13.4.1 Limits of Insurance
Experience reveals multiple limitations of traditional forms of insurance
(Hoff et al.
2005): it is not applicable for all types of risks, does not prevent or reduce the likelihood of direct damage and fatalities from extreme weather
events and does not cover all losses
. Potential un-insurability associated with increasing frequency and magnitude of extreme weather
events poses an additional limitation. Moreover, it is not always the most cost-effective or affordable approach and actor’s behaviour towards low probability, high impact events can make the application of insurance
approaches challenging.
Insurance Is Not an Appropriate Measure for All Types of Risks
Insurance
options can support adaptation
and risk
resilience
for extreme weather
events, but are not appropriate for many, usually slower-onset, climate-induced impacts, that happen with high certainty under different climate change
scenarios. The losses
from long-term, foreseeable risks, such as sea-level rise, desertification and the loss of glaciers and other cryospheric water sources, are estimated to be substantial in the future (IPCC
2012). Even for weather-related events, insurance
would be an ill-advised solution for disastrous events that occur with very high frequency, such as recurrent flooding
. Resilience
-building and prevention in such instances may be cost-effective ways to address these risks.
Insurance Cannot Cover All (Types of) Losses
Insurance can only cover a percentage of losses, and even when policies are in place to offer coverage, basis risk can result in farmers being less protected than they expected to be. Basis risk can be understood as the risk that insurance claims do not adequately reflect the losses incurred; in other words, an individual suffers a loss and does not receive a payment for it because the insurance threshold was not triggered. In this way, even households that are fully insured end up bearing a significant amount of uninsured risk. This is particularly a problem for weather index insurance products (which currently make up the bulk of climate risk insurance schemes) as they pay based on the measure of weather or area yields.
Additionally, we have to note that not all types of losses and damages can be expressed in monetary terms. Insurance cannot address these types of non-economic losses and damages—context-dependent types of losses that don’t have market price and cannot be easily given a monetary value. For example, there is no payout that could compensate for the loss of culture, identity or biodiversity, all of which may be results of climate change related events.
Climate Change May Make Some Risks Uninsurable
As climate change will increase the intensity and frequency of extreme weather events, there may come a time when some risks become so severe that they are uninsurable. An increased risk for currently insurable perils, such as crops and livestock, will lead to higher premiums, which might ultimately make the product too expensive for the poor and the actors who pay premiums on behalf of them.
One determinant of increasing premiums is the rising uncertainty
about climate related risks. To assess risks and calculate premiums, the insurance
industry relies on weather data which are so far based on historical records of hazard occurrences (Herweijer et al.
2009). However, climate change
projections include a high level of uncertainty
as besides predicting impacts of future extreme events, anticipating future vulnerability
, socioeconomic trends and the way complex systems might react to new stressors is challenging (Ranger and Niehoerster
2012). This leads to greater uncertainties of insurers about the frequency and magnitude of future claims. Science
indicates that the greater the uncertainty
of the probability of an event and the magnitude of losses
, the greater will be the insurance
premium charged (Kunreuther
1996). However, if premiums “necessary to cover a disaster in a climatically changed world are greater than homeowners and businesses are willing or able to pay, the private insurance
market will collapse” (Cousky and Cook
2009). On the other side, if insurers under-price risks, the accumulation of capital may be inadequate to cover losses
threatening the solvency of insurers (Herweijer et al.
2009). Insurers therefore have to adjust in particular their underwriting practices that are mostly based on immediate past experience.
It is not known how the private markets would react to rising risk
levels in the future, particularly in developing countries. Cousky and Cook (
2009) point to the fact that “if risk
is increasing over time, such that insurers do not believe they can accurately estimate expected losses
, a key condition of insurability is violated.” Kunreuther and Michel (
2008) therefore conclude that only a requirement by law will make insurers provide coverage for climate-related risk
that have a high enough potential for causing catastrophic losses
in specific areas.
