Coping with catastrophe
Reinsurance leaders Nikolaus von Bomhard, CEO of Munich Re and former chairman of economic think-tank the Geneva Association (GA), and Michael Butt, former chairman of Axis Capital, were joined by Margareta Wahlström, special representative of the secretary general for disaster risk reduction, at a press conference on behalf of the GA in London, to voice their opinions on how reinsurance leaders could help governments change the way that disaster risk management is carried out, reducing damage to local economies and fatalities.
Echoing the views of the association that governments can reduce disaster risk by cooperating with the insurance industry, the speakers explained that education is vital if the partnership is to move forwards.
“Reinsurers have a moral obligation to share their expertise with governments to develop better disaster risk management. The objective is to educate and develop an understanding of insurance. Governments don’t understand what insurers can offer,” says von Bomhard.
The conference followed the release of a report by the GA, Insurers’ Contributions to Disaster Reduction—A Series of Case Studies, which examines existing collaborations between insurers and governments around the world on best practices for disaster risk.
“Climate change dropped off the agenda after the financial crisis, but it’s moving its way back up,” says von Bomhard. “We have provided 12 case studies of what insurers and governments should and can do to reduce disaster risk.”
Butt was also keen to stress the importance of education. “Our understanding of risk management, which is improving in leaps and bounds, is very important when assisting governments in knowledge and risk,” he says.
According to the United Nations’ global assessment report on disaster risk reduction, From Shared Risk to Shared Value: The Business Case for Disaster Risk Reduction, direct disaster losses are at least 50 percent higher than internationally reported figures: Total direct losses in 40 low and middle income countries amount to $305 billion over the last 30 years; of these more than 30 percent were not internationally reported.
However, the report also noticed that business attitude is changing, stating that “embedding disaster risk management in business processes is increasingly seen as a key to resilience, competitiveness and sustainability—a business survival kit in an increasingly unpredictable world”. One recent survey listed disaster risk as the 16th most important out of the top 50 risks, and as the sixth most important driver strengthening risk management.
Reinsurers are rallying to work closely with governments to provide effective pre-event planning rather than focusing all attention on the immediate recovery.
“Governments are more focused on the immediate, emotional reactions and recovery rather than planning, which is not always sensible,” Butt says. “Our pricing knowledge is a real value to the industry. We can be helpful before and after events.”
Von Bomhard and Butt both expressed concerns over countries being left to fend for themselves. “No nation can manage disaster risk alone,” adds Butt.
“We have a social responsibility to spread the word that countries cannot afford to take the risk. The industry paid out $108 billion for losses in 2011. It was a very bad year for unexpected losses, but the Thai floods could have been predicted had someone looked at the increase in infrastructure and the disaster records over the last 15 years.”
Thailand experiences flooding every year, and post 2011, it was considered as a low natural catastrophe risk. However, 2011 proved to be the country’s most expensive disaster to date and, with an insurance market loss of $16 billion to $18 billion, the flooding was one of the world’s most costly insured events.
The scale of losses, which were primarily in manufacturing, housing, tourism and agriculture—with large, unexpected losses coming from disruptions in supply chains for electrical and automotive sectors—combined with the inadequacy of risk mitigation measures, sparked a change in the industry, with premium rates increasing sharply.
These unexpected losses are hugely detrimental to the industry and according to the UN’s report, most disasters that could occur haven’t happened yet. It estimates that the total expected annual global loss from earthquakes and cyclone wind damage alone could reach $180 billion per year. This figure does not include the significant cost of local disasters from floods, landslides, fires and storms, or the cost of business interruption. Agriculture is also at risk. In Mozambique a one in 10-year drought would lower maize yields by 6 percent and GDP by 0.3 percent.
The report goes on to state: “Disaster risk is a new multi-trillion asset class: Global capital flows have transformed the landscape of disaster risk, creating a new pile of toxic assets for business and government that do not currently appear on balance sheets. Globally $71 trillion of assets would be exposed to one in 250-year earthquakes. In Honduras, already a one in 33-year disaster would create a significant financing gap for the government with impacts on future GDP.”
A unified agreement that innovation within the industry is needed was a clear point of discussion among the conference speakers.
Wahlström spoke of China’s new five-year strategy which focuses on managing risk. “Over the past decade we’ve seen how risk accumulation and economic growth go hand in hand,” she says. “China now has a five-year strategy in place, which has changed from managing the events, to managing the risk. We need to see more of this.”
