www.IFC.org/ThoughtLeadership Note 9 | September 2016 INNOVATIVE INSURANCE TO MANAGE CLIMATE RISKS Severe storms, record heat waves, intense droughts, and floods—the impact of climate change rises every year and economic and financial losses rise with it. Insurance plays a major role in helping businesses in advanced economies mitigate the consequences of the changing climate and prepare for policy changes ahead. But insurance in emerging markets isn’t yet able to make the same contribution, despite the fact that natural disasters disproportionally affect people and firms in these countries. Recently, however, a number of new business and donor initiatives have begun to create innovative approaches to using insurance to address climate change. New research from the National Academy of Sciences shows that In 2012, guarantees and disaster relief products, along with the warming planet makes weather patterns more volatile and the traditional life insurance and property and casualty products, likelihood of extreme events greater.1 Climate change will affect generated $4.6 trillion in premiums. weather in a number of ways, only some of which can be predicted. Already global temperatures and precipitation levels Insurance can play a critical role in offsetting climate change risk are becoming more extreme. For example, in 2016, temperatures in emerging-market economies, and a number of factors are climbed to an unprecedented 54 degrees Celsius in Kuwait.2 driving its use. Cellular and digital technologies now make it possible to deliver insurance to a wider range of customers in The impact of heavy floods and extreme temperatures is obvious, these countries at much lower cost. And investors are demanding but climate change poses subtler risks too. Hotter temperatures that companies identify and disclose climate risks, especially in can accelerate evaporation, pulling more moisture from crops and industries more sensitive to climate change. Coffee retailer creating longer periods of drought. Dry soil is also less able to Starbucks, for example, has already expressed concerns about absorb extreme rainfall, increasing mudslides and land erosion. how climate change could affect crops crucial to its supply chain. Gradual changes in climate can affect business operations in ways In addition, the business model of insurers depends not only on that often seem individually minor, but can collectively cause the efficient management of the risks they underwrite, but also of significant damage. Just a few examples include subway doors their investment funds. These include trillions of dollars in long- that don’t close properly when temperatures reach a certain level, terms assets that can be affected by climate change diseases such as malaria that reduce workforce participation, and changes to wind patterns that decrease the output of wind power Countries that are part of the United Nations Framework systems. There are countless other ways that gradual climate Convention on Climate Change are also interested in fostering changes can have an economic or financial impact on businesses. new tools to manage climate risks within emerging markets. These include insurance. As part of the commitment to provide In both the short and long term, the increasingly unpredictable financing for climate change adaptation in emerging economies, nature of weather patterns also heightens the challenge of donor governments have announced a range of commitments to adapting to environmental changes and building what’s known as insurance mechanisms. Often these governments work with resilience—or the capacity of a system to absorb stresses brought commercial insurance providers to create new products. on by climate change. INSURANCE AND NATURAL HAZARD TRENDS That’s where insurance can be a tool to help mitigate some aspects In 2015, re-insurer MunichRe estimated that more than one of climate change. Long used to offset risks from hazards such as thousand natural hazard events resulted in losses of $90 billion fire and flood, to protect investments and assets, and to provide around the world. While the number of such events increased, the peace-of-mind, insurance is one of the world’s largest industries. total costs of associated losses was slightly lower than previous years, due in part to the El Nino effect, which suppressed the Empirical evidence from the insurance sector shows that damage Atlantic hurricane season. More than 90 percent of natural costs from weather related disasters have been rising over the past catastrophes in 2015 were linked to weather-related events, yet 30 years and will likely continue to grow as climate change only about a third of resulting losses were insured, which is in line increases the intensity of storms, droughts, and floods. These with historical coverage trends. From 2004 to 2014, insurance figures only detail economic losses and financial damages, and covered 30 percent of global catastrophe losses, according to don’t capture the devastating human costs of natural disasters. insurer SwissRe. Governments, companies, and people bore the brunt of losses, an estimated $1.3 trillion. Natural Loss Events Worldwide 2015 – Geographical Overview Source: Munich Re, NatCat Service 2016. INSURANCE IN EMERGING ECONOMIES private companies and people tend to