Behavioural Factors: Why People Don’t Insure Against Big Risks
It has often been observed that homeowners don’t purchase disaster insurance
. While budget constraints are one explanation for this behaviour, another explanation is people’s tendency to understate the probability of a rare events and catastrophes for themselves. Kunreuther and Pauly (
2004) could show that “people don’t insure against low-probability high-loss events even when it is offered at favourable premiums.” Due to a pre-disaster “It will not happen to me” perception, people don’t feel the need to voluntarily purchase insurance
coverage (Hertwig et al.
2004). Kousky and Cooke (
2012) conclude that “homeowners, facing a budget constraint and a constraint that their utility with insurance
exceeds that without it, may find the required loadings too high to make insurance
purchase an optimal decision.”
13.4.2 Seven Principles to Design Effective Pro-poor Insurance Solutions
This chapter is based on the observation that poor and vulnerable people and communities already exist and persist at the edges of adaptation limits, operating within adaptation frontiers. To successfully navigate adaptation frontiers, these people and communities need tools that allow them to explore the frontier, stay away from adaptation limits and continuously move into safer domains. So far, this chapter established that insurance can be used as a navigational tool around adaptation frontiers, however has limits that have to be taken into account when applying insurance instruments. Based on these findings, the final part of the chapter examines success criteria for instruments like insurance to approach their potential as risk management tool in developing countries.
In describing these success criteria we make use of an analysis of 18 existing insurance
schemes with regard to success factors and challenges for climate risk insurance
for the poor and vulnerable, conducted by a team from the MCII. Based on this analysis, the MCII team distilled seven Pro-Poor Principles for Climate Risk Insurance
(Schäfer et al.
2016). The principles can aid decision makers and practitioners in reaching poor and vulnerable people with effective insurance
solutions. They can guide the design process of new insurance
schemes that target the poor and vulnerable in particular by following the suggested steps or help with the identification of existing insurance
schemes to be supported by climate risk insurance
initiatives. Additionally, the principles can be used to support climate risk insurance
practitioners in assessing and/or improving their current operations. The principles are described in Box
13.2 and further discussed below.
Comprehensive, Needs Based Solutions
The poor and vulnerable face multiple risks that get in the way of opportunities to reduce poverty. For many of the analysed insurance
schemes, the key to success has been offering comprehensive solutions to mitigate weather risks. Three important factors were identified in the analysis of 18 existing insurance
schemes: (1) implementing risk
, needs, demand and context assessments, (2) linking insurance
to ex-ante climate risk management
, and (3) fostering locally driven and owned schemes (Schäfer and Waters
2016). The Rural Resilience
Initiative (R4) is a good example for this principle. R4 currently reaches more than 37,000 farmers with four integrated risk management
strategies: risk transfer
, risk
reduction, prudent risk
taking, and risk
reserves. While the risk transfer
enables the poorest farmers to purchase a weather index insurance
against drought, farmers can pay insurance
premiums in cash or through insurance
for assets (IFA) schemes that engage them in risk
reduction activities. IFA schemes are built into government safety net programmes or World Food Programme food assistance for assets (FFA) initiatives. Additionally, individual or group saving enable farmers to build a financial base. Providing a self-insurance
for communities
, group savings can be loaned to individual members with particular needs (R4
2015).
Client Value
Ensuring that coverage is reliable and that critical risks are not under-insured is critical for the take up and success of insurance
products that target the poor (Schäfer and Waters
2016). Bundling the insurance
product, where appropriate, with additional services that are valuable to the client and the active reduction of basis risk
, which remains a challenge for index products, were found as effective means to increase client value. SANASA in Sri Lanka is a good example for adding client value through bundling with additional services. The unique part of their index-based crop insurance
product is that it is bundled with other covers like accidental death and hospitalisation which catered to various needs of the farmers and offered a good coverage for both production and livelihood risks (Prashad and Herath
2015).
Affordability
Most insurance
-related approaches targeting poor and vulnerable people or countries have not been started and performed without some form of financial support, often in the form of premium support (Vivideconomics et al.
2016). Affording risk
-based premiums remains a major challenge for this target group, and measures to increase the affordability of products are paramount to the success of insurance
schemes. Finding solutions for this challenge is the precondition for establishing solidarity and human-rights-oriented insurance
schemes that respond to concerns of equity
(Schäfer and Waters
2016). When applied, premium support should always be smart in a way that it’s reliable, flexible and long term, that distorts incentives as little as possible, and that makes the client aware of the true risk
costs.
