Asian Disaster Management News Vol.10-No.-1

Risk Transfer and Insurance/Reinsurance as a Strategy for Catastrophe Risk Management

During the past 15 years there has been spectacular growth in the use of risk analysis and risk management tools developed by engineers in the financial and insurance sectors. In particular, the insurance, reinsurance, and investment banking sectors have enthusiastically adopted loss estimation tools developed by engineers in developing their business strategies and for managing their financial risks. As a result, the insurance/reinsurance strategy has evolved as a major risk mitigation tool in managing catastrophe risk at an individual, corporate, and governmental level. This is particularly true in developed countries such as the US, Western Europe, and Japan. Unfortunately, it has not received sufficient attention in developing countries where such a strategy is most needed.

Recent earthquakes in India, Iran, China, and Turkey have shown once again that the burden of sharing economic losses by risk transfer to global insurance and reinsurance players is not pursued by developing countries. As an example, the following table shows catastrophe insurance penetration in developing countries:

A lesson yet to be learned in these countries is that insurance can play a major role in helping a nation recover rapidly from a catastrophic event. It is generally accepted that for a region to bounce back to social and economic recovery after a catastrophe, there have to be funds for rebuilding. Insurance can provide those funds.

Catastrophe insurance helps individuals, communities, and nations reduce financial risk by spreading that risk to all those who pay insurance premiums against the specific risk. Further transfer and reduction of risk is achieved through reinsurance companies around the world who insure the insurance companies.

Key Stakeholders in the Management of Financial Risk
(Source: Private Communication)

Property owners are the ones who can potentially bear losses due to natural catastrophes. To protect themselves, they may transfer some of their risk to insurance companies. When insurance companies accumulate a large amount of risk, they may want to transfer some of their risk to reinsurance companies. The figure shows the main stakeholders in managing financial risk. The capital markets at the top of the risk pyramid provide the capital to the insurance and reinsurance markets through financial instruments such as catastrophe bonds. The insurance rating agencies and the state insurance commissioners generally regulate the functioning of the insurance and the reinsurance companies. The Securities and Exchange Commissions regulate the capital markets. Thus, in the pyramid of stakeholders, the government, private industries, capital markets, and society at large are interested parties.

"Role of Insurance and Reinsurance in Managing Financial Risks Due to Natural Catastrophic Events" by Haresh C. Shah and Weimin Dong. A Chapter in the book to be published in India by Mr. Shirish Patel.

National catastrophe insurance can help developing countries avoid economic disaster. Most developing countries focus on risk reduction options through engineering strategies. Relatively little attention is given to financial and economic strategies. This needs to change in the light of recent developments in loss-estimation technologies. Until then, post-catastrophe recovery will remain a major challenge to national economies.

Prof Haresh C. Shah is Obayashi Professor of Engineering, (Emeritus), Stanford University, Founder and Senior Advisor, Risk Management Solutions, Inc., and Director, World Seismic Safety Initiative. He can be contacted at haresh.shah@rms.com