Infrastructure, assets, and property created by us generally faces risk of various natural, and manmade hazards, and are often devaluated, damaged, and destructed by these. Compensation of these losses would make post-disaster recovery easy, smooth, and hassle free. Risk transfer is a tool for making all this possible in an organised manner.
Risk transfer is understood as a process of formally or informally shifting the financial consequences of identified risks from one party to another whereby a household, community, enterprise or state authority is assured of resource availability from the other party after a disaster incidence, in exchange for ongoing or compensatory social or financial benefits provided to that other party.
Risk transfer is a common risk management technique where the burden of potential loss from an adverse outcome faced by an individual or entity is shifted to another party, in exchange of periodic payments by the individual or entity as a cost of bearing the risk.
There are two common methods of transferring risk.
Purchasing insurance is a common method of transferring risk. When an individual or entity purchases insurance, it shifts the financial risks to the insurance company. Insurance companies typically charge a fee – an insurance premium – for accepting such risks.
Legally insurance is a contract between two parties wherein one party, the insurer, undertakes to pay the other party, the insured, fixed amount of money on the happening of a certain event in exchange of a consideration or fixed premium.
When an individual purchases insurance, she is insuring against financial risks. For example, by purchasing car insurance she is acquiring financial protection against physical damage or bodily harm to her car from traffic incidents or other causes. As such, she has shifted the risk of having to incur significant financial losses from traffic incidents to an insurance company. In exchange for bearing such risk, the insurance company would typically require periodic payments from her.
Indemnification clause in contracts
Contracts can also be used to help an individual or entity to transfer risk. Contracts can include an indemnification clause – a clause that ensures potential losses to be compensated by the opposing party. In simplest terms, an indemnification clause is a clause in which the parties involved in the contract commit to compensating each other for any harm, liability, or loss arising out of the contract.
For example, consider a client that signs a contract with an indemnification clause. The indemnification clause states that the contract writer will indemnify the client against copyright claims. As such, if the client receives a copyright claim, the contract writer would be (i) obliged to cover the costs related to defending against the copyright claim, and (ii) responsible for copyright claim damages if the client is found liable for copyright infringement.
It is important to note that the financial viability of an insurance company is based on insuring large number of spatially dispersed low probability risks. A major disaster, mishap or accident can however inflict damage to large number of insured assets making the insurance company liable to pay huge insured amount. Such a situation is possible on the occurrence of low frequency – high intensity hazard such as earthquake, and could result in the company going bankrupt.
To cover the risk of such incidences the insurance companies also resort to risk transfer or insurance. Insurance cover by insurance companies is generally referred to as reinsurance, and there are a number of companies that offer insurance cover to the insurance companies. These are referred to as reinsurance companies.
Similar to how individuals or entities purchase insurance from insurance companies, insurance companies shift risk by purchasing insurance from reinsurance companies. In exchange for taking on this risk, reinsurance companies charge the insurance companies an insurance premium.
Swiss Re Ltd., Munich Reinsurance Company, and Hannover Re are global leaders in the field of reinsurance. It is important to note out here that precise, and fine tuned risk assessment is the key to the viability of the reinsurance companies, and therefore it is no surprise that these companies have major stakes in most global risk models, and almost all the disaster-induced financial loss data available globally is provided by these companies. The accuracy of this data is naturally a function of insurance penetration in the concerned society.
Risk transfer is often confused with risk shifting. To reiterate, risk transfer is passing on (transferring) risk to a third party. On the other hand, risk shifting involves changing (shifting) the distribution of risky outcomes rather than passing on the risk to a third party. For example, an insurance policy is a method of risk transfer. Purchasing derivative contracts is a method of risk shifting.
Risk transfer scenario in India
Even though life, and health insurance are slowly gaining social acceptance in the country as a means of social security. The coverage in however abysmally low, and generally restricted to urban areas, and amongst people with assured regular source of income. Only 28.3 and 36.2% of India’s population is covered by life, and health insurance respectively. Overwhelmingly large proportion of this coverage is however through various welfare schemes of the government wherein payoffs are often insignificant.
Insurance of vehicles is however commonplace, largely due to regulatory compulsions. Lately people, particularly in urban areas have also started to insure their houses, and other assets. These insurance covers are however mostly against fire and theft, and often do not cover natural disasters, or other perils.
Developed nations however have high insurance penetration, and most disaster-induced losses in these countries are generally compensated by insurance companies due to which public exchequer is often not overburdened. This ensures that the developmental initiatives are not hampered by paucity of funds, and facilitates smooth post-disaster recovery.
