Public-private insurance solutions in emerging markets
06 Jan 2012
Emerging and developing markets are particularly exposed to the damage caused by natural catastrophes.
Most countries have low levels of private insurance penetration, are unable to tap shallow local capital markets and cannot rely on timely international funding. New forms of public-private partnerships can help countries absorb the financial consequences of catastrophic events and can make them more resilient. The reinsurance sector contributes to innovative solutions that close part of the gap between economic and insured losses. The following article features extracts from the Swiss Re publication 'Closing the financial gap', illustrating how individual countries are using public-private partnerships as a means of mitigating the effects of natural catastrophes.
Mexico: Proactive disaster anticipation
Mexico is considered a pioneer in transferring risk through public-private partnerships. Faced with natural perils from storms over the Atlantic and the Pacific to the risk of earthquakes, Mexico has been hit by no less than six major catastrophes since 1985. However, the government has found an innovative way to strengthen its defences.
In terms of lives lost, the Mexico City earthquake of 1986, which measured 8.1 on the Richter scale, was the worst disaster to hit Mexico in recent decades, resulting in over 9 500 fatalities. However, in economic terms, Hurricane Wilma, which hit in October 2005, was the most devastating. Wilma caused total damages of over USD 22 billion. Only USD 13.8 billion of that was insured.
As early as the 1990s, the Mexican government identified disaster risk reduction as a national priority, creating the Fund for Natural Disasters (FONDEN) in 1999 to improve its financial preparedness for natural disasters. Managed by several government agencies, including the ministry of finance and the ministry of the interior, the fund helps the general population in the event of natural catastrophes.
Boosting disaster preparedness
With the intention of helping smooth the impact of payouts on the national budget, the Mexican government wanted to arrange a risk transfer transaction that would cover USD 290 million of earthquake and hurricane risk. The Mexican government, through FONDEN, appointed the federal government’s insurance company AGROASEMEX to act as the insurer for the transaction.
The result of these efforts was MultiCat Mexico 2009, the first transaction in the MultiCat Programme, a shelf programme arranged by the World Bank in collaboration with Swiss Re. It followed an earlier transaction in 2006 that was designed to cover earthquake risk only. MultiCat uses risk-linked securities, so-called catastrophe bonds, to transfer earthquake and hurricane risks to capital markets. These instruments provide the Mexican government with rapid access to natural disaster protection from the capital markets in the event of a major disaster.
A parametric insurance solution
The 2009 MultiCat cat bond runs for three years and is based on a parametric approach linked to pre-defined triggers: unlike traditional insurance, parametric instruments use a model to calculate the payout of the insurance policy. This pay-out model aims to closely mirror the actual damage on the ground and enables a much more rapid payment, since no assessment of the actual damage is required after the event. In the case of parametric insurance, the payout is triggered by a measure such as the strength of an earthquake on the Richter scale or the air pressure experienced during a hurricane.
Parametric insurance does not require loss adjusters to tally damage after a catastrophe occurs, a process that can take months or even years and which can delay a payout. The speed of payout is one of the significant advantages of this type of transaction: a parametric trigger is transparent, both for the insured and for investors, and it means that loss events can be handled faster and more efficiently than with other kinds of insurance- based solutions.
Securing Chinese agricultural production
By transferring a substantial part of agricultural risk to the reinsurance market, the Beijing government has set a milestone in strengthening a public insurance scheme and promoting rural development.
As demand for food in China continues to increase due to population growth and shifts from rice and cereal to a more enriched diet, the risk of a looming food shortage is increasingly challenging the country’s age-old maxim of agricultural self-sufficiency.
This risk is further compounded by limited arable land, the impact of natural disasters and climate change. Over the past decade alone, droughts, floods, typhoons, pests and diseases destroyed about 10 percent of annual crops, with some regions recording losses of over 80%.
A challenge worth taking
The Chinese government is well aware of the agricultural sector’s importance to China’s economy and the stability of the country. According to its estimates, grain production must increase by around 30% over the next 25 years to satisfy domestic demand. But after production actually dropped in the years between 1999 and 2003, the government decided to take action to boost agricultural output. In 2004 it launched the Three-Dimensional Rural Issues policy to give greater prominence to agriculture, rural development and farmers.
As part of this plan, it identified agricultural insurance as a key financial instrument to stabilise farmers’ incomes and improve their resilience to financial hardship from poor harvests. In a country where the insurance market represents less than 1% of agricultural GDP, establishing an agricultural insurance industry is a daunting challenge. But since 2007, the China Insurance Regulatory Commission (CIRC) has taken bold first steps to make this happen, working with the central and provincial governments to extend insurance to farmers across the land.
A solution at hand
With the CIRC’s support in 2008, the Beijing Municipal Government entered into a ground-breaking partnership with Swiss Re to purchase reinsurance cover for its agricultural insurance scheme. This agreement provides tailor-made reinsurance protection for livestock, crops and fruits against perils such as livestock diseases, flood, hail, wind and rainstorms. It covers about 400 000 farming households.
The immediate beneficiaries of the transaction are the insurance companies under the government-subsidised agricultural insurance scheme in Beijing. It specifies that the Beijing Municipal Government will pool all the agricultural insurance business within Beijing.
Under the terms of the contract, the insurance companies will be responsible for any losses below 160% of the annual premium. Swiss Re and the state-owned reinsurer China Re will take up any losses between 160 and 300%, while those losses over 300% will be covered by the Beijing Municipal Government’s Agricultural Catastrophe Risks Reserve. In the event of catastrophe loss, Swiss Re as the lead reinsurer will settle with the individual insurance companies.
