www.IFC.org/ThoughtLeadership Note 11 | September 2016 HOW BUSINESS CAN INSURE AGAINST CLIMATE RISKS Insurance plays a vital role in protecting people, businesses, and public institutions against shocks, allowing them to transfer risks and purchase security. Insurers in advanced economies even act as financial intermediaries. In many emerging economies, however, insurance is still in a nascent stage. Yet it has the potential to become a critical tool for businesses to build operations that are resilient to climate change while also providing a source of economic growth. For insurance in emerging economies to take off, the public and private sectors must first lay the necessary groundwork. Many elements will go into making emerging-market countries percent in the fourth quarter of 2011, compared to a year earlier, more resilient to climate change. But a lack of developed according to Thailand’s National Economic and Social insurance markets in these countries puts them in a tenuous Development Board. position as they deal with the effects of the changing climate. Because they are often densely populated and more exposed to The potential benefits of insuring against climate related events in slow-onset climate-related changes such as water scarcity, low- emerging markets can be measured in both humanitarian and income and middle-income countries have experienced the largest economic terms. Insurance can help emerging markets better human and economic losses from climate threats.1 protect their economies from climate related threats, distributing the costs of daily as well as catastrophic events and reducing the Insurance mechanisms play an important social, economic, and potential burden on public finances. In a study that looks at China, financial role for managing risks across the world. Yet emerging Japan, Thailand, the United Kingdom, and the United States, economies account for only about 16 percent of the $4.6 trillion insurer Lloyd’s of London estimates that a 1 percent increase in global insurance market, with an even smaller share of property insurance penetration can reduce the burden on taxpayers by 22 and casualty coverage. Without insurance proceeds to help rebuild percent, providing an economic cushion in times of disaster. 3 after a disaster, these countries are often one climate shock away from a major setback in economic growth. And funds used to According to a Bank of England working paper “…the size of the finance recovery often come directly from government coffers in financial losses arising from the occurrence of a given hazard and these countries, diverting money from other priorities. the allocation of those losses are influenced by the ex-ante decisions of the financial sector. For example, the amount of Nor do disaster relief funds don’t guarantee full recoveries for insurance and credit available for financing the construction of communities and businesses. Even in high-income countries, buildings in flood-prone areas will determine the size of the many small and medium sized businesses never reopen after a eventual financial losses arising from the materialization of such disaster. Once their buildings and other collateral are destroyed, risks, as well as the allocation of losses.” 4 many have trouble securing the necessary loans to rebuild. 2 In 2011, for example, floods in Thailand caused $30 billion in Over the long term, insurance can actually help free up resources damages, including damages to the country’s burgeoning for businesses. Without having to set aside a large amount of manufacturing sector. Companies and industries had a combined reserves in case of disaster, business have additional short-term $12 billion in coverage, resulting in a gap between damages and resources to invest in protecting operations against climate insurance of some $18 billion. In addition, rebuilding costs for the shocks. Furthermore, insurance companies and their investment Thai government totaled more than $13 billion. Those costs arms promote the development of local financial markets while dramatically affected Thailand’s economy, which shrank 9 increasing access to capital by businesses. BUILDING INSURANCE MARKETS distribute them. Primary insurers, for example, collect the risk Because insurance is a complex financial product that requires profiles of underlying policyholders and pass them on to sophisticated infrastructure, information flows, and reinsurers. Reinsurers purchase a portion of those risks from intermediaries, both public policy makers and the private sector insurers and aggregate them so that front-line insurers can remain have active roles to play in building insurance markets in sustainable and solvent when disaster strikes. Any information emerging economies. Unfortunately, insurance in emerging breakdown along this chain can lead to market problems, markets is not yet viewed as essential to prepare for climate including incorrect pricing, inadequate loss reserves, insufficient change. equity capital, and poorly designed reinsurance programs. Without the necessary information about potential risks, Financial sector companies—insurance intermediaries, brokers, businesses will have trouble managing them. and agents—manage different aspects of policyholders’ risks and Industrialized economies Emerging economies Low-income economies Emerging economies face the highest average of direct losses per year with respect to GDP. Source: Calculations of Munich Re Economic Research based on data of NatCatSERVICE In order to maintain properly functioning insurance markets, including insurers, to address other risks, governments should public policy makers—and finance ministries in particular —need promote public information such as weather forecasts and to develop specific policies and regulations that promote the emergency warning systems, which are not always available in propagation of objective, clear, comparable, and timely emerging countries. The study focused on five areas where information about climate risks. governments can promote private sector efforts to mitigate climate change: data and information, institutional arrangements, A study by the consulting firm Deloitte for IFC emphasizes the policies, economic incentives, and communication, technology, important role of governments in creating the necessary and knowledge. conditions for insurers and other private companies to invest in climate resilient development.5 Regulations and incentives best Efforts to better disclose climate risks are already underway in address some risks such as limiting buildings in areas prone to many countries. In 2016 the Task Force on Climate Related flooding, according to the study. To allow private companies, Financial Disclosures sought to develop voluntary climate risk This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group disclosure mechanisms for companies in major economies around stations in China. When precipitation falls below a certain level, the world. By creating these policies