On the face of continuously rising state expenditure on post-disaster relief and reconstruction, taking lead from the developed nations the options of replacing state sponsored post-disaster relief, and reconstruction regime by risk transfer is often debated in different forums. Despite Ministry of Home Affairs (MHA), and National Disaster Management Authority (NDMA) championing the cause of risk transfer various Finance Commissions have not formally accepted it as a viable option for the country.
The IX Finance Commission (FC) was formally entrusted the responsibility of exploring the feasibility of establishing a national insurance fund to which the state governments could contribute a percentage of their revenue receipts. After examining various possibilities the IX FC concluded that the concept of an insurance fund for disaster relief was neither viable nor practicable as the process of loss assessment by an external agency was considered to be complicated and time consuming, which would defeat the very purpose of relief, that is providing timely succour to the affected people. It was added that the source of calamity, by its nature and magnitude, would pose problems which no agency, outside the government, could tackle exclusively and in full measure.
This conclusion was based in the fact that it is generally economical to pool risks arising out of low frequency-high intensity disasters, but it is not economical to pool risks arising out of high frequency-low intensity disasters. The IX FC therefore did not find merit in setting up a comprehensive risk pooling mechanism for financing disaster relief in India.
In this perspective the XI FC added that any insurance cover in which the premium is to be paid fully by the government would not reduce the financial burden of the government in dealing with natural calamities. The Commission, however, felt that the crop insurance scheme would help individual farmers, especially at the time of natural calamities, and therefore, suggested strengthening of these scheme.
The XII FC endorsed the views of the IX and XI FC on this issue, and commented that any insurance scheme, the premium for which is to be paid by the government alone would put a very heavy burden on public exchequer without providing any substantial benefit to the affected population. The XII FC however recommended that the government should encourage insurance of private assets by individuals in vulnerable zones. Strengthening of the crop insurance scheme, and loan-linked insurance schemes in rural areas were cited as examples of such measures.
The XII FC at the same time identified micro-insurance to be the need of the hour. Micro-insurance refers to protection of assets, and lives against insurable risks of the target populations, such as micro-entrepreneurs, small farmers and the landless, women and low-income people through formal institutions i.e. insurers and semiformal or informal institutions, such as NGOs, self- help groups and others.
The XIII FC noted risk transfer concept to be at a nascent stage in the country as the Insurance Regulatory and Development Authority (IRDA) was still in the process of finalising, and notifying the micro-insurance regulations. The XIII FC opined that the formal institutions serve only a fraction of the population, which typically lies within the upper quartile of the social hierarchy, and therefore initiatives with the involvement of NGOs, and self-help groups, which are directly accessible to all segments of the population, could be planned, and implemented at the behest of the state governments.
The XIII FC at the same time took cognizance of the “earthquake pool” being created by General Insurance Corporation of India, which would enable all the insurance companies to share the burden of risk in case of huge losses arising out of earthquakes. Under this the insurers would divert the earthquake premia to the “pool” and therefore it could prove useful in providing social security to the public in the unfortunate event of a catastrophe. The XIII FC hoped that an insurance solution like this would result in orderly distribution of disaster relief to the affected population.
The XIII FC also noted that the Insurance Regulatory and Development Authority (IRDA) has framed micro insurance regulations that allow distribution of micro insurance products by micro insurance agents like non-government organisations (NGOs), self-help groups (SHGs), micro-finance institutions (MFIs), and others. These regulations cover insurance for personal accident, health care for individual and family, and assets like dwelling unit, livestock, tools, and other named assets. The XIII FC also took cognizance of the national health insurance scheme, Rashtriya Swasthya Beema Yojana, launched by the Union government that intends to cover families below the poverty line for proper health care. In addition, similar schemes operational in various states were also taken note of.
As disaster relief is considered a welfare activity that the state is obliged to undertake, the XIII FC was apprehensive of mass resistance to insurance premiums and also pointed out challenges in collecting premium from large number of persons dispersed throughout the country.
The XIII FC considered the existing system of providing relief financially viable for high frequency-low intensity hazards. Though accepting risk transfer a viable option for low frequency – high intensity hazards the FC suggested that this option be considered in future as not many options were available in the market at that time.
Despite hoping increased insurance penetration in the country with passage of time, the XIII FC concluded that the insurance schemes do not provide an adequate alternative to government funding for disaster relief.
It is important to note out here that the state is already spending huge amount of money on various pre- and post-disaster activities, and risk transfer should not further increase the burden of public exchequer. It needs to be understood that to be economically viable insured risk should be distributed over large geographical area, and have low probability of occurrence.
The state has no incentive in opting for risk transfer unless it reduces the burden of public exchequer. In case all the premiums have to be perpetually paid solely by the state, risk transfer is never going to be financially viable option for the state.
It is therefore a must that innovative ways and means of incentivising masses to bear a portion of the cost of risk transfer be devised and boldly implemented.