Technical Note 4 A Comparison of Indemnity and Index Insurances. Insurance for Climate Change Adaptation Project

Transcription

1 4 Technical Note 4 A Comparison of Indemnity and Index Insurances Insurance for Climate Change Adaptation Project

2 Technical Note 4 A Comparison of Indemnity and Index Insurances Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ) GmbH -german cooperation- Insurance for Climate Change Adaptation Project Main Advisor Alberto Aquino alberto.aquino@giz.de Jr. Los Manzanos 119, San Isidro Author GlobalAgRisk Design and Layout Renzo Rabanal Photographs GIZ files, Diario El Tiempo, Piura Printing GALESE S.A.C. Av. Cayetano Heredia 839 Jesus Maria First edition, Lima (Peru), August 2012 Made the legal deposit in the Biblioteca Nacional del Perú (National Library of Peru) N.º Cooperación Alemana al Desarrollo Agencia de la GIZ en el Perú Av. Prolongación Arenales 801, Miraflores Total or partial reproduction of this work is allowed, provided the source is cited. 2

3 A Comparison of Indemnity and Index Insurances Index insurance represents a special class of insurance that differs significantly from traditional indemnity-based insurance. While there are many types of indemnity insurance, perhaps the most common type of insurance is protection against loss of a specific asset. This note is intended to describe some of the important differences between index insurance and indemnity insurance and identify the value of index insurance in managing natural catastrophic risks. Index insurance against a disaster provides financial risk coverage against an insured event on the basis of a parametric measurement of the disaster (e.g., estimates of rainfall using advance modeling and a variety of data systems). The policyholder picks the level of payment, called the coverage limit, that it would like to receive in the event of the covered natural disaster. For this benefit, the policyholder makes a premium payment. The cash flow of index insurance contracts can be replicated through a series of put or call options, depending on the risk. For example, the El Niño insurance contract bases payouts on the Pacific SST off the coast of Peru, a strong predictor of flooding in northern Peru. The payout rate of the El Niño insurance contract in Peru is Graphic 1 depicts this payout structure as a percent of the coverage limit (i.e., the maximum insured amount). By way of illustration, suppose a firm held an index insurance contract with a limit of $100 million leading into the severe El Niño. Temperatures during the coverage period reached degrees and so would have led to a payout of 76% of the limit, or $76 million. 3

4 GRAPHIC 1. Payout Structure for El Niño Insurance, an index insurance Product 100% 80% Payout Rate 60% 40% 20% Sea Surface Temperature (ºC) Source: Own elaboration Index insurance and natural disasters Previous to index insurance, disaster risks were almost exclusively managed using indemnity insurance including property, business interruption, and agricultural insurances. Indemnity insurance products base payments on the estimated losses of those insured. It is suggested that index insurance products better fit in the context of contingent insurance. While indemnity insurances pay based on the level of losses of the policyholder, contingent insurances such as life insurance base payments on the occurrence of an adverse event. For our context, this adverse event is a natural disaster. Compared to indemnity insurance, the benefits of index insurance against natural disasters are many: Broader Scope. Many entities are affected by the same event and there is potential for any vulnerable party to use index insurance. Indemnity insurance such as agricultural insurance only serves a specific set of those who are vulnerable. For example, agricultural insurance markets protect producers from yield losses but do not tend to be available for agricultural processors or wholesalers whose revenues are also adversely affected by low yields. Greater Flexibility. Disasters create a variety of adverse consequences for those affected such as revenue losses, increased expenses, and asset losses. For index insurance, the level of coverage is chosen by the policyholder, and an index insurance payout can be used for any purpose the policyholder chooses. Indemnity insurance such as property insurance only protects against asset losses. Lower Transaction Costs. Index insurance is much less prone to problems of asymmetric information that can dramatically increase the cost of indemnity insurance 4

