Q&A: How climate risk insurance can work for developing countries

BONN, Germany — One of the clearest messages at COP23 — the United Nations climate conference now entering its second week in Bonn, Germany — is that developing countries, in particular island nations like conference chair Fiji, are bearing the brunt of the adverse effects of climate change. Rising sea levels and more severe weather patterns are putting the very existence of entire nations at risk.

Against this backdrop, climate risk insurance has so far been one of the most widely-discussed mitigation mechanisms in Bonn. On Tuesday, a high-level event will detail new efforts to increase climate-vulnerable people's access to climate risk insurance — but some developing country advocates have pointed out that selling people insurance is not a replacement for fulfilling obligations to provide them with compensation for losses and damages they did nothing to bring about.

Last week, Devex sat down with geophysicist Ernst Rauch, head of climate and public sector business development at Munich Re, one of the world’s largest reinsurance companies. Having worked in the field of natural disaster risk assessment since the 1980s, Rauch later started working on climate risk assessment and insurance.

He spoke to Devex about various climate risk insurance schemes, how to overcome obstacles to uptake in developing countries, and potential outcomes of COP23. The conversation has been edited for length and clarity.

What is the link between natural disaster risk assessment and climate change insurance?

At Munich Re, we have been collecting data on natural disaster loss events since the 1970s. Analyzing this data, we see that the vast majority — roughly 80 to 90 percent — of natural disaster events worldwide stem from weather-related catastrophes as opposed to geophysical events like earthquakes, seaquakes, or volcanic eruptions. But we realized early on that the statistics are changing. We can no longer use statistics from the past and assume they are reflecting the current risk situation globally. We basically see no change with the geophysical events, their frequency and the losses, but we see significant changes in the frequency of weather-related events. Globally, the number of these events has almost tripled since the 1980s, with enormous differences from region to region.

We're pretty sure this is not only climate-driven but is also driven by socio-economic effects — changes in population, wealth and so on. As a reinsurance company, we define risk as a setup of three components: the hazard, so the probability of events occurring, which could be related to climate change for instance; vulnerability, so if there is an event of a certain intensity, what would the losses be; and exposure.

In two world regions — North America and Europe — we have published research papers that suggest that climate change is very likely having an influence on these changes in the loss distribution. It’s about severe convective storms like thunderstorms, tornadoes, hail and, as a consequence, flash floods from heavy precipitation. But you can only run the analysis if you have long-term, high-resolution meteorological and socio-economic data, which is why we have started in the United States and parts of Europe.

To us, the evidence is clear. Meteorological probabilities of severe weather have changed and the losses have changed in line with it. If you take out socioeconomic data like wealth, it all still correlates, assuming that the vulnerability has remained more or less constant.

[But] we also have strong indications in other parts of the of the world. A good example are this year’s major hurricanes in the Caribbean. If you look at the global losses from worldwide catastrophe events for the private sector, in 2005 the insurance industry paid out more than $100 billion globally for natural disasters. Events like Hurricanes Katrina and Wilma in the U.S. were the main drivers; the former remains the costliest natural disaster to the insurance industry to date. Then, in 2011, our industry had another $100 billion-plus year, which is often attributed to the earthquake in Japan and the Fukushima disaster, but it was really a series of events: floodings in Australia, Thailand and other regions also played a role.

Fast-forward to today, and 2017 will be at least in the same order of magnitude. So in the timespan of 12 years, we had three years with more than $100 billion in payouts from the private sector insurance industry. Never ever in the past have we seen such numbers. Again, this is an indication that obviously it's not only the socioeconomic factors changing weather-related events, because the world doesn't change that much in a dozen years.

Part of the effort that's underway here in Bonn is to think about climate risk insurance as a potential solution for developing countries. The numbers you cited are huge but sound like they're more or less tied to major events in the developed world. What would it take to get to the point where payments would be issued for some of the impacts that developing countries are seeing, like drought and famine?

You're absolutely right. These huge losses are mainly coming from industrialized countries, the reason being that insured values there are higher than in developing and emerging countries. Another reason is that the insurance penetration — so the take-up rate for catastrophe insurance — is much higher. Nonetheless, there’s still an enormous “insurance gap” in industrialized countries. In the U.S., for instance, an average of only 55 percent of losses from natural disasters are insured. The rest is on the taxpayer and those who haven’t purchased insurance policies.

In developing countries, the insurance take-up rate is somewhere between zero and three percent. If you are living on just two or three dollars a day, you have other needs and worries than spending your money on insurance, and I think this is quite understandable. [But] that means that if there is a disaster, it affects not just the people, who are suffering first, but it also affects the economy with a projection into the future. It takes a long time to recover from economic shocks.

In 2015, the G-7 meeting in Germany set up the InsuResilience climate risk insurance initiative, whose aim is to provide climate and natural hazards insurance for an additional 400 million poor and vulnerable people in developing countries by 2020.

Insurance is a means to stabilize economic growth, dampen economic shocks and speed up recovery. A good example is New Zealand, which has a fantastic public-private partnership insurance concept. After the major earthquake in 2011, almost 80 percent of overall losses were paid by the insurance industry, and New Zealand’s relatively small economy was able to recover really fast. In regions in developing countries, on the other hand, you don’t usually see much reconstruction even five or 10 years later. They just abandon damaged and destroyed houses and move away, which is not the best way of handling this.

[We’d like to see] this InsuResilience project improve resilience if governments become the insurance partner. Examples are the Caribbean Catastrophe Risk Insurance Facility and African Risk Capacity, a pool where the African Union is basically the policyholder. The individual countries have to pay the premiums. The capitalization — grants, donor money, and so on — came from Germany, but it’s a regional pool with a number of countries participating and benefiting. The premium payment, at least to some extent, has to come out of the finance ministers’ pockets. This makes sense because the general experience is that you’re only willing to define the proper governance and political framework — rules, laws and regulations — if you have a financial stake in the project.