Risk management and economic growth
This public-private partnership is the first of its kind in China. It marks a departure from post-disaster financing and a shift towards a pre-emptive risk management strategy. By transferring a substantial part of the agriculture risk to the reinsurance market, the Beijing Municipal Government has set a milestone in strengthening its own insurance scheme and helping promote agricultural development in the region. As more and more farmers buy insurance covers, not only will they benefit from protection against catastrophe losses, but they will also gain easier access to loans that are badly needed for investments in high quality inputs and improved farming equipment. The Beijing administration’s use of agricultural insurance to stimulate productivity and its efforts to develop a viable insurance industry are a good example to other regions and countries with underinsured agriculture markets.
Small states with shallow financial markets and limited access to international capital face considerable pressure in retaining the short-term liquidity essential to provide government services in the aftermath of a natural disaster. This challenge is particularly acute for countries in the Caribbean region, which are exposed to the recurring threat of hurricanes and earthquakes.
Faced with limited economic capacity and high levels of indebtedness, Caribbean governments found their resilience tested to the breaking point when Hurricane Ivan swept across the region in early September 2004. Ivan was the tenth most intense Atlantic hurricane ever recorded, killing over 100 people and causing billions of dollars in losses.
In addition to the tragic loss of life, extensive damage occurred to homes, buildings and other essential structures across the region. In both Grenada and the Cayman Islands, losses reached close to 200% of annual national GDP. In the case of Cayman, 95% of homes and other buildings – which generally follow southern Florida’s building codes – were damaged or destroyed. Thousands of local residents were left homeless.
Besides the devastation it caused, Hurricane Ivan also laid bare the obvious limitations of post-disaster financing. Although funding from bilateral and multilateral agencies eventually poured into the region, donor assistance was slow to materialise and could only support a limited number of infrastructure projects.
A new approach to financing disaster risk
In the wake of Ivan, heads of government from the Caribbean Community (CARICOM) held an emergency meeting to discuss the need for catastrophe risk insurance as a priority issue in the region. CARICOM subsequently approached the World Bank for assistance in designing and implementing a cost-effective risk transfer programme that would help mitigate the cash flow problems faced by its members after major natural disasters.
This marked the beginning of what would become the Caribbean Catastrophe Risk Insurance Facility (CCRIF). At the start of the 2007 Atlantic hurricane season, the Caribbean community formally launched the new facility with 16 participating governments. It was the world’s first regional fund utilising parametric insurance, giving Caribbean governments the unique opportunity to purchase earthquake and hurricane catastrophe coverage at the most attractive pricing.
Caribbean governments could now purchase coverage which would be triggered by a hurricane or earthquake with a probability of occurring once in 15 or 20 years, respectively. The maximum coverage available was set at USD 100 million for each peril. The cost of coverage is a direct function of the amount of risk being transferred, preventing cross-subsidisation of premiums and ensuring a level playing-field for all participants. The CCRIF has since moved to a modeled loss approach, which calculates losses using historic and real-time data.
Securing future growth and development
The findings of a CCRIF-sponsored study on the Economics of Climate Adaptation (ECA) in the Caribbean reinforced the importance of building a balanced portfolio of risk prevention and risk transfer measures to cost-effectively address the expected impact of climate change on the region. By putting contingent funding in place before catastrophes occur, the CCRIF represents a real shift in the way that governments have traditionally treated risks and the economic costs associated with them. It is a cost-effective way for an individual government to pre-finance liquidity needs and start with recovery efforts immediately after a catastrophic event, thereby filling the gap between immediate response aid and long-term redevelopment.
The mechanisms of the new risk facility
CCRIF works in a similar manner as a mutual insurance company, combining the benefits of pooled reserves from participating countries with the financial capacity of the international financial markets. It retains some of the risk transferred by the participating countries and transfers the remainder of the risk to reinsurance markets when it is cost-effective to do so. This structure results in a particularly efficient risk financing instrument that provides participating countries with insurance policies at approximately half the price they could obtain if they approached the reinsurance industry on their own.
The CCRIF’s cost-effectiveness is reinforced by low administrative costs and fast payout times. In addition, the CCRIF’s insurance mechanism ensures that each country receives funds from the pool in direct proportion to the amount it has paid in over the long term. United States Geological Survey (USGS) earthquake location data is used as input for the models which estimate earthquake losses. For hurricanes, National Oceanic and Atmospheric
Administration (NOAA) storm data is used as the input for the hurricane model in order to estimate the damage. It is the estimated loss, calculated objectively, which dictates whether or not a policy triggers and how much the payout will be.
 US National Hurricane Centre, Tropical Cyclone Report
This article consists of extracts from the Swiss Re publication "Closing the financial gap – New partnerships between the public and the private sectors to finance disaster risks". The publication can be obtained at www.swissre.com/publications.
 The Caribbean Development Bank (CDB) estimated the damage in the Caribbean Sea region at more
than USD 3 billion – USD 1.85 billion in the Cayman Islands, USD 815 million in Grenada, USD 360 million in
Jamaica, USD 40 million in St. Vincent and the Grenadines, and USD 2.6 million in St Lucia.
 Caribbean Catastrophe Risk Insurance Facility 2010. Enhancing the climate risk and adaptation fact
base for the Caribbean. www.swissre.com/climatechange.
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