5 for agriculture or business interruption. Two sources of asymmetric information are moral hazard, the tendency of insureds to engage in behaviors that increase the probability of a loss, and adverse selection, the tendency for only the most at-risk potential customers to buy the insurance, resulting in more losses than the insurer s initial analyses would suggest. Multiple-peril crop insurance is one example where asymmetric information gives farmers many advantages over the insurer. Moral hazard creates problems in identifying what losses are due to an insured event and what losses are due to negligence on the part of the insured. For some types of losses, the challenge of these information and incentive problems are so great that insurers choose not to insure those risks. Quicker Payments. Index insurance provides payment based on a predetermined measure of the disaster event and so can be paid more quickly than indemnity insurance, which requires a loss assessment. More timely payments have the potential to add significant value to policyholders who are provided with those funds during difficult conditions. Index insurance products using forecasts have the potential to pay even before an event, giving policyholders the opportunity to prepare for an event and reduce losses, as does the aforementioned El Niño insurance. The primary limitation of index insurance is basis risk, which in this context describes a mismatch between the severity of the event as experienced by the policyholder and measured by the disaster index used for payments. Indemnity insurance products are also exposed to basis risk. For example, settlements under business interruption insurance require claims adjusters to disaggregate disruptions caused by an insured event from typical, uninsured business fluctuations. 5

6 Index insurance is often best used as one component of a more comprehensive risk management strategy. Such a strategy often includes investments in risk mitigation and diversification as well as a blend of financial mechanisms reserves, credit, and insurance. In many cases, index insurance is a more effective mechanism for managing natural disaster risks than indemnity insurance; however, indemnity insurance may be preferred in some contexts such as protecting assets that are highly valuable to the policyholder through property insurance. In some cases, a blend of indemnity insurance and index insurance is advisable. Developed country markets for index insurance Developed country entities are increasingly using index-based risk transfer. Index insurance is a specific form of index-based risk transfer; other forms include derivatives, contingent credit, or catastrophe (CAT) bonds. The Weather Risk Management Association estimates that the value of weather derivatives, a specific type of index-based risk transfer, reached $11.8 billion in 2011, growing almost 20% from the previous year. At its height before the financial crisis, this market reached $45 billion in Common uses for index-based risk transfer in developed countries include: Agribusinesses in the U.S. using index insurance products to manage yield risks; The initial index insurance product developed for U.S. agriculture. Energy companies using weather derivatives to manage revenue risks associated with warm winters and cool summers; 6

7 Government agencies protecting against earthquakes and hurricanes using CAT bonds; Hydroelectric managers such as the Sacramento Municipality Utility District using weather derivatives to manage drought risk; and Firms in the tourism industry using weather derivatives to protect against adverse temperature, rain, and snowfall conditions. These developments have occurred since the 1990s and the industry still is in a development phase. An example contrasting the benefits of indemnity and index insurances To illustrate these differences, this section compares the benefits of index-based El Niño insurance and an indemnity insurance policy that protects an asset (e.g., a home or building) to collateralize a bank loan, which is called collateral insurance. This collateral insurance can play an important role as it strengthens borrower collateral and so likely increases access to credit; however, the collateral insurance serves a distinctly different purpose than El Niño insurance. When El Niño comes, it destroys roads, bridges, crops, and land. It disrupts access to electricity and clean water. El Niño will severely damage and destroy some homes and buildings, too, and the collateral insurance will provide some relief to those affected. Even if a borrower s home, which is used for collateral, is unhurt by El Niño its repayment capacity can be severely compromised by the event, for example, through the destruction of important productive assets. El Niño disrupts whole economies and experience shows that many borrowers have trouble repaying loans after an extreme event. For many borrowers, some partial damage to their home or business building may be the most likely outcome so that part, but not all, of the loan is paid by the collateral insurance. Borrowers whose repayment capacity is severely compromised may be unable to repay their loans. Microfinance institutions (MFIs) go through a long process to address problem loans. First, they offer a grace period of up to 90 days. Next, if borrowers are still struggling, they reprogram the loan, which means they change the loan maturity so that monthly payments are reduced. Loans can be reprogrammed up to three times according to one consulted MFI. Finally, if borrowers are still unable to repay, the MFI takes the borrower to judicial settlement. 7

