2 ABSTRACTThis paper analyses the current funding mechanism to finance disaster management in India. It looks atthe drawbacks of the current systemwhich is more focused on ex-post strategies. The paper then looks atpossible ex-ante strategies that can strengthen the current mechanism, and provides relevant examples ofother countries using such instruments. It also highlights the importance of a domestic insurance market,challenges of domestic insurance markets and makes suggestions on the possible features of a domesticinsurance market that can be created in India.
3 Table of Contents1 Introduction: The Present Disaster Management Framework in India ............................................... 4 1.1 Change in Approach towards Disaster Management .................................................................... 4 1.2 History and growth of domestic disaster management funds, and international funding ............. 5 1.3 Significance in the coming years with respect to increase in the population, resource constraints and climate change .................................................................................................................................... 82 Recommended Financial Risk Management Solutions ......................................................................... 9 2.1 Drawbacks in the current mechanism ........................................................................................... 9 2.2 Alternate Options .......................................................................................................................... 9 2.3 Need for Domestic Insurance Market ......................................................................................... 133 Conclusion ........................................................................................................................................... 14Annexure: Efficient domestic insurance schemes in other countries .......................................................... 16 National Flood Insurance Program, USA ............................................................................................... 16 Earthquake insurance system in Japan .................................................................................................... 17 Florida Hurricane Catastrophe Fund ....................................................................................................... 18References ................................................................................................................................................... 20
41 Introduction: The Present Disaster Management Framework in IndiaIndia has been affected by disasters like earthquakes, cyclones, floods and droughts. Besides natural disasters, thevulnerability to nuclear, biological, and chemical disasters and terrorism is increasing day by day. Approximately58.6 percent of the total area of the country is vulnerable to earthquakes of moderate to very high intensity; over 12percent of land (40 million hectares) is prone to floods and river erosion; around 68 percent of the cultivable area isvulnerable to drought; and about 8.5% of land (5,700 km of the 7,516 km) along the coastline of the country is proneto cyclones and tsunamis.Disasters, natural or man-made, have always had substantial economic burden on the country. The annual lossesincurred by India due to floods aloneover the last five decades are shown in the figure below. Figure1: Annual Flood Losses Source: NDMA Flood Guidelines, 20081.1 Change in Approach towards Disaster ManagementHistorically, Indian disaster management strategy has focused on post disaster relief, rehabilitation andreconstruction, and rarely given importance to ex-ante disaster management techniques. However, in the recent pastwith increasing natural disasters occurring across the country, the need for a more holistic approach to disastermanagement has been felt.Based on the recommendations of the Ninth Finance Commission, the Calamity Relief Fund (CRF) was created in1990 for each state1. In 2002, through an amendment to the Allocation of Business Rules of article 77 of theConstitution of India, the mandate of disaster management was transferred to the Ministry of Home affairs from theMinistry of Agriculture. Only drought remained under the Ministry of Agriculture, and epidemics remained underthe Ministry of Health. This brought a broader scope to disaster management in India.The National Centre for Disaster Management (NCDM) was established in 1995 in solidaritywiththe InternationalDecade for Natural Disaster Reduction (IDNDR).In October 2003 the NCDM was upgraded to form the NationalInstitute of Disaster Management (NIDM)2.The Disaster Management Act of 2005 was instrumental in bringing about fundamental changes in approach todisaster management in India. Through this Act, the National Disaster Management Authority (NDMA) 3 under the1 Prior to this, all central assistance to states in the aftermath of a disaster was in the form of margin money.2 NIDM is a centre of excellence for disaster research and conducts training programs for disaster preparedness around thecountry.
5chairmanship of the Prime Minister, State Disaster Management Authorities (SDMAs) under Chief Ministers, andDistrict Disaster Management Authorities (DDMAs) under the chairmanship of District magistrates were set up.This Act brought together all institutions involved in the disaster management process. The NDMA concentrates onprevention, preparedness and mitigation of disasters. The NIDM was given the responsibility of developing trainingmodules andundertaking research and documentation in disaster management through the Act.1.2 History and growth of domestic disaster management funds, and international fundingThe National Disaster Management Program, put in place in 1992, had required increase infunding fromINR 63million (USD 1.3 million) in the 8th Plan to INR 307.7 million(USD 6.3 million) in the 10th Plan. Currently, two(types of) funds are in place: the Calamity Relief Fund (CRF) and the National Calamity Contingency Fund (NCCF).The present financial scheme, operational from 2005-06 to 2009-10, is based on the recommendations of theTwelfth Finance Commission (TFC). The TFC has recommended continuation of the schemes of CRF and NCCF. Ithas also recommended that avalanches, cyclones, cloudbursts, droughts, earthquakes, fires, floods, hailstorms,landslides, and pest attacks are to be considered as natural calamities for providing assistance from CRF/NCCF.CRF has been constituted for each state with an allocated amount. Contributions by the central and stategovernments are in the ratio 3:1. Additional help is provided from the NCCF if the calamity is severe in nature. TheSchemes of CRF/NCCF provide for only immediate relief to the victims of natural calamities. The expenditureforrestoration of infrastructure and other capital assets have to be met from the Plan funds of the States.In 2005, in the wake of the occurrence of several simultaneous natural disasters in India,and following reports onDisaster Management (DM), the Government of India enacted the Disaster Management Act. The Act led tochanges in disaster management mechanisms and financing needs,favoring a more comprehensive and adaptedapproach.1.2.1 Calamity Relief FundThe amountsallocated to the Calamity Relief Fund grewsignificantly from the 2nd Finance Commission (INR 61.5million or USD 1.25 million)to the 8th Finance Commission (INR 2.40 billionor USD 48 million). Until 1990, theprocedure to release funds to a state for receiving national funding required amemorandum by the state governmentapplying for central aid, and a visit by the central team to the affected state.From 1990, each state was requiredtoform its own CRF. The decentralization of this fund enabled each state to assess the funds necessary to ensureappropriate disaster response and relief measures. The initial budgets were calculatedbased on average annualexpenditure for the previous decade, adjusting for inflation.The funds, available as part of the CRF State funds, are to be spent to compensate losses such as loss of life, crop,livestock, emergency daily allowance, and employment as per limitsdefined by the Government. These funds weredeemed unavailable for infrastructure repairs, effectively making them available only for emergency relief.3 NDMA has also taken up the process of formulation of guidelines through a participatory and consultative process involving allstakeholders including government, non government, academic and scientific institutions, corporate sector and community.
