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Integrating natural disaster risks & resilience
into the financial system

Rowan Douglas | 10th November 2014

Integrating climate and disaster risk into the financial
system presents the opportunity to help save millions of lives
and livelihoods in the coming decades and to protect billions
in assets and property in a cost-effective and rational way
when weighed against competing priorities.

This relatively simple solution links the combined power of financial regulation and accounting principles with the acute political priority and growing economic impact of natural disaster risk. It delivers significant progress in natural disaster resilience at the local and global scales, and across public, private and mutual sectors for both short and longer time scales.

The remarkable story of the global re/insurance sector’s near existential crisis in the late 1980s and early 1990s, and its ensuing journey towards far greater structural resilience to natural disaster risk by 2012-2014, provides a number of invaluable lessons on the essential techniques and approaches necessary for such a financial reform to occur.

Learning from crisis

Following a period of unprecedented losses in the 1980s, largely driven by natural catastrophe events, the global re/insurance market entered a crisis, culminating in the losses from Hurricane Andrew in 1992. This resulted in a number of insolvencies in Europe, North America and elsewhere, and structural confidence in the global risk-sharing mechanism of insurance was in disarray. Private capital withdrew, mutual capital could not be expanded and, in most cases, public sector solutions could not be practically applied. With such lack of capital, natural disaster re/insurance became unavailable, severely restricted and/or excessively expensive. It was clear that the sector’s modus operandi of the last 300 years was no longer adequate in coping with the level of risks underwriters were facing.

Three key forces

During the decade from 1993 to 2003, the entire sector underwent a transformation which assumed a deeper understanding of the roles of, and fluid relationship between three key forces, which transformed the treatment of natural disaster risk within global re/insurance. These three key forces were smart capital; a scientific, data and analytical revolution; and public policy and financial regulation.

Smart capital began entering the sector from new private sector investors, mutuals, and even progressive state sector insurance systems, that demanded improvements in the way that underwriters evaluated and priced natural disaster risk in their portfolios.

A scientific, data and analytical revolution thrived with the influence of mid-1990s software and technology trends on underwriting data management and analysis, coupled with an influx of catastrophe risk modelling firms. As a result, the level of analytics of natural disaster risks went from relatively simple aggregate assessments undertaken by a single underwriter, to industrial scale operations: large cross-disciplinary analytical teams were now managing terabytes of data on major IT platforms to assess floods, earthquakes, windstorms and other perils to portfolios of homes and assets throughout the world.

The influence of public policy and financial regulation came to the fore when governments, through their insurance regulators, developed an emerging convention that insurance contracts should deliver their commitments at a 1:200 year level of confidence. This required, in effect, that an insurance company should have access to sufficient capital (either directly or through reinsurance) to remain solvent and pay all insurance claims when it experiences the worst combination of extreme events across the world over a twelve-month period once every 200 years at current (not historic) levels of risk.

Indeed, the year 2005
witnessed Hurricanes
Katrina, Rita and
Wilma hitting Florida
and the Gulf Coast,
causing major insured
losses in excess of
US$50 billion.

Such multi-century scale risk management was new and unknown to insurance, as well as the wider financial world. Over time, however, knowledge was acquired, techniques became more refined, and the general market practice transformed. This policy approach, driven by insurance regulators seeking policyholder protection, was reinforced by re/insurer credit rating agencies who serve the demands of investors and creditors as well as providing metrics of financial strength employed by re/insurance counter parties and corporate insurance buyers.

Together, the three converging forces of smart capital; a scientific, data and analytical revolution; and public policy and financial regulation, created a revolution in the re/insurance market by the mid-2000s: sufficient amounts of capital began to be allocated to match levels of risk; failures became less frequent; and the volatility in the level of underwriting capacity and pricing in response periods of high catastrophe losses steadily dampened.

In short, the market was beginning to master how to manage risk more effectively. Indeed, the year 2005 witnessed Hurricanes Katrina, Rita and Wilma hitting Florida and the Gulf Coast, causing major insured losses in excess of US$50 billion. However, despite the modelling challenges for Hurricane Katrina, the global re/insurance market was capitalised to pay claims and there were few insolvencies. By 2011, the worst global natural catastrophe loss year on record with over US$120 billion in claims, the sector succeeded in managing well within normal market operations, a trend that continued with the response to New York’s Super Storm Sandy in 2012.

Encouraging resilience

Over the last quarter of a century, the insurance sector, with its science and public policy partners, has firmly established a tried and tested operational system for rationally allocating capital in relation to disaster risks, even at extreme probabilities. Furthermore, it has developed conditions and standards of behaviour for its customers to reduce risk to the system and to encourage, and sometimes enforce, resilience as a requirement of access to the contingent capital that an insurance policy represents.

While the insurance sector still has a long way to go and represents a relatively small proportion of the financial system, its remarkable journey through the nexus of capital, science, and public policy, provides the essential ingredients and method to embed natural disaster risks and resilience across financial regulation, accounting, and the condition for the access to capital it governs.

Accounting for disaster risk

The financial sector beyond non-life insurance generally does not take adequate account of natural disaster risk

The financial sector beyond non-life insurance generally does not take adequate account of natural disaster risk: it is not factored into investors’ valuations, creditors do not adequately assess natural hazards against their loans books, and extreme event risk is largely ignored by real estate markets (even in highly exposed locations).

Increasing levels of natural disaster losses in most parts of the world, combined with the growing frequency, intensity and duration of hydro-meteorological extremes, renders the continued invisibility of this risk within financial practice unsustainable. Investors, creditors and prudential regulators therefore urgently need to be informed of material risks to institutions, securities and commitments.