8 The index-based El Niño insurance can add value for borrowers and the MFI in this context. For borrowers, the insurance can provide a quick payout that will help them manage the productivity losses and increased costs they incur beyond the value of their homes and buildings. For the MFI, the insurance payout is capital that can allow it to begin lending more quickly after the disaster despite having many poorly performing loans that it must manage. Thus, for both MFIs and their borrowers, the index insurance adds substantial value as losses extend far beyond homes and buildings. Differences in premium rating for indemnity and index insurances The premium rate for index insurance is not directly comparable to the premium rate for indemnity insurance. These differences stem from fundamental differences between indemnity insurance and index insurance namely, that indemnity insurance is designed to protect against a specific loss and index insurance is designed to protect against a specific event. These differences motivate preparing potential buyers of index insurance that premium rates are not directly comparable and educating buyers if they make inconsistent comparisons. Please note that this example is a simplification intended to illustrate these differences. Consider an asset exposed to a risk, for example a specific crop in production that is exposed to drought. Suppose an agribusiness owns this crop and the value of the crop is $1 million. Drought occurs with a one in ten probability and, when it occurs, it destroys 50% of the crop. Table 1 summarizes the results for this example. Table 1. Comparison of Premium Rates for Index Insurance and Indemnity Insurance Index Insurance Indemnity Insurance Asset value (Crop) 1 million 1 million Expected loss 500, ,000 Probability of drought 10% 10% Premium 50,000 50,000 Expected payout if drought occurs 500, ,000 Calculation of premium rate Premium rate/expected loss Premium rate/value of asset Premium rate quoted 10% 5% Source: Own elaboration Index insurance. This risk could be managed using index insurance or indemnity insurance. Suppose the agribusiness buys index insurance. The transaction requires the following process: 8

9 1. The buyer (the agribusiness) estimates the value of its crop ($1 million). 2. The buyer estimates the loss it expects to occur if there is a drought the expected loss ($500,000). 3. The buyer agrees to buy a sum insured equal to the expected loss. 4. The insurer bases its rate for this sum insured on the probability of the event (10%). The premium is $50, In the case of a drought, the expected payout is $500,000. Indemnity insurance. Alternatively, the owner buys an indemnity insurance. The transaction requires the following process: 1. The insurer estimates the value of the crop ($1 million). 2. The insurer estimates the loss if there is a drought the expected loss ($500,000). 3. The insurer agrees to insure the crop. 4. The insurer bases its rate on the probability of the event (10%) and the expected loss ($500,000). The premium is $50, In the case of a drought, the expected payout is $500,000. Comparison of the premium rates for indemnity and index insurances Index insurance is formulated as a type of contingent insurance that is, the insured must determine the value needed if the risk occurs. In contrast, traditional indemnity-based insurance requires the insurer to assess the expected losses of the insured. With index insurance, the premium rate is calculated using the amount the insured desires when the drought occurs; with indemnity insurance, the premium rate is calculated using the amount the asset is worth. Thus, following the example, it could happen that, comparing index insurance and indemnity insurance, the premium is the same ($50,000) and the expected payout if the event occurs is the same ($500,000), but the premium rate is very different: Premium Rate premium index insurances = = = 10% expected loss Premium Rate premium indemnity insurances = = = 5% value of asset 1 millón 9

10 Thus, a potential buyer of the insurance could easily misinterpret the premium rates to conclude that the index insurance is twice as expensive as the indemnity insurance. In this example, they are actually the same cost and provide the same return. Concluding remarks Consistent with the description of indemnity insurance, the challenges of moral hazard, adverse selection, and assessing losses would, in reality, need to be included in the cost of the indemnity insurance so that its premium would be substantially higher. Also consistent with the first section, the index insurance might be formulated more broadly than crop losses as the drought in the example may also affect the agribusiness in other ways such as damaging its other crops concurrently and increasing its costs of irrigation water. 10

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12 Risk is out there, get insured. The Insurance for Climate Change Adaptation Project is part of the International Climate Initiative (ICI) of the German Federal Ministry for the Environment, Nature Conservation and Nuclear Safety (BMU).