6 Figure 2: Annual CRF allocation Source: NIDM (http://www.nidm.net/Calamity%20Relief%20Fund%20during%2000-05.asp)The amounts deposited by the central government and the states in the CRF are invested in securities, deposits andother safe financial products as prescribed by Ministry of Finance. The investments are made by the local branch ofthe Reserve Bank of India (RBI), or by another bank prescribed by it. Funds transferred and maintained at the statelevel are available to the state within reasonable time when a disaster occurs.Beside the state funds, a national fund, the National Fund for Calamity Relief(NFCR), was created. Its objective wasto cover calamities of “rare severity”. But the definition of the term “rare severity” was ambiguous, leading to statesusing it inappropriately. It was therefore discontinued in 2005 upon the recommendation of the 11th FC.1.2.2 National Calamity Contingency FundAnother fund called the National Calamity Contingency Fund (NCCF) was created upon the recommendation of the11th FC. If the CRF is insufficient for a state confronted with a disaster, the state may request the use of the NCCFprovided by the Central Government. This fund becomesavailable in case of natural catastrophes like cyclones,droughts, earthquakes, fire, floods, hailstorms, tsunamis, landslides, avalanches and pest attacks.The State hit by a natural catastrophe has to request funds for the damage it incurred and funds necessary to copewith the outcome of the disaster. It has to submit a request to a national-level commission (the ICT). The balance ofthe NCCF is transferred to following year if the balance is positive at year-end and all allocated funds were notutilized.Initial Contribution to the NCCF was INR 5,000 million (USD 100 million), deposited by the central government.The fund is replenished as withdrawals are made. Below is atable of assistance amounts dispersed to a selected listof states, as well as a total for the country. One may note that the total amount withdrawn from the fund has beenmuch greater than budgeted every year.
7 Figure 3: Annual NCCF allocationState 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 TotalAndhra Pradesh - 30.4 59.9 116.8 87.2 100.0 203.1 37.5 634.9Bihar 29.7 - - - 398.9 - - - 428.6Gujarat 585.0 994.4 23.3 32.4 55.0 304.3 545.7 - 2,540.1Maharashtra - - 20.0 77.5 173.2 657.3 589.9 168.9 1,686.8Orissa 35.0 114.6 21.8 104.4 53.4 - 25.0 - 354.3Rajasthan 85.0 79.0 434.1 512.7 216.8 - 100.0 0.3 1,427.9Tamil Nadu - - 216.0 289.5 783.1 1,131.9 - - 2,420.5Total 924.2 1,368.7 1,600.0 1,587.4 2,583.1 3,061.4 962.1 363.4 3,265.0 13,460.3 Source: Ministry of Finance - http://finmin.nic.in/the_ministry/dept_expenditure/ In 2008-09, the amount budgeted for the NCCF was INR18 billion(USD 366 million) as against INR15 billion (USD 305 million) in the previous year. However, the actual amount withdrawn was INR 32 billion(USD 652 million),well exceeding the budgeted figures. For 2009-10, the budget was revised and increased to INR 25 billion (USD 509 million). The budget for this fund seems to be inevitably increasing every year, yet without being sufficient for the actual expenses it is supposed to cover. 1.2.3 PMNRF The Prime Minister’s National Relief Fund is a relief fund under the authority of the Prime Minister. The fund does not get any budgetary support, and consists entirely of public contributions. All donations are exempt from taxes. The fund is generally invested in fixed deposits. The PMNRF is utilized to render immediate relief to families of those killed in natural calamities like floods, cyclones and earthquakes, etc. and also to the victims of the major accidents and riots. 1.2.4 ACA – Additional Central Assistance Another financing mechanism from the GOI to support states where disasters occur is the Additional Central Assistance. Unlike the other funds, the ACA is a combination of a grant and a loan to the affected state. States falling into the general category receive 30% grant (70 % loan) whereas the special category states get 90% of the amount as a grant and only 10% as a loan that they will have to reimburse to the Central Government 4. The funds are released weekly according to the recommendations of the Aids Account & Audits division of the Ministry of Finance5. The 12th Finance Commission has recommended that External Assistance may be passed on to states on the same terms and conditions on which the loans/grants are received by GOI. 4 According to the recommendations of the twelfth finance commission, the system of imposing a 70:30 ratio between loans and grants for extending plan assistance to non-special category States and 10:90 in the case of special category States should be done away with. Instead, the centre should confine itself to extending plan grants to the States, and leave it to the States to decide how much they wish to borrow and from whom. 5 AA&A Division is responsible for scrutinizing claims received from the Project Implementing Agencies as to their eligibility as per relevant credit agreements and submitting the same to the donor for obtaining disbursement.
