The Elusive Window of Opportunity for Risk Reduction

Session 3 Concept note Risk transfer: promoting disaster insurance in low-income countries

ProVention Consortium Forum 2007 Making Disaster Risk Reduction Work

Dar es Salaam, February 13-15 2007

Workshop 3 Concept Note Risk Transfer and Risk Reduction: Moving from a Dysfunctional to a Symbiotic Relationship

Financial Risk Transfer in Developing Countries

Risk transfer provides individuals, communities and countries flexible insurance and financial risk pooling mechanisms to manage and reduce their vulnerability to disaster risks. As it reduces the financial vulnerability of those insured, risk transfer should help lead to more stable livelihoods and a breaking of the cycle of poverty in the medium to long term, in turn creating opportunities to manage risks more effectively. It should thus form an integral part of disaster management strategies.

In low income countries, the development of risk transfer faces many challenges including affordability, accessibility, viability, governance and regulation. ProVention aims to help identify risk transfer solutions for developing countries, in particular to improve access to natural disaster insurance/reinsurance and other effective mechanisms. Current experiences and initiatives range from the regional to household levels:

Regional/National Level . Index-based “hunger” insurance to ensure food security; . Regional risk pooling to share risks at the government level; . Catastrophe bonds to utilize the strength of the global financial market; . Regulatory incentives to encourage the provision of insurance to poor communities; . Global facilities providing reinsurance for developing countries’ risks.

Community/Household Level . Micro-insurance to protect low-income households, farmers and businesses; . Community insurance to protect public facilities; . Insurance as a component of rebuilding to ensure sustainability of recovering communities.

Current Risk Transfer Efforts

A number of ProVention partners are addressing the challenge of applying risk transfer solutions in developing countries. For example, the World Bank and Opportunity International, together with the National Smallholder Farmers’ Association and the Insurance Association of Malawi, have developed a parametric index-based weather insurance product for groundnut farmers. The All India Disaster Mitigation Institute (AIDMI) also continues its micro-insurance pilot project, now with 5,500 policy-holders, including 1,500 tsunami-affected families.

At the macro-economic scale, the World Bank’s Commodity Risk Management Group and the EU are establishing the Global Index Insurance Facility (GIIF), aimed at facilitating and co-financing access to index- based insurance and hedging products for developing countries. At the same time, the World Food Programme successfully piloted index-based famine risk insurance with Axa Reinsurance for drought- affected farmers in Ethiopia, and will continue to develop this exciting new concept.

Incentives for Risk Reduction

1 / 3 Session 3 Concept note Risk transfer: promoting disaster insurance in low-income countries

While risk transfer is itself a component of disaster risk reduction, it should at the same time provide incentives for risk reduction. Insurance is a measure of last resort, covering only the risk remaining after hazards have been avoided, possible impacts have been mitigated and response has reduced adverse effects, as portrayed in the figure below1. Generally only high-intensity and low-frequency events are to be covered through risk transfer, although parametric insurance can be used to cover more frequent weather risks.

In theory the primary incentive of risk transfer for risk reduction is financial: if the risk is not reduced enough, then appropriately-priced risk transfer becomes prohibitively expensive. The insurance concept of deductible or excess, so well described in the German Selbstbehalt (“self-retain”, or keeping the risk oneself), is integral to any successful risk transfer scheme. If the insured does not carry some of the risk burden her/himself, then there is no incentive to reduce risk.

Although the concept of rewarding reduced natural hazard risk with insurance premium discounts is based on sound theory, its implementation in developing countries is so far limited. To keep insurance affordable for low-income communities, transaction costs are often reduced by offering standard insurance/finance packages. Monitoring and rewarding risk reduction at the individual level is however difficult and increases transaction costs; consequently no premium discounts for reduced risk are offered. Some providers of pilot schemes have however been integrating risk transfer within a disaster risk management approach and indirectly promoting risk reduction.

One exception may be index-based insurance recently implemented in Asia and Africa, such as crop insurance for weather risks. As claim payments are triggered by a physical or monetary index, not individual loss experiences, there is incentive to reduce risk. Although current experience with such products in developing countries is limited, their potential is high.

