The financial consequences of natural disasters

The impact of natural catastrophes such as earthquakes, storms and floods on societies and economies has increased considerably in the last two decades and is likely to grow further as a result of two complementary trends. Firstly, the scale and frequency of major weather-related events are likely to rise due to climate change. Secondly, the economic impact of natural catastrophes is increasing due to the growing number of people living in areas with a high risk exposure, as well as more economic activity in these zones. Natural catastrophes typically affect individuals, companies, insurers and the public sector.

Apart from the loss of lives, they often result in major financial problems as assets are destroyed, while the liabilities – mortgages and loans – continue to exist. They also place a huge burden on the public sector, which has to shoulder not only relief efforts but also much of the rebuilding after an event. As a consequence, natural disasters typically hurt the budget of the affected city or country. Furthermore, public entities consciously take risks, for example when public infrastructure, such as power stations, hospitals, roads, bridges and schools, remains uninsured.

A variety of instruments can be considered in setting up a risk financing strategy. Most importantly, a public entity can act either before a disaster hits or afterwards. Pre-event risk financing measures include the building of financial reserves, contingent debt agreements, insurance and alternative risk transfer solutions. Post-disaster risk financing methods include budget reallocations, tax increases, use of domestic and international credit markets, loans from multilateral finance institutions, etc. Many developing countries also rely on the assistance of international aid agencies.

Pre-event finance

The financial and insurance markets can play a key role in preparing for the impact of extreme natural events, and there is significant value in shifting from the traditional disaster relief approach – financial support after the event – to an approach which includes the accumulation of funds before a loss occurs and the spreading of risks.

Pursuing a post-disaster financing strategy involves high opportunity costs. Funds must be diverted from priority development projects in order to pay for emergency and recovery needs. It can also be costly to raise new domestic debt in an expensive post-event capital market, which may, in turn, significantly raise a country’s debt servicing burden. Finally, raising taxes may discourage new private investments that are central to restarting the economy.

Financial risk transfer solutions

Risk avoidance and mitigation strategies must be the first priority in managing natural disasters, but while certain risks can be reduced or even avoided, no organisation or country can fully protect itself against extreme events. Transferring catastrophic risk should be a key element in the financial strategy of every disaster- prone country or region to enable and sustain growth, and the same applies for corporations and individuals.

This is where the insurance industry can offer its expertise to find innovative solutions. A new generation of sovereign insurance (or macro-insurance) instruments can make it easier for a municipality or country to cope with a disaster (see case studies on the next page). In parallel, innovative micro-insurance solutions can protect previously uninsured individuals and small enterprises from the disastrous financial consequences of natural catastrophes.

Such products can help governments and residents in a number of ways, including:

• Protecting and smoothing their budgets with potentially positive implications on debt levels, sovereign ratings, foreign exchange fluctuations, etc after an event

• Ensuring that funds are in place to compensate victims of catastrophic events, particularly in developing countries or in less developed areas of developed countries

Big risks are best placed on many shoulders

The larger and more complex a natural catastrophe, the more players are needed to share the risk. In case of a small event, an individual or company may bear the (full) costs in form of a deductible, but it takes many more players to absorb large natural catastrophes. Here, risks need to be shared between policyholders (individuals and/or companies), the domestic insurance industry and the global reinsurance industry and capital markets.

Different partners bring different strengths and play different roles. In developed countries with a functioning insurance market, there is less need for the government to absorb risk actively. Here, the role of the government consists of market enabling and potentially widening the boundaries of insurability. In less developed countries, the government often needs to play a more active role as a risk taker, as the insurance market cannot absorb the risks (yet).

As complexities and costs rise, single organisations can no longer meet the challenge alone. This is particularly true for developing countries which, besides having fewer financial resources, also bear the brunt of global warming.

To be better prepared for disasters and to adapt to the consequences of climate change, new forms of partnership between the public and the private sector are needed:

The public sector has the power to set framework conditions that facilitate adaptive responses by individuals, the public and the private sectors, but it typically operates under significant financial constraints. As costs rise, the capability of governments to meet this challenge will be stretched even further.

The private sector has the resources – approximately 86% of global investments are made by corporations and individuals – but not the power to set the appropriate frameworks. Furthermore, insurance and reinsurance companies have accumulated valuable knowledge and experience in dealing with catastrophes. Finally, companies like Swiss Re have the global diversification which is required to absorb these risks in a cost-efficient way.

The advantages of private-public risk transfer partnerships are obvious: They can help governments absorb catastrophes and stabilize their finances after an event. They also allow them to participate in global portfolios, reducing the costs of these risks due to the benefit from diversification. Furthermore, they enable public entities to tap the vast experience of insurance and reinsurance companies. In future, we expect to see more public private partnerships to manage the financial consequences of natural disasters.