81.3 Significance in the coming years with respect to increase in the population, resource constraints and climate changeIn the coming years, the need for a more efficient Disaster Management strategy will be felt in the face of a host ofproblems. We will mention a few and describe how it will lead to increased vulnerability to disasters.1.3.1 Rise in Urban PopulationUNDP studies show that a majority of Indian poor would be residing in urban areas, specifically in mega cities.Since time immemorial, rural-urban migration has been prevalent in India as villagers seek to improve their standardof living. Thus, India has a large and increasing urban population. As of 2011, about 30% of the Indian populationresides in urban areas, and still growing. The extension and intensification of urban areasis a planetary phenomenonand according to the United Nations’ estimates for 2006, Delhi, Mumbai and Kolkata figure in the top ten mostpopulated cities of the world. In the next couple of decades, as India’s population is still increasing and its economyis developing at a high rate, these factors will put further stress upon the financing of disaster relief and recovery. Inparticular, an increasing urban population leads to increasing density in cities and megalopolis, which are prone todisasters. In case of disaster in an urban environment, the relief effort for an ever larger population as well as thereconstruction activities required would be greater than they have ever been in the past. Moreover, if urban planningis not adequate, the impact of disasters in densely populated areas could be even greater.1.3.2 Increased economic disparity and increased vulnerabilityIn its World Disaster Report 2001, the International Red Cross presented data from the UNDP and CRED (Centrefor Research in the Epidemiology of Disasters) that compares the impact of disasters on countries with low, mediumand high HDI. Data for 2557 natural disasters was observed and it was found that there is a clear trend ofcommunities systematically becoming more disenfranchised and more vulnerable. This will lead to a higher base ofpopulation with poor coping strategies fordisasters.1.3.3 Development and InflationFurthermore, the loss of property and infrastructure will require larger funding as the cost of reconstruction and thevalue of the infrastructure increase with the economic development of the nation. The development on theinfrastructure front means additional exposure to losses for governments at national and local levels in the upcomingyears.1.3.4 Impact of climate changeRecent scientific research has indicated that the severity and intensity of many natural disasters will increase in thefuture. This compounded with the fact that the population of the earth is increasing manifold will mean thatvulnerability is increasing with time. The loss caused by a disaster at a given place today will be much more thanthat of a disaster of similar magnitude at the same place fifty years ago.Natural disasters have a severe impact on the economy of the affected region, and in the case of developing or smallcountries, the effects are more pronounced. Often, losses might amount to a significant percentage of the country’sGDP6, in which case, most insurers and re-insurers turn bankrupt and the government has to shoulder the burden.The Asia-Pacific region is highly prone to natural disasters. Between July and October 2009, Typhoon Morakotdevastated Taiwan and created havoc in coastal China; two ultra-powerful typhoons battered the Philippines;amassive earthquake rocked western Sumatra in Indonesia;serious floods swept southern India;and an earthquake andtsunami struck Samoa.6 When Hurricane Ivan struck Grenada in 2004, the loss was calculated at US $800 million, about two times the country’s GDP –of which government losses accounted for about 30 per cent.
9These natural disasters not only caused widespread damage and heavy strainon public budgets,but they also soundedurgent alarm calls for more sustainable risk financing arrangements. There is a dire need to reducevulnerability andenable the affected regions to recover swiftly. Concentration of population and exposure ofgoods in urban areascouldlead to potentially heavy losses in India if disaster were to strike. Without doubt, it necessitates adequatefunding mechanisms on an urgent basis.2 Recommended Financial Risk Management Solutions2.1 Drawbacks in the current mechanismAn analysis of the current mechanisms of fund flows to disaster affected regions shows thatthere is ample scope forimprovement.Generally state governments access the Calamity Relief Fund (CRF)during emergency disasters. But if the CRF isnot sufficient to cover the losses, which is the case when severe disasters strike, the state government requestsadditional support from the Central government. Whenever state governments request additional financial support,the Centre does a loss assessment on the basis of which, it decides the amount to be disbursed to the stategovernment. If the Central government is not able to supply funds, then it seeks help from bilateral and multilateralagencies, which requires acceptance of loan conditions which might not be in-line with national or state capacityand/or policy. So, there is always a time gap between request for relief and actual financial support made available.There is considerable uncertainty in forecasting the actual losses and availability of funds, and hence it is impossibleto keep sufficient reserves to tackle disasters. Also, there is no standardized way for accurate loss assessment that iscommon to both the states and the Centre, which almost always leads to a large difference between the amountsrequested by the states and the amounts delivered by the Centre.Besides, the states cannot use the excess relief fundsfrom the CRF for risk mitigation activities as there is uncertainty in the amounts needed for the next financial yearfor post disaster relief.There are no specific strategies towards the growth of domestic catastrophe insurance market. An efficient domesticinsurance market backed by such entities asthe international reinsurers andpublic sector insurance companies cantake a significant part of the burden off the government’s shoulders. This will be explained in detail in the latersections.2.2 Alternate OptionsThere are a number of exclusive pre-disaster mitigation tools that can be used by the government. These ex-antemechanisms, which are enlisted below, can be used as a rider with ex-post instruments. Pooling Commercial insurance and reinsurance Capital Markets Bank-based solutions2.2.1 Catastrophe Risk PoolingCatastrophe risk pooling refers to the coming together of a range of parties like governments, insurers andreinsurers, people and donors who pool their resources to share the burden of an economic setback induced by anatural or man-made catastrophe. A country can share their disaster risk with other countries through a form ofcooperative insurance. This is the concept of pooling. Such a mechanism can be effective when the number ofcountries sharing the risk is large enough, and the correlation of risks between participating countries is low which is