As a new wave of urbanisation unfolds in hazard-exposed countries, new opportunities for resilient investment emerge. According to the UN’s report, in India alone, the urban population is expected to grow from 379 million in 2010 to 606 million in 2030 and 875 million in 2050. Private construction company Mori Building has successfully invested in earthquake-resistant housing developments in Japan, where for 92 percent of businesses earthquake resistance is the most important criterion when choosing new offices.
Case study: California Earthquake Authority
Following the substantial damage caused by the Northridge earthquake in 1994, policymakers and insurers found they had underestimated California’s risk exposure to earthquakes, which led to many insurers pulling out of the market for fear of further claims on their exhausted resources.
In 1996, the California Earthquake Authority (CEA) and a publicly-administered, privately-funded insurance scheme that provides basic cover at ‘affordable’ premiums were established.
This public–private cooperation makes insurance available for extreme risks that would not otherwise be insurable for a broad public at an actuarially sound price.
The CEA provides financial incentives for risk mitigation and is implementing policies for adaptation, enhancing financial solvability and decreasing the costs of catastrophe insurance in the long term. For example, it has adopted a building code for retrofitting existing structures to withstand earthquakes and is trying to develop a financial incentive rebate programme that would cover a portion of retrofit costs. The programme acts as a double incentive to buy the insurance and to install retrofits, thereby lowering the insured’s premium.
According to Paudel et al (2012), premiums can also be kept more affordable in public–private partnerships such as the CEA by using the insurance sector to sell and administer insurance policies and process claims. In the US, partnerships maintain lower premiums by minimising fees.
Despite being widely available, the CEA has only a 12 percent penetration rate. Swiss Re has said, “California’s current level of earthquake insurance is insufficient for a region with such high seismic risk, high accumulation of property and high economic activity” (Swiss Re, 2012). The state is consequently attempting to double the current number of insureds in the next five years.
Even though the CEA’s premium costs are reduced by many factors, it is legally required to purchase reinsurance, the costs of which are included in the premium, increasing its cost.
However, the authority is not without its problems, such as the possibility that individuals or businesses may assume that the 53rd state assembly of California will reimburse them for their losses from an earthquake, resulting in a disincentive to buy earthquake insurance.
This low market penetration rate is the reason why the state may, under political pressure, provide government relief after a disaster to compensate uninsured damage. In this sense, the state of California has similar problems to the federal National Flood Insurance Program (NFIP). Despite offering ex ante disaster programmes, both governments can rely on ex post funds because of a lack of policy uptake.
It is difficult to know why people are not buying CEA-offered insurance; according to Paudel et al (2012), the problem of low penetration could be resolved if the government were to establish and enforce strict mandatory purchase requirements.
This is a more paternalistic strategy, as it assumes that the government should dictate what insurance people have. And, depending on enforcement mechanisms and how the insurance is distributed, it may not necessarily be effective, as has been seen with NFIP’s limited mandatory purchase requirement. A wider mandatory purchase requirement seems unlikely or is likely to be unpopular, if the benefits of the insurance are not effectively communicated to the general public.
Case study: Japan’s earthquake system
The Tohoku earthquake and tsunami of March 2011 were the most powerful ever known to hit Japan and provided the severest of tests for the Japanese Earthquake Insurance System, a public-private cooperation between the Japanese government and insurance industry established following the Niigata earthquake in 1964.
The system is designed to provide prompt post-disaster financial relief, avoiding the kind of administrative congestion that attends more conventional indemnity-type cover. It is commonly recognised that the system proved its efficacy and contributed greatly to the recovery process: over 90 percent of the reported claims were settled in the first three months and no insurance company ran into financial difficulty after the event.
n the system, the government of Japan functions as a reinsurer. Primary insurers cede 100 percent of the written earthquake insurance exposure to Japan Earthquake Reinsurance Co Ltd (JER), a special purpose reinsurance company managed by the leading Japanese non-life insurance companies, which retains a portion of the risk and retrocedes the remainder to the member companies and the government.
The total payment limit from a single event has evolved over the years, and currently stands at JPY6.2 trillion($7.95 billion), an amount considered sufficient to withstand a catastrophic event affecting the metropolitan Tokyo area.
