Financial tools for risk management

A specific category of economic instruments are risk sharing and alleviating tools. They take the form of catastrophe bonds, insurance, weather derivatives. Catastrophe bonds securitise risks associated with natural hazards. In particular, reinsurance companies and large corporations issued cat bonds in order to reinsure or retrocede these low frequency – high severity risks appearing on their balance sheet.

Insurance is the typical risk sharing/alleviating instrument. The insured pays a premium to the insurer that covers the risks regarding either one or more climate variables. Compensation depends on the assessment of losses caused by the specified variables, e.g. crop loss in agriculture. Weather derivatives are based on a specific 'weather' trigger rather than proof of loss, for instance temperature over a specified period, and therefore are simpler (and cheaper) to administer than other financial options. Although applicable to most businesses, the greatest potential for these may lie in the agricultural sector. Weather derivatives are derivative securities (taking most commonly the form of futures) in which an investor hedges against the future state of the weather. For example, one investor pays another if a weather indicator (rainfall, temperature, number of heating or cooling degree days, soil humidity) in a given place over a given period of time is above a certain amount. Likewise, the other investor pays if the indicator is below the agreed-upon amount. Higher levels of disaster risk can be managed using instruments provided by international capital markets such as weather derivatives. Weather derivatives are financial mechanisms that can be used by individuals and businesses as part of an overall risk management strategy. They are based on a specific 'weather' trigger rather than proof of loss, for instance temperature over a specified period, and therefore are simpler (and cheaper) to administer than other alternative options. Although applicable to most businesses, the greatest potential may be for use by the agricultural sector.

In the construction industry, Whole Life-Cycle Costing (WLCC) is an assessment of flood risk and response effectiveness. It is a relatively new concept, for the primary purpose of WLCC is to aid capital investment decision making by providing forecasts of the long-term costs of construction and ownership of a building or structure. It is also a dynamic approach and can provide up-to-date forecasts on costs and performance throughout the life of the building or structure. Similar methodology can be used to assess direct and indirect and private and societal costs of adaptation options, and could be applied to any option or investment.

IPCC categories

Institutional: Economic options

Stakeholder participation

As this is largely a private sectors initiative by (re)insurance companies and large corporations no real stakeholder participation is foreseen.

Success and Limiting Factors

Taking the example of insurance in flood management, its role is important for two reasons. First of all it provides the necessary funding for the recovery phase of the risk management cycle. And secondly, insurance companies have more direct access to home owners and can demand prevention measures when setting the level of insurance premiums. If, for instance, flood damages were covered by state funds only, there would be limited incentives for those in the private sector to minimise their own risks. This is partly the case in, for example, France. The French system is characterized by a high degree of solidarity, since premium differentiation is not allowed and the insurance scheme is kept affordable with public reinsurance. The public reinsurance solves problems associated with high correlated risks. But the drawback of the absence of premium differentiation is that this impairs efficiency by failing to reward development in low-risk areas and loss-mitigating investments. On the other hand just private insurance has drawbacks too. For instance the flood insurance market in the United Kingdom is closest to a pure private market because premiums are risk based, the government is not involved as a reinsurer, and a public compensation scheme is absent. This makes insurance premiums relatively expensive, which, in combination with the voluntary nature of the market, may explain a low coverage among poor households. Therefore multi-layered insurance programs seem to be a promising public-private partnership that can provide adequate incentives to limit flood losses and overcome capital shortages in insuring large catastrophe losses. All natural hazards could be incorporated in a single contract, since most hazards like flood, storm, earth slides, hail and heavy rainfall generally occur in the same event, which makes it difficult to separate out the damage that corresponds directly to the insured hazard. Since every place is exposed to some natural hazard, the creation of a larger (cross-border) insured community leads to lower premiums. Insurance is widely acknowledged as important adaptation option. Moral hazard is a serious problem for insurance system. In the agricultural sector disaster payments act as an insurance policy and tend to encourage production of high return, high risk crops in marginal areas. Rising incidence of natural disaster damages lowers profits for insurance companies. 1) Potentially high start up costs. 2) Accurate prediction of information is required.

Costs and Benefits

An important aspect of economic instruments is cost/benefit sharing. Formal credit and insurance institutions can pool risks across large and diversified portfolios and, in principle, offer an efficient way of overcoming regional covariance problems and reducing the cost of risk management. Costs will be location specific and will be determined by risk calculations.

Implementation Time

1-5 years.

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