10a typical requirement in insurance for the „law of large numbers‟7 to work. Countries that are diverse geographicallyor among the types of risks they face can form a group that will support each other during times of need.An example is the Caribbean Catastrophe Risk Insurance Facility (CCRIF 8), the world’s first regional insurancefund created in 2007. It is an insurance pool covering earthquake and hurricane that was created by 16 Caribbeancountries with help from the World Bank. The fund fulfills the liquidity needs of the affected countries and to avoidcircumstances where the country gets paid more than its losses, the sum insured is kept at 20% of the total riskexposure to catastrophes. The countries contribute a proportion of their exposed risk to the pool every year. For this,a detailed study of catastrophic exposure is carried out initially. The contract is parametric in nature and thus thepayouts do not depend on the actual losses but on the parameters like wind speed. A certain amount of risk isretained by the pool,while the rest is transferred to the international reinsurance markets and catastrophe bondmarkets. Figure 4: Structure of CCRIF Premium Reinsurance / ART Country 1 (Purchased in Country 2 Reserves Growth international Claims capital markets) Country n CCRIF Source: World BankSome of the features of the scheme are:1. Being parametric in nature, it resolves the issue of moral hazard.2. As the pool grows, its dependence on the international risk carriers reduces and thus the premium amount reduces.3. As the pool is administered by the contributing countries, the problems of adverse selection and any other frauds are curbed.4. The risk layering in the pool is done as follows: The Group retains all losses up to $12.5 million (2008: $10 million) per annum. The next $12.5 million (2008: $15 million) of losses are reinsured with four (2008: 3) reinsurers with an A.M.Best rating of at least A-. The next $30 million (2008: $25 million) of losses are reinsured with four (2008: 3) reinsurers with an A.M.Best rating of at least A-. The next $90 million (2008: $70 million) of losses are ceded 66.7% to three (2008: 71.4% to 2) commercial reinsurers with an A.M.Best rating of at least A-, and 33.3% (2008: 28.6%) to the World Bank. The Group retains all subsequent losses above $145 million (2008: $120 million). 92.2.2 Risk Transfer to Commercial Insurance and ReinsuranceIn the absence of partners to share disaster risk, the government can transfer a part of the risk to insurers andreinsurers, who can managesuch risks as they generally have a diversified portfolio. Moreover, all commercialinsurers operate under the auspices of some reinsurer(s). Reinsurers are to insurers what insurers are to the end7 The implication of this law in insurance is that if there are a large number of entities with similar risk profiles, the variability ofthe claims payout from the insurer’s point of view decreases substantially.8 Source: http://www.ccrif.org9 Source: CCRIF annual report 2008-09
11policyholders. But what to insure and what proportion of the risk to transfer to these organizations are defined basedon specific contexts.Insurance can be used to cover public assets, disaster funds at the state level or even individual households. The typeof scheme used depends on the economic, geographical and social aspects of the region concerned. Generally indeveloped countries, after a disaster strikes, the governments and the private insurance industry are able to take careof the losses. But, in developing countries, due to low demand for insurance, the cost of relief and reconstruction isleft to the government with aid from international donor organizations. Moreover, due to the lack of technical andfinancial expertise, most developing countries are not able to adapt to the complex financial instruments currentlyavailable.Ethiopia has traditionally been suffering from drought and to top this, approximately80% of its population isengaged in some form of agriculture. In 2006, to limit the losses from extreme drought for the nearly17 million ruralEthiopian farmers, the World Food Program of the World Bank started the Ethiopian Drought Insurance scheme incollaboration with the Ethiopian Government. This is also known as the world’s first humanitarian insurancescheme. An example of governments taking insurance at the country level is the Ethiopian Drought Initiative aidedby the World Food Program (WFP). The insurance contract for this was designed by AXA Re and the scheme waslaunched to reduce the time lag and uncertainty in the donor relief funds reaching the government. The WFP was thecounterparty to the risk transfer.The main features of the scheme are: The WFP pays the premium and the payouts are given to the government. It is an index-based contract. The index is based on rainfall data from 26 weather stations throughout Ethiopia for the March to October growing season of 2006.10 The payout will be either in the form of food aid, social support or cash relief to farmers in pre-selected districts of the country. Humanitarian assistance was expected to arrive four months earlier than usual.2.2.3 Transferring Risks to CapitalMarketsCapital markets represent another entity to which disaster risk can be transferred. This has been increasinglyobserved in the recent years following the hurricane season in the Atlantic. The volume of loss caused by a disasteroften renders insurers and reinsurers bankrupt. This brings the heat on the government, which has to take care of theeconomy and infrastructure besides the usual relief and rehabilitation efforts. Global capital markets, due to theirimmense depth in capital, can theoretically supply the capital to deal with extremely devastating catastrophes. Thereare currently many instruments that are being used to channel capital from the capital markets to disaster insurance.One such channel is the Catastrophe bonds.Catastrophe BondsCatastrophe bond or cat bond is one of the instruments linking natural disasters and the capital markets. After manyexperimental transactions, the first set of cat bonds were issued in 1997. The adoption of cat bonds has grownrapidly, as measured by the number and value of issuances consumed. Cat bonds are different from normal bondsbecause their performance is insulated from variations in the stock market; and their returns are higher than fromnormal securities. So, they are a perfect choice for investors looking to diversify their portfolio. Moreover, they aretailor made for the sponsor who aims to reduce the basis risk by a large degree.The growth of these instruments hasbrought previously uninsurable risks under the umbrella of insurability. These instruments present themselves as10 Source: Syroka& Wilcox, 2006.
