Harnessing Insurance Markets to Enhance Climate Resilience

Farmers prepare rice seedlings for planting in the Philippines, where less than 10 percent of farmers have crop insurance.

As the impacts of climate change become increasingly frequent, severe, and destructive, countries around the world are stepping up efforts to prepare for the consequences to come. But we all nevertheless remain extremely vulnerable to climate impacts, and this is especially true for poorer people and countries around the world. In recognition of this, the Group of Seven countries, or G-7, launched an ambitious goal on Monday to greatly expand insurance coverage to people who are most vulnerable to climate-related hazards:

We will aim to increase by up to 400 million the number of people in the most vulnerable developing countries who have access to direct or indirect insurance coverage against the negative impact of climate change related hazards by 2020 and support the development of early warning systems in the most vulnerable countries. To do so we will learn from and build on already existing risk insurance facilities such as the African Risk Capacity, the Caribbean Catastrophe Risk Insurance Facility and other efforts to develop insurance solutions and markets in vulnerable regions.

At the 2012 G-7 Summit at Camp David, these countries demonstrated their interest in advancing innovative market mechanisms—such as the Pilot Auction Facility for methane reduction—to achieve reductions in greenhouse gas pollution. Monday’s announcement complements this effort by harnessing markets, not to reduce the greenhouse gas pollution driving climate change, but rather to cope with its impacts.

Although the need to combat climate change through private-sector investment in adaptation and resilience is well recognized, there has been inadequate progress in developing successful market-based models for doing so. Fortunately, there are some promising early entrants to this space that could be replicated and scaled up. Not surprisingly, the companies that stand to lose the most when disaster strikes are the first entrants into this space: namely, insurance and reinsurance companies.

Insurance and reinsurance companies underpin the world’s private disaster-recovery financing. In 2011, physical losses from natural disaster-related damage totaled $386 billion, of which only 28.5 percent, or $110 billion, was insured. Primary insurers experienced $46 billion in losses, while $64 billion was passed on to reinsurers. This risk transfer process makes the insurance industry particularly susceptible to the costs of climate change, which are expected to increase as the effects of climate change intensify. This susceptibility has motivated the insurance industry to develop innovative finance tools for climate adaptation and resilience to help hedge against these risks.

These risk management instruments include:

  • Catastrophe bonds, or cat bonds, are public bonds designed as a hedge against damage from future natural disasters. New York City issued cat bonds in the wake of Superstorm Sandy to insure the city’s transit infrastructure against storm-driven flooding through 2016. In the event that a similar storm strikes the city during this timeframe, the bonds will provide the city with resources to recover.
  • Parametric risk insurance is a type of catastrophe insurance for governments that pays out immediately in the event of a natural disaster that meets specified criteria. For example, Caribbean nations that are part of the Caribbean Catastrophe Risk Insurance Facility pool receive an immediate payout to finance disaster response and government functions in the event of major natural disasters at precisely the moment when funding is most needed. This contrasts with ordinary insurance that requires lengthy damage assessments. After the earthquake in Haiti, for instance, a parametric policy enabled the country to keep paying its police force during a crucial period of crisis.
  • Weather index insurance schemes are developed to insulate national budgets against costs associated with unpredictable weather in a changing climate. Uruguay, for example, worked with the World Bank and Swiss Re to mitigate the costs that prolonged drought can have on the country’s hydropower-dependent energy sector. Since hydropower provides about 80 percent of the country’s electricity, insufficient rainfall can force the country to rely on expensive oil-run electric generators and have disastrous effects on the country’s energy expenses. The weather index insurance plan pays out immediately if rainfall is below a certain level and oil prices rise beyond a set benchmark, alleviating the inevitable budgetary strain.
  • Crop insurance has existed for generations, but as climate change exacerbates the incidence and severity of drought, this practice will require modernization and expansion. The African Risk Capacity agency is an insurance pool for African nations to secure early intervention funds in the event that a season’s rainfall falls below a specified threshold that would severely affect food production. By pooling their premiums, participating countries can reduce their exposure to seasonal drought. This effective tool should be replicated and expanded to the countries that are most vulnerable to drought and famine.

While some public financing and capacity building is needed to launch these insurance programs, the premiums that countries pay for their insurance can sustain them over time. This, in turn, helps to incentivize improvements in planning and investment, as countries can reduce their premium costs by reducing their own vulnerability—either on their own or with international support—and as the world takes action to reduce the drivers of climate change.

So how can governments foster these tools and scale up these partnerships? One way is through greater support—both technical and financial—from multilateral development banks, or MDBs. The MDBs have already collaborated with G-7 member countries to help finance natural disaster risk insurance pools such as the Caribbean Catastrophic Risk Insurance Facility, the African Risk Capacity, and the Pacific Catastrophe Risk Insurance Pilot, and these efforts could be expanded.

It is also important that countries provide targeted support to ensure that innovative financing is available to the nations that are most in need. While the G-7’s goal of providing insurance access to an additional 400 million people in low- and middle-income countries is certainly worthwhile, it is important not to neglect the needs of smaller but high-risk population pockets, such as the Pacific islands.

This is also an opportunity for the new Asian Infrastructure Investment Bank, or AIIB, and the Brazil, Russia, India, China, and South Africa, or BRICS, bank—which share a goal of ramping up infrastructure investment—to engage by working with countries and MDBs to ensure that new infrastructure is built in a sustainable and resilient way.

Of course, there is no insurance policy that decreases the absolute urgency of meeting the climate change challenge. But as countries work to slash their greenhouse gas pollution, they also need to make sure that they are as prepared as possible to cope with the climate impacts that are already unavoidable. Innovative finance provides one arrow in that quiver.

Pete Ogden is a Senior Fellow at the Center for American Progress. Ben Bovarnick is a Research Assistant with the Energy Policy team at the Center.