Innovative but dull: disaster insurance is starting to pay off

Stefan Dercon

Chief Economist at DFID, Professor of Economic Policy at the Blavatnik School of Government, Oxford University and co-author, with Daniel Clarke, of “Dull Disasters: how planning ahead will make a difference”, published in 2016 by Oxford University Press

Hurricanes and an earthquake have caused havoc across the Caribbean and Mexico. Lives, livelihoods, roads, buildings, and infrastructure will need repair. But in the wake of these disasters, there is some surprisingly good news: Millions of dollars of relief finance are already being paid without fuss, social media campaigns, or photo-ops. What is this remarkable “innovation”? The answer is dull: it’s insurance.

This year, this hurricane season, we are beginning to see the benefits of pre-arranged disaster response financing.

One of the key problems with responding to these disasters traditionally has been that too often there are few incentives to be prepared, or to plan how to respond. There is often ambiguity about “who owns the risk” – who needs to act and who needs to pay for it.

In an immediate crisis, governments simply have to respond with what they have to save lives and protect citizens and infrastructure. But soon afterwards, recovery will need to start, and then the question will emerge: who will pay for what: local or national governments, international partners, families or firms? And where will the resources come from?

"Who owns the risk?"

Typically, without clarity on who will be responsible for what, and what to prioritise, recovery plans are usually just glossy reports on a dusty shelf, and funding arrangements just left for later. In poorer countries, this is about relying on what others give in response to appeals – and that’s typically less than half than what is asked for.

Only then, the scramble over these resources begins. This was shown in 2015, when more than $4.1 billion was raised after the earthquake in Nepal for recovery, but it took until seven months after the quake before a political agreement was reached on how to use the recovery fund. In better-off countries, we see squabbles between central and local governments, scrambling to reallocate budgets, and expectations of citizens that government will bail them out. This similarly stifles recovery efforts and their effectiveness.

Pre-agreed financing – such as sovereign parametric insurance, risk pools, or catastrophe bonds – provide incentives to change this: It forces governments to accept the risk, and clarify what they will do and won’t do when disasters strike.

Some definitions: Sovereign parametric insurance is where a premium is paid beforehand by a government and payouts are obtained based on an objective trigger, or parameter, such as wind speed or the Richter scale for earthquakes. A sovereign risk pool works in the same way, but countries jointly own the insurance company. In a catastrophe bond, capital is paid in by private investors, who get a return each year, but they lose the capital when a disaster strikes, otherwise the capital will be returned after a pre-agreed length of time.

As they are based on easily observable features, these products can get resources quickly transferred into the hands of whoever is considered to own the risk in a country, typically the central government.

Many of the affected countries in the Caribbean as well as Mexico had invested in these kind of products, mostly with clear rules on how to use the funds: paying for insurance forces you to think about what to insure. It gives hope that early recovery can be handled sensibly and effectively, without the usual political and media circus.

In Mexico, for example, the Fund for Natural Disasters (FONDEN) operates as a budgetary mechanism that makes sure that finance is in place for rebuilding infrastructure after earthquakes and other disasters, using pre-agreed rules across different layers of government, protected by a budget line, reinsurance, and catastrophe bond.

This week’s earthquake will trigger a release of funds by FONDEN, which should make the early rebuilding of key infrastructure possible, without excessive drains on public resources. Early reports suggest that the catastrophe bond (the IBRD/FONDEN 2017) will most likely be triggered too, resulting in a quick release of a large fraction of the $360 million capital to help with further relief and reconstruction.

In the Caribbean, the CCRIF, the Caribbean Catastrophe Risk Insurance Facility, set up 10 years ago as a risk pool with 17 member countries, has already announced it will pay out, within a fortnight, $15.6 million to the governments of Antigua and Barbuda, Anguilla and St Kitts and Nevis – providing resources to get public services and infrastructure functioning again.

Other countries are beginning to see the benefits of entering such schemes as well. For example, after the devastation of typhoon Haiyan, the Philippines has pursued its own sovereign insurance coverage, and only this week it has completed a catastrophe insurance arrangement with international support to provide financial protection to 25 provinces against the cost of relief operations and damage from typhoons and earthquakes. A similar scheme, African Risk Capacity, provides financing related to drought.

Setting these schemes up well is complicated, while they only really pay off if there are commensurate investments in risk reduction, public financial management, and preparedness, such as social protection plans that can be triggered after disasters.

Some key donors are recognising that. The UK Department for International Development (DFID), which has been involved in many of these mechanisms, has also just set up a Centre for Global Disaster Protection, along with the World Bank and insurance industry players. The Centre will give fair and unbiased advice to countries on managing risk and responses, as well as evaluating financial instruments.

None of these financing arrangements are silver bullets. They can‘t substitute for risk reduction, solid preparedness planning, and informed decision-making.

But they can help to provide the glue that holds it all together, making sound planning beforehand worthwhile.

Innovative? Yes.

Dull? We hope so.