Can insurance markets jump-start resilience?
By Jeff Byles
March 16, 2017
Whether it’s Superstorm Sandy, an earthquake in Nepal, or runaway California wildfires, natural catastrophes take an enormous economic toll — upwards of $100 billion every year. You might think that sum is largely covered by global insurance markets, with their various products to hedge against risk. Not so. “If you add up the total cost of disasters globally, only about 30% are insured,” said Alex Kaplan, senior vice president of global partnerships for reinsurer Swiss Re. “The overwhelming majority of those uninsured economic losses fall on the back of government.”
In other words, the stricken nation’s taxpayers foot the bill.
This alarming state of affairs has prompted risk-management experts to seek out creative ways to finance resilience investments — e.g., storm-surge barriers, earthquake-fortified bridges, flood-proofed coastal properties — that prevent catastrophic damage in the first place. What’s becoming clear is that insurance markets, with their direct stake in protecting homes and businesses, can be key partners in this effort.
There’s a strong precedent, after all, for insurers as public-safety champions. To reduce their risk exposure, they helped pioneer the modern fire department and fought for mandatory seat belt laws. Today, many believe that insurers, armed with innovative underwriting tools, can play a transformational role in buttressing communities against disaster.
“Governments are struggling to fund the resilience-building they need,” Kaplan added. “The hope is that we can develop a solution that effectively rewards them for reducing their risk in a way that ends up paying for that risk reduction.”
The result, if successful, could be a win-win for insurers and society.
Simple solutions to slash insurance premiums
Broadly speaking, the world of insurance can be divided into two different sectors: private insurance companies and government-run programs. In the United States, the latter have long enticed policyholders to embrace resilience through a simple reward system: make risk-reducing upgrades to your building, and we’ll lower your insurance rates. This mechanism underlies much of the thinking about the power of insurance markets to drive resilience investments.
Consider the National Flood Insurance Program (NFIP), America’s federal flood-insurance provider. Established in 1968, and today administered by the Federal Emergency Management Agency (FEMA), the NFIP partners with more than 80 private insurers to provide insurance to property owners if their communities agree to adopt ordinances that reduce the risk of flooding. For the NFIP, measures such as elevating the lowest floor above the base flood elevation qualify homeowners for reduced rates.
If you add up the total cost of disasters globally, only about 30% are insured.
Strategies like these can be hugely effective. As detailed in a 2015 report by the nonprofit Enterprise Community Partners, one multifamily building in Hoboken, New Jersey, installed floodwater vents and elevated the first floor to ground level. The $25,000 retrofit reduced the cost of flood insurance by 83%, with a return on investment of less than three years. (The owner originally paid $12,000 for $300,000 worth of coverage; after the retrofit, the premium dropped to $2,000 for $820,000 worth of coverage.)
Through NFIP’s Community Rating System, incentives have been expanded to more than 1,300 communities, which receive flood insurance discounts ranging from 5% to 45% in exchange for resilience-boosting activities exceeding minimum NFIP standards. Altogether, nearly 3.8 million policyholders participate in the program, with some of the highest-achieving communities including King County, Washington; Fort Collins, Colorado; and Tulsa, Oklahoma.
These rewards could be still more effective if integrated with other federal programs. Katie Wholey, an Arup resilience consultant, pointed out that federal disaster-recovery funds are linked to investments like meeting minimum housing elevation regulations, which is required for homeowners whose houses were substantially damaged and located in the 100-year floodplain to receive federal rebuilding funds.
But such investments won’t necessarily reduce premiums. A chance to tie those two together could be on the horizon: reauthorization of the Stafford Act, which provides the framework for disaster-recovery funding. If overhauled, the act could better incorporate not just financial incentives, but a storehouse of knowledge gained by local governments as they administer federal funds. “Given the number of large-scale disasters in recent history,” Wholey said, “reauthorization of the act provides an opportunity for lessons learned on the ground to make their way up to higher-level policy makers.”
Innovations to scale up resilience incentives
While revamping federal policies is a start, they apply to only the limited pool of property owners covered by government-supported programs. How could incentives extend to the universe of privately insured properties? Andy Thompson, founder of Safehub, a start-up focused on advancing resilience through smart-building technology, believes the key lies in including site-specific information in the insurance pricing models.
Insurance is generally priced at a macro level, based on building classes. If a single property owner makes a resilience investment, that won’t shift pricing for the larger class. Moreover, most risk ends up in the hands of reinsurance companies, which effectively insure the insurers. Those carriers price risk based on average data for portfolios of thousands of buildings, and it is their pricing that ultimately drives the individual property owner’s premium. “Right now, you might have a very granular understanding of a particular building’s risk,” Thompson said, “but it is challenging to scale that understanding into the insurance markets.”
Safehub seeks to bridge that gap by using building sensors to provide real-time, site-specific data that can be scaled to large portfolios, thereby affecting insurance pricing. If a retrofit is made that improves the risk profile, that information can be included in the risk-pricing model. This creates financial incentives for resiliency while also supporting business continuity efforts through rapid-response alerts and damage detection.