buy more insurance, In order to stem the increased potential for losses, build-in primarily for motor vehicle usage.3 resilience, and promote economic growth, companies and investors in emerging markets will need to proactively address In many cases, prospects for developing insurance in emerging climate risks, create new tools to mitigate damages from climate markets will depend on multiple factors, including how to change, and find ways to adapt to a warmer world. understand risks, the capacity of insurance customers to bear product costs, regulatory infrastructure and transparency, and the Insurance is still a nascent risk management tool in emerging reliability and ease with which claims can be processed and economies. These markets account for only about 16 percent of funding deployed. More fundamentally, in many emerging the global insurance market, although they are growing rapidly. markets insurance is still seen largely as a luxury good, with lower While some of these countries have a more mature insurance priority than food, shelter, and savings. Governments have made market, in general their consumers, businesses, corporations, and great strides in supporting financial literacy and promoting private government regulators have less experience with insurance insurance, but in many countries few people consider buying it. products than those in advanced economies. India, for example, is among those countries most vulnerable to Public entities typically form the bulk of insurance customers in climate change, with annual losses of between $9 billion and $10 emerging markets. As a country’s wealth level rises, however, billion, because of extreme weather incidents. Nearly 80 percent This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group Out of a Global Insurance Market of $4.6 trillion per year, developing countries and economies in transition accounted INNOVATIVE INSURANCE PRODUCTS IN RESPONSE for 16% (2012). TO CLIMATE CHANGE The World Bank and IFC are taking part in a broad effort to create innovative insurance products that will be crucial to economic growth in emerging markets. They also participate in the Global Innovation Lab for Climate Finance, which supports the identification and piloting of cutting-edge climate finance instruments, including programs to develop new insurance mechanisms. Though many of these initiatives are at an early stage, they could soon offer insights and strategies to use insurance to promote climate risk management. Index insurance for small farmers By paying benefits on the basis of a pre-determined index, index insurance can help stabilize the income of the world’s 2.5 billion Source: Swiss Re Economic Research & Consulting, 2103. small farmers. The index used for this insurance tracks objectively Note: 16% of the $4.6 trillion insurance revenues are in what insurers deem “emerging markets”, as of 2012, with the share projected to roughl y double by 2023. determined indicators such as rainfall or livestock mortality rates in order to estimate assets and investment losses resulting from weather or other catastrophic events. Eliminating the need for traditional claims assessment makes the settlement process of those costs are uninsured. While the penetration and density of simpler, quicker, and more objective. Index insurance initiatives insurance products in India today stands at 1 percent of gross are being tried around the world. The largest effort is the Global domestic product, losses from extreme weather conditions are Index Insurance Facility, a multi-donor trust fund managed IFC boosting awareness about the ability of insurance to offset risk. Despite Growth, the proportion of insured weather-related CLIMATE CHALLENGES FOR INSURABILITY losses in developing countries is lower than in developed Because climate scientists are still trying to understand the countries. physical and ecological processes affected by climate change, estimates about the magnitude and timing of expected damages vary widely, with some regions better understood than others. Uncertainties remain as to how sensitive climate and biological systems will be because of increased greenhouse gas concentrations and the timing of major changes. Even as predictive models rapidly advance, unpredictability could be a major hurdle in developing an approach to insurance that addresses climate risk.4 A number of additional factors further complicate the ability to develop and price climate change insurance products, including the rising frequency and severity of natural disasters, rapidly expanding populations, and higher concentrations of assets in hazard prone areas. Existing infrastructure, built without Source: Vivid Economics based on data from Munich Re, NatCat Service. consideration of climate risks, may also become harder to insure. These factors are important for policy makers and the insurance industry to consider when developing insurance markets and other measures to manage climate change. Still, given the very early stage of insurance markets in emerging economies, significant opportunities exist in the short and medium term to develop tools and financial products that can help manage and mitigate climate-related risks and help those exposed to these risks absorb economic and financial shocks. This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group