12efficient means of risk transfer because of their ability to attract investors thus speeding up the process of capitalinflow.Figure No 5 (given below) demonstrates how a cat bond is structured. A reinsurance company (or even thegovernment of a country) can act as a sponsor. The sponsor establishes a special purpose vehicle (SPV), which isentrusted with the task of issuing the bond and thereby investing the capital in low risk securities. The returns, addedwith the premium paid by the sponsor, are paid to the bond holders. The trigger for payout is some pre-definedcatastrophe occurring in a pre-defined region. If the trigger event does not occur, the investors get back the principal.Otherwise, the entire or a part of the principal is retained and paid to the sponsor by the SPV.The SPV issues a catastrophic insurance policy to the hedging party. Under this arrangement the insurance risk isfully collateralized and therefore, unlike conventional insurance, there is no counterparty risk.Securitization usually requires rigorous and, therefore, expensive modeling. It makes more sense to insure high-endlosses with such complex instruments. The additional interest burden is often a multiple of the expected loss. Thereason for this load is partly to cover the modeling costs and partly because of the capital cost of collateralizing theloan. An obstacle to the use of such instruments has been the inability or unwillingness on the part of the State tobear this cost.11 Figure 5: The structure of a cat-bond Reinsurance Investment recoveries s Investors Special purpose Sponsor vehicle Interest Principal (at maturity) Premium Source: David Hoffman and Patricia Brukoff.The Mexican Government issued a cat bond (Mexi Cat ILS) in 2006 to insure its national disaster fund (FONDEN)against earthquake risk. The reinsurer involved in the contract was Swiss Re. The principal issued for the bond wasUSD 160 million. It was renewed recently in October 2009 by Swiss Re for USD 290 million. Earlier, in 2003,Taiwan Province of China had also issued a cat bond to insure its residential earthquake insurance pool withFormosa Re as underwriter.2.2.4 Bank Based Solutions18.104.22.168 Debt ForgivenessDebt forgiveness (waiver) is a strategy for addressing post disaster financing. This makes the repayment of loans forprojects or sovereign debt conditional on the non-occurrence of catastrophic events. A country can apply thisstrategy when it takes loans from other countries or multilateral organizations. However unlike a cat bond, whichinjects new capital, debt forgiveness repays existing debt. There is no automatic input of new capital that can then bespent. Debt is reduced, which frees up new borrowing capacity. But in order to invest in post disaster projects, thecountry has to activate this new debt capacity by appealing to its lenders for new capital.11 Source: Eugene Gurenko
22.214.171.124 Contingent FinancingIt is difficult for a country receiving severe blows from catastrophe to raise money from debt in a medium term.Most of such mid-term financing is essential to reset the infrastructure necessary for basic re-development of theaffected region. However, very few lenders would agree to offer credit to such affected countries. Hence it is alwaysbeneficial to arrange for such credit in advance, contingent upon the catastrophe. That is, if a catastrophe occurs, thelender will deliver a certain amount of credit to the affected country/party in the country at the pre-determined rate.Though both these financing techniques have been hardly implemented in the real world, they definitely hold goodpotential. However, radical reforms – particularly in the banking sector - will be required to actually see them inpractice.2.3 Need for Domestic Insurance MarketThe Catastrophe insurance market in India is in a very nascent stage. Only one percent of the losses (all catastrophelosses together till now) are insured. Uninsured loss of income and assets caused by natural disastersis a major threatto the lives and livelihoods of a large section of the population in India. Hence, it is very important to promote thedomestic insurance market.Typically, during a catastrophe government needs to give grants or soft loans to the needy. So, a well-developedcatastrophe market not only protects the insured but also puts lesser burden on government budget so that it canfocus more on providing relief and restoring public infrastructure.Mitigation of losses is an important aspect of disasters, and, without community participation,it will not be veryeffective. Again, by making insurance available to only those communities that follow the norms, it is easy toimplement the law. For example, in United States it is estimated that loses amounting to $1 billion are reduced inevery major flood because of the mitigation measures taken by the community alone.The insurer can manage risks better if he is able to market better. With its huge presence, the insurance industry willbe able todeliver the products and assess the claims better. An insured individual is more certain about the time itwill take for his claim to be settled and the amount he would receive.Though developed countries also are affected by disasters, they do not suffer severe casualty loss because of strictadherence to safety norms compared to developing countries, like India. For instance, by making insurance availableonly to the buildings that adhere to the norms set by the Government, enforcing building standards and other safetynorms could become easy.2.3.1 Challenges in India Due to the underdeveloped general insurance industry in India, there is hardly any historical data on damages due to previous shocks. In the last decade for instance, only 1% of the total losses were insured in India. 12 There has been no systematic classification of properties which is considered to be a key factor in vulnerability assessment process. Naturally, the general insurance industry has been relying on crude actuarial methods and most of the premium prices are based on the competition in the market. Thus there is no significant difference in the premiums in geographically different regions. Current regulations state that maximum FDI share in an insurance company cannot be more than 26%. Thus major investments in the insurance industry are domestic. The advantages of international risk transfer cannot be obtained without relying upon international reinsurers. The problem of moral hazard is always there. In fact, indemnity based models have been tried out in crop insurance and the experience has been miserable. The loss ratio of such schemes has been as high as five. An index based insurance scheme would perform better, but this would require more efficient modeling.12 USAID insurance India report