Other tools also offer intriguing potential. In parametric insurance, payouts are triggered based on the parameters of a catastrophic event, such as wind speed or earthquake location. Property owners can receive a predetermined payout based on event parameters (for example, the higher the earthquake magnitude, the higher the payout). This model is intended to simplify claim settlements, getting citizens back on their feet more quickly after a disaster. While it doesn’t directly incentivize resilience, such a model does deploy a creative insurance tool to help communities bounce back from shocks and stresses.
You might have a very granular understanding of a particular building’s risk, but it is challenging to scale that understanding into the insurance markets.
Then there are catastrophe bonds. Despite their name, such bonds are not debt instruments like typical municipal bonds. Instead, they are risk-linked securities, which offer a payout to the insured party when triggered by a catastrophe. To date, they’ve been issued by a variety of public and private entities, including insurance companies, the World Bank, the Mexican government, and Amtrak. Their structure allows investors, such as hedge or pension funds, to buy into the risk with the promise of a handsome return. Given their attractiveness to investors, many believe that catastrophe bonds could become a powerful tool to fund resilience investments. The theory runs like this: If new infrastructure lowers the potential for a catastrophe bond to trigger, it should lower the insurance premium. If that savings could be captured in advance, it could then be used to build the infrastructure.
In their current form, catastrophe bonds don’t provide such a mechanism. Some experts have sought to create precisely this linkage with a financial tool known as resilience bonds. In short, such bonds modify catastrophe bonds to incorporate risk-modeling of the reduction in expected losses made by resilience investments. They then generate rebates, based on the anticipated insurance savings, that can be used to fund resilient infrastructure projects.
Another promising tool on the horizon is the disaster deductible. Proposed by FEMA, this tool would give states a financial incentive to invest in resilience by tying those investments to federal disaster funding. For example, states could be required to pay an up-front share of disaster funds (the “deductible”) before federal payouts are made. If states make basic resilience investments — say, beefing up building codes — the deductible could be reduced. Such a tool could make a big impact: according to FEMA, just 63% of local jurisdictions have disaster-resilient building codes.
Framing the bigger policy picture
Steven Sachs, executive vice president at Willis Towers Watson, a global insurance adviser and broker, believes that policy innovations are a key piece of the puzzle. Critical for resilience, he argues, are stronger codes that would mandate safer buildings and state or local tax credits to incentivize improvements. “If you ended up having better buildings that were less susceptible to damage across the board,” Sachs said, “insurance rates would come down because losses would come down.”
Such thinking has helped drive standards on the West Coast, where, given the high cost of earthquake insurance, just 10% of Californians carry it. “I don’t see a major shift in that 10% of coverage happening any time soon,” said Patrick Otellini, who until recently served as chief resilience officer of San Francisco. A 2013 program in that city now mandates the retrofit of older multifamily buildings with a first story weaker than those above. “When the city can make a public policy argument that its building stock needs to be addressed and it impedes the city’s ability to respond and recover, then it becomes a policy issue, not a property-owner issue.”
Kaplan, of Swiss Re, notes that in the developing world, innovative insurance tools have supported broader policy goals. For example, African nations have created an insurance pool to help manage risks from catastrophic drought. Based on parametric insurance models, the program uses satellite weather surveillance to estimate drought-related crop losses, then triggers automatic payouts to governments when there is not enough rain during a harvest season. “If you have a year with extreme drought, the GDP of the nation is heavily impacted,” Kaplan said. “If you can create a floor to prevent these countries from going deeper into poverty, you are increasing their chances of developing positively over the next several generations.”
For Lisa Dickson, who leads Arup’s resilience practice in the Americas, the issue ultimately boils down to risk. She points out that insurers, while making some resilience-enhancing adjustments, still have a ways to go to fully incentivize resilient behaviors. “In order to move the needle with respect to resilience, insurers must change how risk is defined, disclosed, and underwritten,” she said. For example, insurance coverage is generally based on either annual or slightly longer terms of three to five years, not on an asset’s total life cycle. Moreover, risk is predominantly evaluated based on past events, not accounting for current and future climate threats. And misleadingly, it’s almost always assessed on a year-by-year basis. In fact, a 1% annual chance of flooding is actually a 26% chance after 30 years and a 39% chance after 50 years.
These factors combine to significantly understate the risks we face. “Underestimating the cumulative risks makes it much more difficult to capture the full value of avoided costs or savings from developing resilient projects,” Dickson added.
Indeed, time will tell whether the nation’s property and casualty insurance markets, worth hundreds of billions of dollars annually, can be redirected to supercharge resilience initiatives. “That’s a huge missed opportunity,” said Safehub’s Thompson, who agrees that a transformative shift in underwriting models is required before we’ll see real innovation in the industry. “It’s not going to be Catastrophe Insurance 1.1,” he added. “It’s going to have to be Catastrophe Insurance 2.0.”