and the World Bank which operates in 31 countries and insures a sufficiently severe deviation from normal rainfall levels. This total of 1.3 million farmers. approach gives countries quick access to capital when most needed, without lengthy processing. In its first year, Africa Risk Natural Catastrophes Losses: Insured vs Uninsured losses, Capacity made $30 million in payments in response to severe 1975–2014 (in 2014 dollars, $ billions) drought events. The World Bank Group, along with private insurers, supports similar programs in the Caribbean and Pacific regions. Private insurers benefit from participating in these programs. While they remain mostly oriented for governments, these programs benefit the local private sector by reducing losses to the national economy and speeding recovery. Penetration Rates Vary by Product Line and Region Source: Swiss Re, Underinsurance of Property Risks: Closing the Gap, 2015. In India, a favorable regulatory environment and effective outreach have led to a dramatic increase in small farmers using index insurance. As of 2012, 22 million farms were covered by a yield-based index and three million by weather index insurance. FN 1 2014 based on available 1H or 3Q reporting; at fixed exchange rates 2013. Source: McKinsey Global Insurance Pools, Oxford Economics. The Syngenta Foundation in India offers farmers a product that combines weather index insurance with high value hybrid corn seeds. Seeds sown by farmers are insured for failure of monsoon Uruguay insurance for power, drought, and oil imports through a replanting guarantee.5 Syngenta has a similar program Because Uruguay generates a substantial amount of energy in Kenya. The expanded reach of mobile phone banking is also through hydroelectric plants that rely on rainfall, lower than usual making it possible to bundle crop insurance with phone services rain levels have decreased energy production in the country. In to reduce transaction costs and reach more farmers. 2012 hydropower production slumped because of a prolonged drought, forcing the government to buy costly fossil fuel Establishing a successful, commercially sustainable index electricity. Another drought in 2008 caused $900 million in crop insurance program still faces many challenges, including the need losses and threatened the availability of power. for reliable local weather information, which is a resource many poor countries lack. Without it, payouts may be inaccurate and In 2013 Uruguay adopted climate insurance, facilitated by the farmers unwilling to participate.6 Another challenge is the World Bank and administered by Swiss Re, to insure against reluctance of smaller farmers to pay premiums, which results in drought. Throughout the country’s main water basins, 39 stations the need for public subsidies for a program even when it is measure precipitation and generate a daily index. When rainfall economically viable and attractive. drops below a minimum index level, which is re-established every Sovereign risk programs for disaster response few months, the insurance contract goes into effect. The amount of money disbursed depends on the severity of the drought, as well Disaster relief programs are primarily a government as on the price of oil on the date the insurance is activated. responsibility, with donor help often provided after major weather events such as hurricanes and floods. However, the insurance CONCLUSION industry also has an important role to play in designing and Insurance products are one approach among many that offer administering publicly supported post-disaster relief programs. innovative methods to manage and mitigate growing risks of climate change to economic development, particularly in Africa Risk Capacity, for example, is a program that supports pre- emerging markets. Insurance may also help businesses and approved disaster relief programs for participating African consumers withstand financial shocks brought about by climate- countries, and is based on risk pooling and risk transfer. Payments related events and may be an important component to managing are made when a pre-agreed threshold event occurs, such as a the impact of climate change on growth. Still, challenges remain This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group to building insurance markets in these economies and to Stacy Swann is the former head of IFC’s Blended Finance Unit, Climate Change Business Department, and is currently the CEO of Climate developing products that manage climate change risks. Finance Advisors, LLC (sswann@climate-fa.com). Alan Miller is an independent consultant on climate change finance and policy and retired from the IFC Climate Change Business department (astanley92@gmail.com). 1 The National Academy of Sciences, Engineering, Medicine, “Attribution of Extreme 4 William Gail, “A New Dark Age Looms,” New York Times, April 19, 2016. Weather Events in the Context of Climate Change,” 2016. 5 Earth Security Group, “Indian Insurance and Sustainable Development,” 2016. 2 James Tapper, “Think you’re hot?” The Guardian, July 23, 2016. 6 Allianz, Microinsurance, “Effective protection against poverty?” March 16, 2015. 3 SwissRe Global Insurance Review and Outlook 2015, 2016. This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group