfer services are available for affordable purchase through the commercial insurance market or that may be offered through government social protection schemes. Microfinance institutions also increasingly offer insurance as part of a comprehensive financial services package.
Businesses that already have insurance against disaster hazards should check their policies to be sure that they have comprehensive coverage for the full range of hazards to which their facilities, assets, and employees are exposed. Businesses also need to recognize that the extent to which their employees own families are protected by insurance also affects the businesses ability to maintain continuity of operations.
Changing risk patterns necessitate a regular review of business continuity plans, including the role of insurance and risk transfer. National meteorological and geographic agencies typically provide a range of useful information products that can help inform business decision-making and some private sector services also exist to provide the latest information on a wide range of risk to private sector customers of their services.
Community-based organizations working in microfinance have a variety of opportunities to combine their microfinance work with microinsurance to provide packages of bundled financial services to communities. Such programs often target the same communities and can benefit from economies of scale in distribution and administration networks at local levels. Microfinance and microinsurance can also be quite complementary in meeting the financing needs of the poor for effective disaster risk management. While insurance can be effective for covering less frequent, larger shocks, other forms of financing such as savings and credit may be more flexible and efficient for addressing smaller shocks that occur on a more frequent and regular basis [Churchill 2006].
Local and National Government
Governments are increasingly recognizing the utility of risk transfer mechanisms to help them reduce their fiscal exposure to disaster events and smooth expenditures for disaster relief and reconstruction. The government of Mexico has led the way in developing a rich set of disaster risk financing tools under its FONDEN program, and other national governments are now establishing similar mechanisms. Such tools however can also be used by local governments to better manage their own fiscal exposure and provide a more consistent set of disaster assistance services to their communities.
Disaster preparedness and risk management has important implications for daily decisions that are made by people in a wide variety of contexts. For families these decisions include where individuals or families live and work, how they save and invest resources, and what strategies (e.g. education or migration) they adopt for growth and development. Businesses, communities, and governments, face similar decisions as to which risks to avoid and which risks to cope with. Instead of a black and white world of either completely avoiding risk or completely ignoring risk, for most of us risk management means maximizing protection against the greatest risks and coping with others.
As Figure 1 illustrates, risk transfer when combined with other risk management strategies becomes a key component of comprehensive disaster risk management.
Figure 1. Risk transfer in comprehensive risk management.
Source: ProVention Consortium, 2007 adapted from SDC, 2006
Swiss Agency for Development and Cooperation (SDC), 2006, Regional Course on Integrated Risk Management, 28 Sep – 3 Oct, 2006, Yerevan, Armenia
A variety of risk financing tools have been developed to facilitate management of risks, These include a range of insurance, savings, and social protection tools which can help individuals, families, businesses, and the public sector protect development gains, reduce impacts and losses of disaster shocks, and provide resources for disaster prevention and risk management.
For upper and middle income families, large businesses, and wealthy governments, these tools are often readily available through existing insurance and financial services markets. However for those living in poor communities, gaining access to financing options for disaster risk management often requires creative and innovative solutions to address market gaps and failures of formal market products to meet the needs of the poor.
As illustrated in Figure 2, with robust coping mechanisms, the development loop is a positive spiral of increased investment and access to resources. Without, the loop becomes a negative spiral that threatens development gains and local buffers, which is a significant part of what makes many communities vulnerable in the first place.
Figure 2. Disaster risk management as an integral part of the development loop.
Bundling – Bundling refers to the integration of insurance for disaster risk with other types of insurance or with other financial services. For example, crop insurance is often bundled with loans for the purchase of seeds. Other schemes bundle together disaster, life, health and employment insurance.
Index-based insurance – While most insurance schemes have used traditional indemnity insurance, which pays insurance claims in responses to specific losses, new index-based schemes have also emerged.
So far these most often cover weather risks for crops, using precipitation levels (as measured in rain gauges at local meteorological stations) as a physical trigger. This type of insurance is also called parametric insurance. In this case farmers collect an insurance payout if the index reaches a certain measure or “trigger”, regardless of the actual losses.
The use of parametric triggers has greatly facilitated the creation of workable business models for insuring catastrophic risk. The parametric triggers reduce the need for expensive claims adjustment processes and greatly reduce administrative and disbursement costs.
Innovative distribution channels – While it is critical for enhancing penetration, distribution can also have “a huge impact on profitability, product design, and most importantly the cost of the insurance (premium levels)” [Kelkar et al. 2003]. Particularly in rural areas which lack distribution infrastructure for insurance, post offices, banks, and neighborhood stores are being explored as new distribution points for microinsurance. Many microinsurance schemes have been established through partnerships of MFIs or community organizations and commercial insurers. Such partnerships allow the MFI to use its existing distribution network to market the insurance, manage client relations, and bundle aggregated sets of insurance policies. The insurer then absorbs the bundled risk either itself or through reinsurance.
Technologies like kiosks and mobile phones also offer new distribution channels with the potential to make insurance accessible to a wider range of clients. For example, in Andhra Pradesh and Madhya Pradesh, India Megatop is using community IT kiosks to sell insurance to farmers [DfID].
Micropayments – As mentioned above in the point on Gender, allowing small payments at frequent intervals can help to make insurance affordable for those with irregular and low incomes. Allowing payment through local kiosks or through mobile phone billing services can also facilitate the use of micro-payments.
Pooling – While pooling as a general concept has been a part of insurance since its creation, pooling continues to be used as a important mechanism for increasing the number of policies under coverage which can both lower the costs for policies and eliminate the need for compulsory coverage schemes.
Public private partnerships (PPPs) – PPPs have been key to the development of certain types of risk transfer solutions (e.g. catastrophe pools) thus far. Initially PPPs have been used to gather the wide range of detailed research and analysis necessary to design the schemes.
PPPs have also been used for ongoing management and oversight of the pools which require active engagement from both private sector reinsurance partners and government regulators, often as well as additional credit-backing and advisory roles by International Financial Institutions or donor governments.
Risk assessment – Collecting or accessing appropriate risk analysis information is often very hard in developing countries. However without it proper risk identification/exclusion and proper risk layering (spreading layers of risk among insurers and reinsurers) cannot be done.
Risk layers – The viability of catastrophe pools is often based on their ability to transfer a part of their risk to third parties through risk layering be it private insurers, reinsurers, government, or donor community. This allows the pools to transfer some portion of the risk to reinsurance and capital markets even if commercial markets would not be willing to take on the whole risk.
Subsidies – Subsidies are frequently mentioned as a means for reducing the costs of insurance premiums. However such subsidies must be smartly targeted to address market gaps and to ensure movement toward market-based strategies; otherwise subsidies will distort responses to risk and undermine efficiencies and incentives within the insurance structure.