Burden-sharing between the government and the private sector is defined under the relevant ordinances of the Earthquake Insurance Law. Based on the April 2012 revision, the public–private liability split is set in the following three layers depending on the scale of loss:
- The first loss up to JPY104 billion ($1.33 billion): 100 percent covered by the private sector.
- The second layer in excess of JPY104 billion up to JPY691 billion ($8.86 billion): 50:50 percent split between public and private sectors.
- The top layer in excess of JPY691 billion up to JPY6.2 trillion ($79.52 billion): Approximately 98.4 percent public versus approximately 1.6 percent private (see table).
- In case of a loss, primary insurers take care of claims handling and payments, which in turn are compensated by the government through JER, pursuant to the above-mentioned criteria. As a mandatory practice, the earthquake insurance premium, net of operational expenses, is reserved separately by both the private insurer and the government, under a special account.
The devastating earthquake that struck the port city of Kobe in January 1995 ignited another round of debate on the system, which matured in the substantial increase of coverage limits (from JPY10 million [$128,250] to JPY50 million [$641,293] for buildings, from JPY5 million [$61,425] to JPY10 million [$128,250] for contents).
The coverage issue aside, the earthquake revealed that the public was not well informed about the scheme; this prompted the industry to publicise the system better. As part of the effort to attract more clients, in the 2006 fiscal year the earthquake insurance premium became subject to income tax deduction.
Response to Tohoku
On March 11, 2011, a magnitude 9.0 earthquake hit Japan’s Tohoku region, which was followed by unusually strong tsunamis. The total insured loss is estimated at JPY3 trillion ($38.46 billion), which is currently the world’s second most costly insurance loss since 1970.
Of this loss, the Earthquake Insurance System will pay out an estimated JPY1.2 trillion ($15.4 billion). In order to expedite the payment process, insurance companies sent supporting staff to the affected areas while opening extra toll-free call centres.
Meanwhile, member companies of the General Insurance Association of Japan (GIAJ) made collaborative efforts to streamline the claims adjustment process by utilising aerial photos to designate the total loss area, adopting a simplified claims assessment standard, and agreeing to a common definition in adjusting tsunami claims.
The collective action enabled the industry to settle more than 90 percent of the reported claims in the first three months after the event. Even with the high percentage of settlements, the industry continues its efforts to reach out to policyholders who may have suffered but have yet to recognise valid coverage under their policies.
The swift payment of earthquake insurance was among the first to reach the disaster-stricken area. According to the survey on the economic effects of the earthquake insurance conducted by GIAJ, more than 80 percent of the respondents used the insurance money to either reconstruct damaged structures or purchase furniture or living appliances.
While contributing to the economic recovery of the Tohoku region, it should be noted that no insurance company ran into financial distress after the event. This is largely attributable to the Earthquake Insurance System.
Hand in hand
Estimating that around 75 to 80 percent of investment in the world is from the private sector, including annual institutional investments worth more than $80 trillion globally, Wahlström stressed the need to get the message through that the private sector needs to evaluate the way risks are being managed.
“Around 50 percent lower losses are predicted out of the total disaster total. This proves that it is not high enough on the agenda,” she says. “The UN work goes back a few decades to when it was driven by scientists. Unfortunately they couldn’t get decision-makers to see how quickly risk accumulates.”
Research carried out among 1,300 small and medium sized enterprises in disaster-prone cities in the Americas revealed that the biggest losses following a natural disaster were from electricity failure, poor infrastructure, a lack of insurance and no financial buffers.
“Many go out of business for these reasons, yet these are what keeps the local economy going,” says Wahlström. “There is no insurance in poor countries, even local European countries are not very well insured. After a hurricane they buy insurance and after two years they stop paying the premium.
“We want to look at reducing tactical risk and find out where the scope for innovation is. Insurance needs to be used more proactively rather than just to cater for losses.”
Insurance is vital to business resilience, yet pricing often does not reflect risk levels or provide an adequate incentive for risk-sensitive business investment, particularly in low and middle income countries with low penetration rates but rapidly growing markets. In China, for example, only 3 percent of properties are insured against earthquakes, and 5 percent against typhoons and floods.
“Africa has had a huge growth in infrastructure, if just 50 percent of the country thought of resilience for the future, it would cut the risk globally,” says Wahlström.
Von Bomhard adds: “In Japan, 90 percent of claims were paid in four months. Haiti is still struggling. In the US, the GDP can be up by 4 percent after a disaster, but developing countries at best can only move sideways.