Limited access to international capital markets
H M Recent experience (e.g., Mexico, Caribbean, India) supported by donors, shows that innovative solutions can facilitate access to international capital markets.
Insufficient domestic insurance capacity
H M Domestic insurance markets have limited financial capacity to be allocated to catastrophe insurance.
International reinsurance capacity L L Capacity is increasingly available in low- and middle-income countries if programs are well structured and properly priced.
Reinsurance cycles M M Less sensitive in developing countries than
in high-volume developed markets when not correlated with peak risks in developed markets.
Agency & monitoring costs H H Can significantly impact the cost of risk financing. Index-based products can lower these costs.
Limited technical capacity of the domestic insurance industry
H M Many domestic insurers lack actuarial, modeling, and financial skills to efficiently manage catastrophe risks. There is a need for capacity building.
Regulatory impediments M M Arbitrary reinsurance rules may impede the
adequate supply of catastrophe insurance or inflate the premium rates.
Informational costs H M They can significantly increase the
commercial (re)insurance premium through the uncertainty load. Excessive CAT risk transfer pricing M L Pricing is competitive when programs are
well structured. It tends to decrease because of new capital inflow on reinsurance and capital markets.
Source: Authors.
Note: The challenges faced by donors are rated H (high), M (medium), and L (low).
LIC = Low-Income Countries; MIC = Middle-Income Countries.
Table 2.3 Summary of Market Imperfections in Low- and Middle-Income Countries
Challenges faced by donors
Market imperfections LIC MIC Comments
Market Imperfections and Catastrophe Insurance 73
international reinsurance and capital markets. Technical assistance may be needed to create domestic insurance and financial infrastructure to structure packages of risks that can be reinsured or securitized. If this step can be accomplished, the reinsurance placements and securitizations should be relatively successful. Once the foundation has been developed, risk transfer can be accomplished at a reasonable price and without sig- nificant exposure to supply constraints.
Risk-transfer placements from developing countries are generally quite small in comparison with developed-market transactions and are valuable to reinsurers and investors for diversification purposes. These placements cover off-peak perils and geographical areas where reinsurers and investors currently have little exposure. For some middle-income countries, some technical capability may already be present to assist in structuring pack- ages of risks for transfer into global markets.
Reinsurance underwriting cycles have been severe for some developing countries, such as Mexico, which faced significant pricing volatility dur- ing the hard market of 2004 and 2005. This limits the ability of local insurers to respond effectively and consistently to demands for catastro- phe insurance coverage. Technical assistance may be necessary in design- ing risk transfer solutions that mitigate the effects of pricing and avail- ability swings associated with underwriting cycles.
Notes
1. For example, in China, insurers had 52 percent of their assets in low-yielding bank deposits in 2003. In part, this was due to regulation, although investment restrictions were gradually relaxed during the late 1990s. Mostly, it is due to the immaturity of China’s financial markets, so that supplies of other types of assets are insufficient or subject to excessive return volatility (Sun, Suo, and Zheng, 2007). By contrast, insurers in the United States are almost exclusively invested in stocks, bonds, and other tradable securities.
2. These are also non-earning assets, that is, they typically are not invested and do not earn investment income, and such assets can create credit-risk problems arising from the possibility that policyholders or agents will default on their payment obligations.
3. In discussions of insurance programs, the term reserves is often used incorrectly to refer to a company’s equity capital, that is, funds that are available to pay
unexpectedly large losses and not owed ex-ante to a particular creditor. Here, we adopt the correct accounting terminology, referring to premium and loss lia- bilities as reserves and the company’s capital cushion as equity.
4. Equity capital is also called surplus or policyholders’ surplus in the insurance industry.
5. The high non-life insurance penetration in the US is mainly driven by the fact that health insurance is provided by the private sector, whereas public social security programs exist in most European countries.
6. Industry capital is based upon data from Guy Carpenter (2008a), which pro- vides total capital (including equity, retained earnings, and debt) for the Guy Carpenter Composite, consisting of the top 16 global reinsurers. Guy Carpen- ter estimates that the companies in the Composite account for 80 percent of industry premiums. Accordingly, as a rough estimate of total industry capital, we divided the Composite capital total by 0.8. Reinsurance industry premiums are from Standard & Poor’s (2007). Premiums for 2007 are estimated based upon the estimate in Guy Carpenter (2008a) that premiums declined by about 9 percent in 2007 from their level in 2006. Allowing for some exposure growth, we reduced the Standard & Poor’s (2007) premium total by 5 percent as our estimate of 2007 premiums.
7. Catastrophe reinsurance multiples are not available for other regional markets.
8. Figure 2.11 is based on tranches, whereas Figure 2.12 is based on bond issues, based on the reporting basis in the respective data sources for these figures. Many bonds issued over the past few years have had multiple trances covering various geographical regions or perils.
ased on the insurance and reinsurance market imperfections identified in the preceding section, which present impediments to the implementation of sustainable and competitive catastrophe risk financing solutions, this chapter discusses how and when the public sector, with assistance from the donor community, should intervene. The emphasis is on the role that can be played by IFIs, such as the World Bank, operating in conjunction with governments, private institutions, and donors. Public intervention can be helpful in two broad areas. First, com- petitive private insurance and reinsurance markets can be fostered to increase the amount of affordable and cost-effective insurance coverage purchased by individuals and businesses to protect against catastrophe events. Second, sovereign insurance programs can be created to provide liquidity to governments to finance their immediate needs without adding significantly to sovereign debt or diverting funds from economic develop- ment projects.
The overall objective of any market intervention by the World Bank and donors related to catastrophe risk financing should be to reduce the vulnerability of developing countries to natural disasters by encouraging countries to develop sustainable, affordable, and effective risk financing strategies to deal with natural disasters. In the higher-level strategic con- text, projects supported by the World Bank and donors should meet the