So it seems we’re moving towards this model you just described where developing countries pay into an insurance platform where they’re at least partial policyholders. Isn’t one of the aims of insurance to create incentives for people to reduce their risk, and therefore wouldn't you want people who hold the risk paying into it?

You're absolutely right. That's one of the biggest differences between an insurance solution and a bank solution. In the case of a bank solution, you typically have a funding or lending agreement that provides you with a credit line after an event. Insurance is much more than that. It starts prior to the event, and, if designed properly, provides an incentive to reduce your own individual vulnerability. Individual can mean on a private person's level or on a nationwide level, because insurance premiums depend on the risk the individual person or country has. So if you reduce your own vulnerability, you pay lower insurance premiums. That's why insurance would be the preferred vehicle to start prior to an event, addressing areas of high vulnerability and reducing vulnerability so you can get this risk transfer product at lower cost.

In the aftermath of an event, insurance can provide you with information on how to recover from it and how to rebuild. It can also help improve your situation in the run-up to the next event. So the service spectrum that comes with an insurance with respect to vulnerability reduction, adaptation and resilience is higher than with a bank product.

But we also see that when it comes to engaging governments in natural disasters risk transfer solutions, there are a number of reasons to go for support through development bank products. From a political perspective, it's just a better sell to have a product where you only receive money and start paying back after the disaster. Insurance means you have to start paying your premiums even in years where there’s no disaster, which makes for a more difficult sell.

Is this particularly challenging when dealing with elected officials, in a scenario where someone paying into an insurance policy never sees a payment during a politician’s tenure?

What is absolutely necessary in order to start thinking about and developing an insurance framework in developing and emerging countries is that these countries need to understand the benefit of a long-term process leading towards a holistic approach on risk management and insurance. The payoff may only come after the next election period, but when it comes to the question of responsibly acting politicians, it should be on the agenda. We need, especially in low-income countries, a paradigm shift that recognizes that catastrophe insurance helps grow and stabilize the economy. There’s plenty of proof for this. It’s not a silver bullet, but it’s a good instrument. Haiti is a case in point: Every earthquake and tropical cyclone hits the country’s economy so hard that people are suffering more and more rather than being able to build up wealth.

What happens after an insurance company issues a payout to a government that has bought into a climate risk insurance platform — does the government usually undertake a recovery and reconstruction plan on its own, or does it distribute resources to people?

There are different models out there currently. One example is the aforementioned Caribbean Catastrophe Risk Insurance Facility, which is a regional pool and a public-private partnership. It paid out more than $50 million to participating Caribbean islands after the hurricanes of 2017. The government receives the money, and it's up to them to use it properly to help those who suffer. It’s up to them whether they use it to rebuild infrastructure like roads or pay it out to people directly.

The African Risk Capacity is another example. It’s also a regional pool, and the participating countries have given themselves governance on how to pay out if one or more countries receives money from the insurance policy. With a regional pool, other participating countries watch closely what's happening to the payouts because they are based on premiums all countries participating in the pools are paying.

I believe we will see improving governance and rules on payouts over time. It’s not going to happen overnight. Gradually, more people will benefit from the payouts. The reason ARC is working [well] is internal oversight.

There's a conversation here in Bonn about risk management and climate finance in particular, and how insurance might fit into that picture. What do you think needs to happen to better coordinate some of these activities and create a more comprehensive risk management approach?

So far at COP23 I am seeing more momentum than expected on the Paris Agreement and its understanding that we need to address both the mitigation element, and the adaptation element, which is about climate financing. I also notice with all these side events and talks that adaptation is moving up higher on the agenda for all countries. The big open question is how to finance this.

Low-income, developing and emerging countries put a strong emphasis on international financing mechanisms for adaptation. The call for $100 billion a year for climate finance, both public and private, can be heard everywhere. I am sometimes not absolutely sure whether these loud calls for international financing is the best way to get this support. From a private sector perspective, it would make sense to sit down with a group of stakeholders who want to support the climate adaptation issue to find solutions where all stakeholders can contribute in a realistic manner.

International funding, or at least co-funding, is necessary to kick off risk management solutions, and the private sector has to contribute as well. When it comes to developing insurance schemes with entirely new partners, like developing countries, it is about sharing information, data and expertise. From a private sector perspective, it's an investment. We’re ready to support this, and also to provide risk capital for some solutions. But in the long run, it must be clear that the private sector can only stay on board if there is a business case. Not at the very beginning, but in the long run, all parties involved need to understand that if you want long-term private sector support you need to scale it up to reasonable loss transfer amounts, otherwise it won’t be sustainable.

There is no one-size-fits-all solution, but one of the blueprints we currently see — a best practice which is still not the best practice — is, again, the African Risk Capacity. It’s basically in the hands of African governments and states. They have the biggest skin in the game, which is necessary to have an interest in moving this project forward. You need to address regional and local culture and other issues. Having a regional pool rather than a national solution has, so far, proven to be the better way to go. And then you need to have governments really address issues like regulation and centralized risk management.

There are so many funds out there, including the InsuResilience project. We can only move forward if governments demonstrate their interest in their participation. I'm quite optimistic about this project. The challenge currently is that there is a lot of push, a lot of openness coming from the private sector to sit at the table and talk about joint solutions, but we don't see or feel enough pull [from developing countries themselves]. We need to build up trust and convey what we can and cannot do. The most important step is to start these talks. There's still a long way to go.

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