14 Financial literacy, insurance literacy in particular, is the key demand side issue. Even though many awareness campaigns and capacity building programs are being carried out, people in remote locations (some of which are high-risk zones) still remain ignorant about financial risk management mechanisms. Further, they might not appreciate the risk posed by low frequency (but very high impact) events. As an extension, putting aside capital for catastrophic risk mitigation might not be considered a priority by representatives of the people in India. Instead, other capital expenditures,like building infrastructure, might be a priority for them. Distribution of insurance and other risk management solutions also remains a challenge. Micro finance and micro insurance sectors have been struggling in delivering low cost insurance to the masses. Though various models have been tried, hardly a few seem to be working. Further, due to current banking regulations, banks or other lending organizations might not be keen on trying out innovations like event-triggered loan waiver schemes126.96.36.199 Possible Features of Domestic Insurance System in India:Most of the developed countries have a good domestic catastrophe insurance market (we have described some ofthem in the annexure.) The following could be some features of catastrophe insurance market in India Public-Private partnership is necessary for the growth of domestic insurance market and thus the overall risk reduction initiative. The risk can be classified into private and public risks. From an Indian perspective, domestic insurance companies should bear the entire private risk and government should provide premium subsidies for the needy. The low- and medium-end public risk can be borne by the government and the high-end risk should be transferred to the insurer or capital markets. Domestic general insurance companies should bear the entire private risk. Along with managing risks proficiently, they can also market and control the moral hazard problem efficiently. People usually underestimate catastrophe risks. Hence, catastrophe insurance should be compulsory. This will reduce the premiums considerably and also increase the involvement of the community. The government should provide subsidies for the needy. The premiums should be based on risk profile. There should be premium subsidies for houses built according to land-use regulations and safety norms. This will help to increase the insurance coverage as well as help in the enforcement of the safety regulations. Overall, there will be significant risk reduction both from the points of view of economics as well as from a casualty perspective. There is a need for the development of a public disaster database containing historical data including om on catastrophes and property classification; and more accurate vulnerability maps should also be designed.3 ConclusionFocus on Ex-Ante StrategiesAs already seen, ex-post financing is not a fool-proof risk management solution when it comes to catastrophes. Indiahas had to request help from international financing agencies many times in the past due to catastrophic disasters.The overall vulnerability of India to disasters is increasing mainly due to rapid urbanization in high risk zones andnon-enforcement or lack of land-use regulations. The issue of climate change induced problems is going toexaggerate the situation. The effects are going to be more severe economically as well as from the casualty angle.The government, with its ex-post funding mechanisms alone, will not be able to cover the losses if a high-intensity(one in hundred or one in two hundred year) event strikes India. So, the government has to try a mix of ex-ante andex-post mechanisms.Insure government funds, contingent financing and public assets13 These are provisions by which a loan is written off when certain pre-specified event occurs in a pre-specified period of time.
15In the current Indian scenario, the government should insure its public finances so that in the event of a calamity,there will not be any pressure on the government budget. If a calamity strikes, the government will have thenecessary finances to deal with rescue/relief/rehabilitation activities. For high-end losses, the government can issue acat bond and be assured about relief funds flowing in from the capital markets within a short time of the disasterstriking the country.Encourage domestic catastrophe insurance marketAlong with government insuring its funds and public assets, it is important to encourage domestic insurance market.A good domestic market will not only reduce the burden on the government but can also mitigate losses effectively,and protect private assets. The ongoing process of increasing the FDI cap from 26% to 49% in the insurance sectoris a good signal that the government is trying to open up the insurance industry. The government can also help theinsurance industry by giving them warranties of reinsurance (as an reinsurer of last resort) and helping them to gethigh-rated reinsurers by providing premium subsidies. Besides, the government can start extensive awarenesscampaigns to promote insurance in the country.Easily accessible public disaster databaseDisaster insurance is in its nascent stage in India. However, its growth can be catalyzed by promoting catastrophemodeling agencies. A publicly available national disaster database can substantially help in bringing about thesevital changes. As more and more information becomes available, more sophisticated catastrophe models to predictregional variations will be available and thus more tailor-made products14 can be introduced in the market. Recently,a project for creating unique identification numbering for the whole Indian population has been commenced by theIndian government. On similar grounds, creating a database of residential and commercial properties withcharacteristics pertaining to the vulnerability should also be initiated. The same could be done with land-useregulations.Facilitate the growth of capital marketsA smoothly functioning market mechanism is required for an efficient nationwide domestic catastrophe insurancemarket. There should be a legal framework wherein the insurance, banking and the securities market can worktogether smoothly. This will help the growth of capital markets in particular and the alternative risk transfer (ART)mechanisms market in general.Incentives and EnforcementAdded incentives, such as premium discount (if property satisfies safety codes and abides by land-use regulations),should go a long way in increasing insurance penetration (at least in the urban areas). But to create such anenvironment, the government has to ensure that all safety regulations and town planning bye-laws are actually put inplace and being enforced strictly. This, again, reflects the need for the public and private sectors to work together.As regards land-use regulations, the growth of coastal urbanization as well as colonization of high-risk zones has tobe checked immediately because this increases the vulnerability of the population and adds to the final damage toll.14 Index-based insurance products are favored typically because of their low operational costs and timely claimssettlement. But they require complex modeling and sufficient data. Besides, catastrophe bonds and otherinstruments also require sophisticated modeling.