when insurance markets are the insurer pays out a certain amount to the company. still in development and placing an emphasis on disclosure up front, emerging markets have a better chance of building more Index insurance targets small agricultural businesses in emerging transparent insurance sectors. With a clear understanding of markets. Insurers pay benefits to business owners on the basis of climate risks and their potential impact on the overall economy, a pre-determined index such as rainfall level, seismic activity, or policymakers can then foster insurance markets that emphasize livestock mortality. When the owner faces capital losses because preventative measures to soften the blow of climate shocks. of weather related events, the insurer pays them without a traditional assessment. The Global Index Insurance Facility is a EXAMPLES OF INNOVATIVE APPROACHES IN multi-donor trust fund that seeks to expand index insurance in EMERGING MARKETS emerging markets, primarily in Sub-Saharan Africa, Latin International development finance institutions have been using America and the Caribbean, and the Asia Pacific region. GIIF’s innovative approaches to help emerging market countries create implementing partners have covered more than 600,000 farmers, insurance products that fit into their overall development plans. pastoralists, and micro-entrepreneurs with $119 million in assets Many of these approaches target specific threats such as floods, insured, and reached more than one million people with storm surges, or losses to agriculture productivity. Agricultural information and access to index insurance. insurance, for example, generally allows small enterprises to transfer the risk of a large and possibly devastating loss from an The Agriculture and Climate Risk Enterprise was launched in extended drought or heat wave to a third party in exchange for a 2009 and uses mobile technology to provide index insurance to predictable premium. farmers in Kenya and other African nations. So far it has insured more than 200,000 farmers with its portfolio of index insurance Agricultural insurance also helps small businesses manage products, which track weather and yields, among other metrics. specific sector risks that arise even when they are taking the appropriate steps—irrigating fields and using pest management, The insurance portfolio has more than $12 million under for example—to head off other climate-related threats to management, and as of 2013 paid out about $370,000. Insuring production, such as extraordinary rainfall or drought. These one acre of maize against drought costs a farmer about $37, or 10 insurance products—examples are production, weather, and percent of harvest value. Farmers can pay premiums through a commodity price insurance—can cover crops, livestock, and mobile phone, and insurers can transfer payouts to the farmer’s fisheries, and are especially important for climate related risks. In mobile wallet at the end of the season. In Kenya and Rwanda, addition to reimbursing small business owners for losses beyond where more than 96 percent of agricultural land is rain-fed and so their control, they can serve as collateral for agricultural loans and is vulnerable to drought and erratic rainfall, this type of insurance provide a safety net for investments. also opens up credit sources for small farmers. With support from IFC, the program plans to expand to one million farmers in Catastrophic insurance programs have also been adapted to help coming years. emerging market countries address climate-related disaster risks. They are well suited to the purpose because they quickly transfer Blue Marble Micro-insurance, launched in 2015, reaches people funds to policy holders when climate related disaster strikes. in low-income countries who have no safety net in the event of Some countries have even entered into regional catastrophe natural disasters. The organization’s efforts include increasing insurance pools that give them access to international reinsurance financial literacy for these target consumers and lowering the markets with competitive rates. The programs also give the global costs of distributing insurance. Blue Marble, which is a reinsurance industry an opportunity to enter new markets. partnership of eight global insurance companies including Hamilton, AIG, Zurich, Aspen, XL Catlin, TransRe, Old Mutual, Another innovative insurance product in emerging markets is and Marsh & McLennan, is testing 10 microinsurance products designed for hydropower and wind power projects and tackles the that meet the needs of consumers and businesses in emerging problem of increasingly unpredictable weather patterns. markets. Unexpected droughts and changing wind patterns make it a challenge to calculate the output of alternative energy plants.6 In CONCLUSION response, Swiss Re developed precipitation index insurance for Climate change poses a significant threat to people and businesses Guangdong Meiyan Hydropower, which operates hydroelectric in low-income countries. A new and innovative set of insurance products has emerged to address these threats and lower the long- This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group term impact of natural disasters on individuals and businesses in businesses and governments will need to create a foundation for these countries. Increasing the role of insurance depends on strong well-functioning insurance markets. public policies. As the penetration of insurance rises, greater planning and emphasis on where houses are built, how water and Stacy Swann is the former head of IFC’s Blended Finance Unit within IFC’s Climate Change Business Department, and is currently the CEO of Climate power are supplied, and how people live will help increase Finance Advisors, LLC (sswann@climate-fa.com). resilience. The World Bank Group is just one of several international institutions helping to tailor innovative insurance Alan Miller is an independent consultant on climate change finance and policy and retired from the IFC Climate Change Business department. approaches in emerging markets to help these countries respond (astanley92@gmail.com). to climate change. For these products to take off, however, 1 E. Sebastian Kaderják, “Diminishing the economic impacts of 4 Bank of England, Staff Working Paper No. 603, “Let’s Talk About The Weather: natural disasters,” Münster University International Model United Nations, March The Impact of Climate Change on Central Banks,” May 2016. 2016. 5 V. Stenek, J. Amado, and D. Greenall, “Enabling Environment for Private Sector 2 G. Von Peter, S. von Dahlen, and S. Saxena, “Unmitigated Disasters? New Adaptation,” IFC, 2013. Evidence on the Macroeconomic cost of Natural Catastrophes,” BIS Working Paper 6 A. Blomfield and J.Plummer, “The allocation and documentation of No. 394, 2012. hydrological risk,” Hydropower & Dams, Issue Five 2014. 3 Lloyd’s Global Underinsurance Report, 2012. This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group