PPPs can improve risk sharing for natural catastrophes

07 January 2016 Consultancy.uk 6 min. read

Natural catastrophes cause considerable human, environmental and economic losses. Insuring against losses on the economic scale is by no means an easy feat however, with governments at real risk of incurring unmanageable debt in the face of a wide scale catastrophe. Between 1980 and 2014, 73% of catastrophe damage was not covered, creating considerable financial hardship for individuals involved. In a bid to improve the situation, Guy Carpenter considers how public-private-partnerships might create a more sustainable environment.

Natural catastrophes can be devastating to people, their property and livelihoods. Natural disasters sometimes kill hundreds of thousands and lay waste to swaths of inhabited areas. The cost to people and their lives are considerable as repairing and reconstructing lives following disasters can run from thousands to tens of billions of dollars. The cost of the 2011 Tōhoku earthquake and tsunami has been estimated at $300 billion, with areas around the melt-down at Fukushima Daiichi nuclear power plant still off limits. Hurricane Katrina, with the inundation of New Orleans and surrounding area, caused an estimated $108 billion in economic damage and $45 billion in insurance pay-outs, while flooding in Thailand, following the landfall of Tropical Storm Nock-ten, caused an estimated $45.7 billion in economic damages and affected more than 13.6 million people.

With the costs so significant, few global institutions have the means to cover such costs. In Guy Carpenter’s report ‘Partnerships: the way to public sector risk financing’, the risk to government and communities are considered, as well as how private-public partnerships (PPPs) may help offset some of the low probability high cost risks faced by many emerging and developed regions.

Change in debt-to-GDP ratio 2007-2014

Government protection
Securing cover for remote risks, such as earthquakes or tropical cyclones, has led individuals to forgo coverage. Private markets often charge considerable premiums, if they cover the risks at all, and as such, some government entities provide facilities to offer insurance coverage directly to individuals. These instruments are often set up to provide a basic market of last resort for citizens; however, given their government security and non-discriminatory intent, they have become the major source of protection.

A downside of such approaches is that the premiums tend not to be sufficient to cover the actual cost of major disasters, requiring wider government capacities to be deployed. For major disasters, the consulting firm states, many governments stand to be considerably exposed, even to the extent that the disaster may risk long term government finances. Between 2007 and early 2014, global debt grew by $57 trillion with almost 45% of the expansion coming from government spending ($19 trillion in advanced economies and another $6 trillion from developing economies).

Overall losses and insured losses 1980-2014

While governments have played a role in insuring losses, the overall losses that are insured vs. those that are not have been trending upwards and diverging since the 1980s. Approximately 73%, or $2.7 trillion, of natural catastrophe losses globally between 1970 and 2014 were uninsured. This divergence can be explained by a number of factors, according to the consultancy.

One factor is that governments are likely to be the one holding the short end of the stick, and with more and more infrastructure value being added every year, the costs from disasters is expected to continue to rise. A second issue is that property owners often do not understand their level of risk, resulting in them not preparing for an adverse event – and as such, not securing insurance.  Further, globally, most funding for hazard mitigation is made available post-event, which in turn is coupled with an over-reliance on post-event financing.

Percentage of insured versus uninsured natural catastrophes (2000 to 2015)

The result is that since 2000, there has been over $1,600 billion in uninsured loss from natural catastrophes (70% of total losses), which required various forms of post-event funding and loss financing or was held directly by those impacted. As most people are not insured for catastrophes, and will likely walk away from assets owned by private institutions that are too damaged to use, a double risk is created for the government. They might end up not only financing the losses of the individuals, but that of the private institutions that have not protected themselves from the risk of the disaster either. Without the homeowner to mitigate loss, carry out repairs and continue to make mortgage payments, the ultimate economic loss multiplies.

According to the Guy Carpenter, “This creates a larger economic problem for the public sector to manage. Despite this exposure to significant loss, there is no urgency on the part of public sector entities or lenders to address the matter. As a result, we are left with an environment ripe for greater utilisation of private sector monies.”

Spectrum of government held insurance risk

Private-public partnerships
There are ways forward that are win-win-win for the three stakeholders involved: governments, private insurers and communities. If, as has occurred in some instances, private and public players work together to create affordable insurance packages for consumers, enough money will be transferred into insurance funds to cover at least the potential financial catastrophe following a natural catastrophe. Innovation around models for PPs is being considered, with a focus on different models that work in the vastly different conditions in emerging and developed markets.

“We have seen significant growth in public sector entities transferring risk to the reinsurance market via traditional risk transfer structures, collateralised reinsurance and catastrophe bonds,” says Jonathan Clark, Managing Director and North America head of Guy Carpenter’s Public Sector Specialty Practice. “Reinsurance capacity has been instrumental in providing both savings to public sector entities in years with outsized loss activity as well as protections for loss reserve funds/surplus.”