16 Annexure: Efficient domestic insurance schemes in other countriesNational Flood Insurance Program, USAThe United States has a comprehensive flood insurance program called National Flood Insurance Program. Theprogram was created in 1968 to make federally backed flood insurance scheme available to individual households.Flood insurance was then virtually unavailable from the private insurance industry. Some of the key features of theprogram are: It is a voluntary scheme and mandatory only if home loan is taken from federally regulated lending institutions. There is a waiting period of 30 days. It is compulsory for all those who receive disaster assistance to buy insurance so that they become eligible to get financial assistance next time. Coverage is available for both structures and contents - to business, home owners and tenants. Insurance is available only to those structures which adhere to the norms set up by the government. Insurance is not available in some designated areas so as to discourage development in those areas. For example, in some of the Coastal Barrier Resource systems areas the scheme is not available. It covers all types of floods, including floods causes by hurricanes and landslides. Differential premiums are charged based on the zone. The Flood Insurance rate maps are used to create risk zones and these are updated at least once in five years. The average flood insurance policy costs a little more than $400 a year for a cover of about $100,000. ( 0.4% of the sum insured) The risk is entirely borne by the government and sold through the insurance companies which also settle claims.The program is designed to be a win‐win situation for the NFIP and private insurers. The NFIP makes use of theprivate insurance industry’s marketing channels and also the presence of many insurers in flood prone areas.The NFIP retains responsibility for underwriting losses. In return, the private insurers receive an expense allowanceand do not bear the risk. In other words, they play the role of a financial intermediary and claims manager on behalfof the federal government.Experience of National Flood Insurance Program:The figure shows the cumulative losses and cumulative premiums from the inception of the program till 2006. Figure 6: Cumulative premiums and losses Source: NFIP
17The above figures do not take into account the administrative expenses, insurance company commission andinvestment benefits. By making realistic assumptions on expenses and investment returns, we can conclude thatover 37 years, -from 1968 to2005, NFIP’s revenue was $23.6 billion, itstotal insurance expenses were $24.3 billion (including $16.5 billion of claims paid to insured victims of flood and$7.4 billion paid to companies participating in the Write Your Own WYO) program).In addition, the program spent $2.2 billion for administrative expenses. After 37 years of operation, the cumulativeoperating result was a deficit of about $3 billion. (Source: Wharton publication15)Despite this potentially synergistic effort between the NFIP and private companies, takeup rates for flood insurancehave historically been low. One reason for thisis that private insurance agents do not seem to market NFIP policies. Another reason is thatindividuals are not interested in voluntarily purchasing flood insurance due to behavioral biases in evaluatinglow probability risks and/or lack of information/awareness.Earthquake insurance system in JapanThe earthquake insurance system in Japan was initiated in 1966 by the Japanese Government. Since its inception, ithas undergone many changes regarding the coverage of half damaged and partially damaged houses. The JapanEarthquake Reinsurance Company (JERC)16 is at the centre of this insurance system in which the non-life insurers,JERC and the government participates to ensure that insurance claims can be settled without fail. Figure 7: Structure of earthquake insurance system in Japan Source: Earthquake insurance in Japan: NLIRO Japan15 Managing large scale risks in a new era of catastrophes16 JERC was established with share capital of 1 billion yen by 20 domestic Japanese non-life insurance companies on May 30,1966. The Company was licensed for the earthquake insurance business and started its operation on June 1, 1966.