Risk Reduction is Key to Risk Transfer Success

A recent ProVention/IIASA study (see recommended reading) concludes that while micro-insurance has great potential for protecting the poor against the consequences of natural disasters, there are challenges and limitations that must be considered. These issues are generally also applicable to macro-scale risk transfer: . A lack of direct links and incentives on the part of risk transfer programmes to reduce the direct losses from disasters; . Affordable premiums for poor and high-risk communities; . The financial sustainability of insurance providers; . The different roles played by national and international solidarity in supporting risk transfer schemes; . Little transparency and few commonalities in the financial backup arrangements of private market providers; . The need for alliances among NGO/community groups, microfinance organizations, government regulators, entrepreneurs, and international financial and donor institutions in pioneering risk transfer programs.

The financial sustainability of insurance providers can only be ensured through sound risk management. A provider’s risk of large covariant losses (generally referring to natural disasters) must be reduced through diversification and/or national/international solidarity mechanisms, including reinsurance. The partnerships that are needed for successful risk transfer involve all stakeholders in disaster risk reduction. To keep risk transfer viable, risk must not only be reduced at the individual level, but also higher level alliances are needed to ensure community/national risk reduction activities. Further, direct- or cross-

1 Adapted from: Swiss Agency for Development and Cooperation (SDC), Regional Course on Integrated Risk Management, 28 Sep - 3 Oct, 2006, Yerevan, Armenia. 2 / 3 Session 3 Concept note Risk transfer: promoting disaster insurance in low-income countries subsidization may be needed between stakeholders to make the product affordable to the poorest communities.

All of these issues further highlight that risk transfer must be integrated into disaster risk reduction and that without disaster risk reduction risk transfer will not be successful. A symbiotic relationship is thus needed.

ProVention Forum 2007 Session on Risk Transfer

Recognizing the important symbiotic relationship between risk transfer and risk reduction, this session will focus on how risk transfer can effectively encourage risk reduction in poor communities. While the direct impact of risk transfer can only be felt after a high-intensity low-frequency disaster, if risk reduction is encouraged by risk transfer, it could make a difference in everyday practices. Further, when micro- insurance is linked or bundled with other microfinance products, a poor household’s liquidity and access to funds is increased, helping manage more frequent crises.

Considering that risk reduction is a key factor in all aspects of risk transfer, discussions will focus not only on specific risk reduction incentives, but also on how risk transfer can be used as a vehicle to further the general risk reduction agenda. At the same time, risk transfer will itself profit from the advancement of risk reduction.

The session will be divided into two panels: micro and macro approaches. Expected outcomes include the identification of specific activities/incentives that risk transfer schemes can use to encourage risk reduction, as well as approaches to incorporate risk reduction into risk transfer schemes and vice-versa.

Key Discussion Points

Some key points to consider before and during the session include: . How can risk reduction be incentivized and promoted directly or indirectly? . Is there evidence of successful incentivization, for example in the weather index-based schemes implemented in India and Malawi? . Should a risk transfer provider offer risk reduction support to its insureds and if so, how? . How can risk transfer effectively be integrated with disaster risk management? . How can the general disaster management community be made to understand the importance of risk transfer? . What partnerships between risk transfer providers and the general disaster management community would be most effective? . How can donors support risk transfer and risk reduction as a combined effort – do subsidies threaten the risk reduction incentives of risk transfer? . When are regulatory incentives by national or local government appropriate for encouraging or requiring the provision of insurance services among poor or vulnerable communities?

Recommended Background Reading ProVention/IIASA (2006). Disaster Insurance for the Poor? A review of microinsurance for natural disaster risks in developing countries . Geneva, Switzerland, July. Presentations from 6 th Annual IIASA-DPRI Forum on Integrated Disaster Risk management. Session on the Turkish Catastrophe Insurance Pool.

Further Reading ILO & Munich Re (2006). Protecting the Poor: A Micro-Insurance Compendium . C. Churchill, ed. Geneva Switzerland & Munich, Germany.

Daniel Kull with Reinhard Mechler February 2007