Risk financing instruments to minimize impacts of climate extremes

Risk financing instruments to minimize impacts of climate extremes

Different types of financing instruments are required to address the impacts and frequency of climate extremes in vulnerable developing countries, a recent analysis finds.

Original Paper:
Linnerooth-Bayer, J. and S. Hochrainer-Stigler (January 2014). "Financial instruments for disaster risk management and climate change adaptation." Climate Change. Springer Netherlands DOI: http://dx.doi.org/10.1007/s10584-013-1035-6

Recent scientific reports on managing disaster impacts and climate adaptation emphasize reducing risks from extreme climate events. They suggest that risk sharing, or the consequences of risk being distributed among several participants, and risk transfer, shifting insurable risks to other parties, are important mechanisms to minimize risks and address climate impacts. However, despite the role of risk reduction – i.e. the systematic reduction in the level of exposure to a risk and/or the possibility of its occurrence – selecting appropriate financing instruments is critical.

In an analysis of case studies from developing countries, a team of researchers from the International Institute for Applied Systems Analysis (IIASA) has proposed a risk layer framework. This framework provides basis to select appropriatetraditional and/or innovative financial mechanisms according to the frequency and impacts of climate extreme events. It categorizes disaster events in the range of 'high frequency-low impact events" to "low frequency – high impacts event." For instance, catastrophic events are not covered by private sector insurance, and thus one viable option might be insurance supported by public agencies or multi-lateral support.

Diverse financial mechanisms for risk mitigation should be selected based on the frequency and impact of disasters, they write. Mechanisms for finance recovery — such as government and humanitarian aid, savings and credit, or informal risk sharing — are among the portfolio options of risk financing approaches. The options differ primarily in that they target high, medium, and low risks to varying degrees. For instance, insurance and pre-disaster risk financing instruments are not appropriate for slow-onset climate impacts, such as desertification or sea level rise.

Traditional risk financing mechanisms are solidarity, savings and credit, and informal risk sharing. Traditional mechanisms can be applied based on the range from low-risk to high-risk disaster events in terms of impacts and frequency. The institutions involved in their implementation are government, bi-lateral and multi-lateral agencies, emergency liquidity funds and re-insurance. For example, solidarity includes victims in vulnerable countries depending on their governments and donor assistance for relief. Savings and credit, on the other, includes pre-disaster savings and post-disaster credit, which can take the form of stockpiles of food, grains, seeds and fungible assets.

Innovative risk financing mechanisms such as index-based micro-insurance, catastrophe bonds and contingent credit are considered to address the issues of high risk and high consequence disaster events. Index-based micro-insurance programs avoid the high costs of traditional insurance in servicing low-income markets by offering limited cover and greatly reducing transaction costs. If governments lack input of capital to rebuild critical infrastructure after disasters, public sector risk transfer can be used to restore homes and provide humanitarian assistance.

Moreover, catastrophe bonds are instruments whereby international insurers do not absorb risks directly. Instead, financial markets via investors receive returns from interest rates calculated on the basis of the estimated risk. Under contingent credit, governments can pay a fee for the option of a guaranteed loan at a pre-determined rate dependent on the disaster.

Another important issue is the estimation of risk, as disaster events are well connected with climate change variability and long-term changes in weather patterns. Many in the insurance industry regard climate change as a serious threat to the sustainability of their business.

Disaster risk reduction and risk financing contribute importantly to climate change adaptation by lessening exposure and vulnerability, and enhancing resilience to adverse impacts of climate extremes.

The selection of risk financing options based on the frequency and occurrence of disaster, as proposed by IIASA, can be helpful to policy makers and practitioners in striking the right balance between numerous investments. Balancing investments appropriately will help reduce risk, transfer risk, and effectively manage disaster impacts. Similarly, for negotiators, understanding investment balance will help them appreciate the link between risk financing, risk reduction and climate change adaptation.

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