18The above diagram depicts the structure of the Japanese insurance system. Some of the key features of theearthquake insurance system are: The coverage for policies is limited to residential buildings and movables for living The risks covered are losses to objects insured due to fire, destruction, burial or flood directly or indirectly caused by earthquake, tsunami, or volcanic eruption. The claims are paid on an indemnity basis. Three kinds of losses are considered- total, half and partial. o If the insured object suffers total loss, the total sum insured is paid subject to an insurable value. o If the insured object suffers half loss, half of the sum insured is paid subject to a half of the insurable value. o If the insured object suffers partial loss, 5% of the insured value is paid subject to 5% of the insurable value. Private Insurers write policies and settle claims. The total risk is reinsured with JERC. The JERC cedes back a part of the risk to the private insurers. The JERC also reinsures a part of the risk with the government through an excess of loss reinsurance 17 treaty. Risk layering structure o Claims upto 115 billion yen are totally paid by the JERC and the private insurance companies. o From 115 billion to 1.925 trillion yen, the claims are equally shared between the government and the combination of JERC and the private insurance companies. o From 1.925 trillion yen to 5.5 trillion yen, 95% is paid by the government and 5% is paid by the combination of JERC and the private insurance companies. o If the total amount of claims per quake exceeds the aggregate limit of indemnity, claims payable shall be reduced pro rata by the proportion of 5.5 trillion yen to the total amount of claims.Florida Hurricane Catastrophe FundFHCF is a reinsurance program administered by the state government of Florida, USA. The fund was created afterthe huge losses due to Hurricane Andrew in 1994. Under the mandate of this fund, every insurer has to pay a certainproportion of the premium of residential property policies. A pool is thus created from the premium amounts and isutilized in case a hurricane occurs. The trigger is not based on the actual losses, but is based on the characteristics ofoccurrence of the hurricane. The two key conditions for a triggering event are that it be declared a hurricane and thatit cause damage in Florida while it is a hurricane. Due to its compulsory nature, the administrative costs of thisscheme are very low. The administration and actuarial modeling tasks are outsourced by the State Board ofAdministration of Florida (SBA). A separate entity called Florida Hurricane Catastrophe Fund was set up to issuebonds for the fund. In other words, it is a Special Purpose Vehicle for this fund, in which around 200 insurersparticipate. As of June 2008, the fund held assets worth $95.26 million 18 whereas the net premium collected for theyear ending 30th June 2008 was of the tune of $13.36 million. As of June 30 th 2008, the fund was rated Aa3 byMoody’s and AA- by Standard and Poor.Replicability in India17 An excess of loss reinsurance treaty is one which I triggered when the total loss exceeds a pre-determinedamount usually used to insure against high end losses.18 Financial reports of FHCF
191. It is not very difficult to create such parametric trigger based reserves and funds for cyclones for at least some of the states in India where the occurrence of cyclones can be modeled in a sophisticated way.2. Another way of introducing a good risk mitigation mechanism is to create parameter based loan waiver schemes. Under such schemes, if a cyclone hits the particular state, the loans given in the territory could be waived off completely or partially depending on the strength of the event. For floating such loans, the lending agency might have to avail a separate catastrophe insurance. The premium can then be included as part of the interest. Thus though the yield of the loan will be higher than the usual, there would be certain assurance to the lender organization as well as the loanee state.Having said this, it should not be misinterpreted that such funds can be instantly implemented in Indian territories. Itshould be noted that the premium collected for the residential properties is dependent on many factors like territoryrating, construction type etc. Creating a detailed inventory of such characteristics of residential properties is achallenge.
20 ReferencesDoherty Neil, Clarke Caroline, “Development enhancing risk management”, part of “Catastrophe Risk andReinsurance: A country risk management perspective”, edited by Gurenko Eugene, Risk Books Publication, 2004KrovvidiAdityam, “Quantifying the catastrophe exposures from cyclones, earthquakes and floods in four Indianstates”, part of “Catastrophe Risk and Reinsurance: A country risk management perspective”, edited by GurenkoEugene, Risk Books Publication, 2004Gurenko Eugene, “Building effective catastrophe insurance programmes at the country level: A risk managementperspective”, part of “Catastrophe Risk and Reinsurance: A country risk management perspective”, edited byGurenko Eugene, Risk Books Publication, 2004Nicholson Jack, “Florida hurricane catastrophe fund: Lessons and experience”, part of “Catastrophe Risk andReinsurance: A country risk management perspective”, edited by Gurenko Eugene, Risk Books Publication, 2004Hofman David, Brukoff Patricia, “Insuring Public Finances Against Natural Disasters—A Survey of Options andRecent Initiatives”, International Monetary Fund, 2006“Earthquake Insurance System in Japan”, Non Life Insurance Rating Organization of JapanJapan Earthquake Reinsurance Co. Ltd., Annual Report, 2007Ghesquiere Francis, Mahul Olivier, Forni Marc, Gartely Ross,“Catastrophe Risk Insurance Facility: A solution tothe short-term liquidity needs of small island states in the aftermath of natural disasters”, World Bank“Humanitarian Aid as Insurance: WFP Drought Insurance Project”, International Seminar on Emergency andAgricultural Insurance, Porto Alegre, Brazil, 30 th June 2005.Ad hoc Discussion Group on Drought, “Drought- Living With Risk: An Integrated Approach to Reducing SocietalVulnerability to Drought”, ISDR, 2009EriyagamaNishadi, Smakhtin Vladimir and GamageNilantha, “Mapping Drought Patterns and Impacts: A GlobalPerspective”, IWMI Research Report, 2009National Rain-fed Area Authority, “Drought Management Strategy-2009”, Ministry of Agriculture, Government ofIndia, 2009Dr. Bruce Chapman, Dr. Linda CouretnayBotterril, “An Income-Related Loans Proposal for Drought Relief forFarm Businesses”, 2004Edited by Jesperson Kathy, “Drought Planning for Small Community Water Systems”, NDWC, 2006Skees Jerry, Murphy Anne and Collier Benjamin (GlobalAgRisk, Inc.); McCord Michael J. and Roth Jim(Microinsurance Centre LLC), “Scaling Up Index Insurance- What is needed for the next big step forward?”, 2007The World Catastrophe Reinsurance Market, Guy Carpenter, 2006, 2007, 2008, 2009.Report of the Twelfth Finance Commission (2005-10)CCRIF Annual Report 2008-09.
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