Accessibility
Efficient and cost-effective delivery channels that require minimum input but ensure a widespread reach are key for reaching a large client base and scale (Schäfer and Waters
2016). One way to achieve this can be by building on natural aggregators, such as associations, cooperatives, mutuals, federated self-help groups, and savings and credit groups, which have established successful and trusted delivery mechanisms and align the insurance
scheme with the local context. Investing in tech-leveraged secure client identification and targeting as well as payment systems to reduce fraud and improve the timeliness of payouts were identified as success factors by the case study analysis. Moreover, it proved successful to utilise social protection
programmes, where appropriate, to implement large-scale development of insurance
for the poor and vulnerable.
Participation, Transparency and Accountability
Target group ownership and trust are essential for the effective use of insurance
as a risk management
tool. It is crucial to include the insured and beneficiaries in the design and implementation of insurance
solutions and disaster risk reduction
activities to ensure products truly work. Participatory approaches to product development can create trust, help with capacity building and make sure that the insurance
actually meets the real needs of people at risk
, thus creating client value. The case study results showed that it is important to actively support and build partnerships, networks and communication channels that allow for inclusive and meaningful involvement of the poor and vulnerable (Schäfer and Waters
2016). Organisations and structures that have deep roots within the local context are favourable partners. Schemes moreover need to ensure that the design and implementation processes are transparent and accountable. An effective monitoring and evaluation framework that measures outputs, outcomes and impacts to ensure that the insurance
schemes actually reach and benefit poor and vulnerable people is crucial.
Sustainability
Safeguarding financial, social and ecological sustainability is crucial for the long-term success of insurance
schemes. This includes providing a long-term perspective on project planning and financing as setting up insurance
schemes is a multi-year effort. Reliable flows of money accompanied by a long-term perspective helps to create a safe environment for key actors to engage in. It also involves making sure that insurance
schemes do not incentivise practices that are not environmentally sustainable and incentivising risk
reduction and prevention through the design of the insurance
scheme, including risk
-based premiums. From a social perspective, ensuring the participation and inclusion of women in climate risk insurance
policy
and programming is key (Schäfer and Waters
2016).
Enabling Environment
An enabling environment is a set of interrelated legal, organisational, fiscal, informational, political and cultural conditions that facilitate the successful development and implementation of an insurance
scheme. Although the criteria for an enabling environment will be inevitably contextual, it is vital to actively build an enabling environment that accommodates and fosters pro-poor insurance
solutions. Key factors of an enabling environment include capacity-building of key stakeholders, appropriate regulatory framework, strong, long-term partnerships and availability of data and technology (Schäfer and Waters
2016). First,
capacity building is needed to improve the financial and insurance
literacy and risk
awareness of the insured, local insurers, distribution channels and governments. In the context of pro-poor insurance
solutions it is important to use capacity building tools that respond to the needs of the target group and are suitable to educate clients with low written literacy about the complexity of index insurance
. Second, successful insurance
schemes need functioning
regulatory and legal frameworks that govern the market, support the effective functioning of the scheme and allow growth by actively working with national governments and regulatory agencies. Third,
strong, long-
term partnerships, in particular public–private partnerships, which foster a clear allocation of roles is an important component of an enabling environment. The Index-Based Livestock Insurance
Project (IBLIP) in Mongolia was first introduced in 2006 and provides herders with insurance
through partnering with local private insurance
companies. Insurance
protects herders from climate-related losses
to their livestock. With IBLIP there is a risk
-layering approach to holistic risk management
, combining self-insurance
, market based insurance
and a social safety net. Herders only bear the costs of small losses
that do not affect the viability of their business; larger losses
are transferred to the private insurance
industry and the final layer of catastrophic loss
is borne by the Government of Mongolia. The combination of the public disaster response product (a social safety net for herders offered by the government) and the private base insurance
product (commercial product sold by private companies) proved to be highly successful for IBLIP. Fourth,
freely accessible data and technology as well as hazard/weather monitoring infrastructure are essential for effective and efficient design and implementation as well as for ensuring the uptake, distribution and payout of insurance
products.