Feature articles

Insurance in a changing climate
At the 2007 United Nations Climate Change Conference in Bali, the participating countries called upon policymakers to consider insurance as part of a post-Copenhagen adaptation strategy. Insurance mechanisms offer substantial benefits for developing countries, both in reducing their vulnerability to climate variability and helping them adapt to climate change.

IIASA and the Munich Climate Change Insurance Initiative (MCCII) have proposed an insurance approach designed to help developing countries better prepare for, and recover from, extreme climatic events, by reducing risk, promoting adaptation, and adopting a comprehensive approach to risk management.

Over 95 percent of deaths from natural disasters in the last 25 years occurred in developing countries. Direct economic losses averaged US$100 billion per annum in the last decade. In gross national income terms, these were more than twice as high in low-income countries as in high-income ones. According to the United Nations International Strategy for Disaster Reduction (UNISDR), more than three-quarters of recent economic losses can be attributed to climate-related hazards. The Intergovernmental Panel on Climate Change (IPCC) has also predicted that increasing weather variability due to climate change will make matters even worse.

Financial vulnerability to extreme weather events Countries in red are vulnerable to severe weather events that are expected once every 11 to 50 years. The event would exceed the public sector’s financial ability to restore damaged infrastructure and continue other planned development projects. Source: IIASA (Mechler R, Hochrainer S, Pflug G, Lotsch L, Williges K) as published in the World Development Report 2010.

A recent study by IIASA, published in the World Development Report 2010 (see map), has also identified the countries most vulnerable to extreme events and the associated economic costs likely to be incurred by them, providing further guidance on those most likely to benefit from insurance support.

Insurance—Why, and when to apply it?

Donor aid, while an invaluable mechanism for post-disaster recovery, is not necessarily sustainable, as extreme events escalate in scale and frequency. In turn, external investors are wary of the risk of catastrophic infrastructure losses, while small firms and farmers cannot access the credit necessary for investing in higher-yield/higher-risk activities. This leads to slowed economic recovery and prolonged poverty. A different mechanism is needed.

While insurance will not necessarily be appropriate for slow-onset climate impacts, such as sea-level rise and desertification, when applied as part of a broader climate change risk-management strategy, insurance mechanisms may be a powerful tool to help avoid or minimize human and economic losses following environmental catastrophes.

Well designed and implemented insurance reduces disaster losses. By providing early liquidity, it prevents long-term loss of livelihood and lives; by pricing risk, it sets strong incentives for pre-disaster preventive behavior; and by providing security it enables high-return, high-risk investments, reducing vulnerability to disasters.

Still, the costs of insurance can greatly exceed the ability to pay of the poor who, without support, will continue to rely on insufficient and ad hoc international aid.

How are insurance approaches being applied in developing countries?

Donor-supported catastrophe insurance is playing an increasingly visible role in developing countries. Novel programs are demonstrating not only their potential to pool economic losses and smooth the incomes of poor people facing weather variability and climate extremes, but also to transfer risks to the global capital markets. For example:

• In Malawi, smallholder farmers can now buy affordable, index-based drought insurance. Unlike traditional claims-based insurance, indemnity is based on an index of local rainfall. By making farmers more creditworthy, this pilot loan/insurance scheme enables farmers to purchase hybrid seeds and thus greatly increase productivity.
• To insure against insufficient funds for post-disaster relief and infrastructure repair, the Mexican government has insured its catastrophe reserve fund, including a catastrophe bond, which pays an above-market interest rate if rainfall exceeds a specified level, with part of the principal going to the Mexican government if rainfall is below this level.
• The Caribbean island states have recently formed the world’s first multi-country and index-based catastrophe insurance pool to provide governments with immediate liquidity in the aftermath of hurricanes or earthquakes.

While it may be too early to assess if such internationally backed systems are viable in the long haul, they may radically change the way development organizations provide disaster aid and support adaptation to climate change. They may also provide a cornerstone of a post-Copenhagen adaptation strategy.

The MCII proposed risk-management module, together with other adaptation activities, would help vulnerable countries adapt to climate change.

IIASA and the Munich Climate Insurance Initiative (MCII) have proposed a risk-management approach to adaptation consisting of two pillars, prevention and insurance, which together would reduce the human and economic burdens on developing countries (see figure above and Winter 2008 edition of Options). Both pillars could be financed by a post-Copenhagen multilateral adaptation fund.

The prevention pillar focuses on risk prevention through targeted risk assessments and identification of strategies to minimize risk exposure, such as the use of early-warning systems and land-use restrictions, and help lay the groundwork for risk-transfer systems. Qualification for participation in the insurance pillar might include progress on a credible risk-management strategy, with a specific focus on the most vulnerable communities and sectors.

The insurance pillar has two tiers, reflecting the different layers of risk that need to be addressed for effective climate adaptation.

Tier 1 takes the form of a solidarity fund, or Climate Insurance Pool (CIP) and would provide insurance cover to vulnerable governments for a predefined high-risk (e.g., very low-frequency, high-consequence events), and the premiums would be paid from a post-Kyoto adaptation fund. The CIP operations would be managed by an insurance team responsible for risk pricing, loss evaluation, and indemnity payments, as well as placing reinsurance.

Tier 2 would be in the form of a Climate Insurance Assistance Facility and would enable mainly micro-scale risk-pooling and transfer mechanisms that provide cover for medium-loss events (e.g., a 1 in 50 year event). This tier would provide direct insurance to households, farmers, or governments, and offer support to nascent micro-, meso-, and macro-scale disaster insurance systems, like those operating in Malawi and the Caribbean.

Further information

Further information Linnerooth-Bayer J, Bals C, Mechler R (2009). Insurance as part of a climate adaptation strategy. In: Making Climate Change Work for Us: European Perspectives on Adaptation and Mitigation Strategies, M Hulme, H Neufeldt (eds), Cambridge University Press, Cambridge, UK.

Dr. Joanne Linnerooth-Bayer is Leader of IIASA's Risk and Vulnerability Program.

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Last updated: 08 Jul 2010