In due course, appropriate natural disaster risk factors will inevitably need to be incorporated into banking and securities protocols to reflect the basic tenets of regulation, accounting and audit which are underpinned by the principle that liabilities and material risk should be identified, and where appropriate, evaluated and reflected in reporting protocols and financial returns. This envisioned yet attainable financial reform would need to be founded on the principles of simplicity and consistency, which are important elements in financial regulation, accounting and reporting. Upon these principles, and borrowing from the insurance experience, a number of metrics would be developed and applied to securities and debt instruments.

The Value of Disaster Risk Resilience

But how might this translate in the context of natural disaster resilience? Increased disaster risk exposure would discount valuation and the attractiveness of assets, while lower risk and reduced vulnerability would be positive. In short, natural disaster resilience would be valued, with a resilience intervention acting as a credit against the contingent disaster risk liability. As such, capital owners (from the small urban homeowners or cooperative farmers to large multinationals) will become incentivised to avoid excess natural disaster risk and hence impairment to their valuations or liquidity of assets.

To corroborate this process, public companies listed on stock exchanges could be required to publish their maximum probable annual losses to natural disasters at the 1:100 year return period (representing a stress-test to the company’s solvency in an extreme natural disaster scenario), the 1:20 year return period (representing a profit risk/earning event for a company in a given year), and average annual loss. These reflect the kind of basic metrics (“tolerance requirements”) that have evolved to drive financial resilience and capital efficiency within the insurance sector. In essence, if two otherwise identical companies exhibit a marked different exposure to natural hazard risk which has material implications on their potential solvency or profit, the company with higher vulnerability to natural hazards will have a reduced valuation/share price and would be a less desirable stock due to the reduced quality of its earnings.

To increase valuations, reduce interest rates or strengthen credit ratings, institutions could engage in increasing their physical, financial or operational resilience to disaster risks. For example, a property portfolio may be refined to reduce the proportion of highly exposed locations by focusing on optimal building codes and resilience characteristics.

In time, capital is generally allocated towards the more attractive and valuable assets, with natural disaster risk and resilience appropriately incorporated within the valuation. In due course, asset owners will invest in resilience to remain competitive and, where necessary, undertake actions to reduce specific or systemic levels of risk towards tolerable levels.

Facilitating the Uptake of Resilience Measures

At present, these risks or resiliencies are not evaluated or reported, and related factors are largely ignored by analysts, markets and investors. As a result, companies have limited incentives to compete by reducing risk and developing resilience.

However, following its experience of the techniques for measuring the 1:100 / 1:20 year natural hazard risk and average annual loss across exposed sectors and industries, the insurance sector could facilitate the uptake and institutionalisation of these techniques within standard corporate practice in a relatively short period of time and at a fraction of the cost of natural hazard losses.

The G20 under the
auspices of the Financial
Stability Board has
agreed key aspects of the financial regulation agenda
operating through existing and often reformed

One fundamental driver that will enable disaster risk to be applied across the different elements of capital at a global scale (with local application via regional and national institutions) is the growing concentration of financial regulation. Indeed, following the financial crisis of 2008, the G20 under the auspices of the Financial Stability Board has agreed key aspects of the financial regulation agenda operating through existing and often reformed institutions. These include the Bank of International Settlements (BIS) and the International Association of Insurance Supervisors (IAIS) in Basel, who are respectively responsible for developing the capital regulations for banks and related transactions, and overseeing the development of global solvency rules for re/insurers. In Madrid, the International Organization of Securities Commissions (IOSCO) coordinates the rules for securities, including public company stocks and bonds.

These three bodies work closely with banks, insurers, asset managers, national/regional regulators and accounting organisations, to develop rules and standards which can then be implemented through the financial sector institutions at local levels with due preparation. Here, once again, the approaches and techniques developed by insurance organisations to evaluate and regulate natural disaster risk can provide the reference guide for banking and securities application. For example, if properties or companies are assessed for natural disaster risk for insurance purposes, relevant data could be employed by banks or other financial institutions under appropriate protocols. To support these developments, a corresponding science, information and analytics environment will be necessary for risk assessments and portfolio management in these markets.

As with all regulatory change and innovation, a period of trial, shadow assessment and professional training before new rules and standards are applied within formal regulatory and related accounting processes will be inevitable. However, a timeline for the creation of new disaster risk standards, the development of supporting facilities and services, testing and lead time, through to formal adoption, could be as near as 2020 given that these approaches are already an established body of knowledge and practice in one part of the financial sector.

Though this may seem ambitious, the various processes underway in relation to the international agenda in 2014 and 2015, including the UN Secretary General’s Climate Summit and the renewal of the Hyogo Framework for Action, are already indicating a growing demand for a stable, transparent and trustworthy financial system that will formalise the influence of natural disaster risk on fiduciary responsibilities and thus presage a long-awaited paradigm shift within resilience.

About The Author

Rowan Douglas
Capital, Science and Policy

Rowan Douglas is Chief Executive of the Willis Capital, Science and Policy Practice; Chairman of Willis Research Network; Chair of the UN Hyogo Framework for Action Renewal Consultation (HFA-2) Financial and Private Sector Working Group

In this issue
Integrating Natural Disaster Risks & Resilience Into the Financial System


Including the Private Sector in Disaster Risk Management


On WillisWire
Seasonal climate impact prediction


UN Climate Summit: 1-in-100 Initiative


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