As the COVID-19 pandemic spread from region to region, it has drawn attention to a hitherto unnoticed protection gap in insured and noninsured property/casualty (P/C) risks. The problem is global, and even affected mature economies, where insurance penetration (insurance premium as a percentage of GDP) is typically high. In June 2020, the International Monetary Fund indicated global economic losses from COVID-19 of about $12 trillion over 2020-2021 while Munich Re estimates insured property/casualty losses at $30 billion-$107 billion for 2020. Moreover, S&P Global Ratings expects global GDP to fall by more than 2.5% in 2020.

Although the pandemic's protection gap had not previously been recognized, other protection gaps have been raising concerns for some time. As the growing wealth of the rising middle class has outpaced insurance penetration, it has created protection gaps in life, health, cyber, and natural catastrophe insurance.

The most studied protection gaps are those associated with natural catastrophe risks. As temperatures rise with climate change, we expect the number of extreme weather events to increase in some areas of the globe. Our research shows that each of the top 20 most vulnerable nations are in emerging markets, and average insurance penetration in these countries is less than half of the global average.

Warming Temperatures Amplify Vulnerability To Extreme Weather Events

Today, much of the world faces increasingly frequent and long periods of meteorological drought. Previously, economic consequences from drought mainly affected African countries; this is changing. Chile, India, Australia, the U.S., France, and even Russia have suffered badly in recent years. Indeed, many natural disasters, such as drought and forest fires, have started to affect regions that historically had been relatively untouched, adding to more-frequent natural weather events, such as flood or tropical and winter storms.

By 2030, we expect 80% of the poorest people to be concentrated in the most fragile countries, according to a report from the Organisation for Economic Co-operation and Development. These countries have characteristics that substantially impair their economic and social performance, such as weak governance, limited administrative capacity, chronic humanitarian crises, and persistent social tensions. With their economic performance already impaired, it can be hard to deliver basic social services and make best use of donor assistance.

Few governments in developing countries have implemented initiatives to secure the financing that would aid recovery and reconstruction after a natural catastrophe, in advance of a crisis. Instead, they tend to react after the event, selling assets, reallocating budget items, or seeking international aid and loans.

A reactive approach has several disadvantages. In many cases, the amount raised proves insufficient to meet relief requirements. The process is also conducted at a time of stress, and often without a cohesive plan and vision. Several studies have shown that the result of such a lack of preparedness against shocks is felt at both an individual and a national level. For individuals, it worsens their living standards; for countries, their long-term economic prospects.

The insurance sector, and more particularly reinsurers, could help countries to proactively build their resilience to the financial shocks associated with natural catastrophes (and pandemics). Such a partnership is likely to benefit both parties by boosting national recovery capabilities after catastrophe events while increasing revenue in its insurance sector. For reinsurers, it would increase geographic diversification, which would be positive for ratings in the sector.

Natural catastrophe events, which include extreme weather events, have been occurring more frequently around the world (see chart 1). Given that the 20 nations we consider most vulnerable are all in emerging markets where insurance penetration is less than half of the global average, we expect the insurance sector to contribute comparatively little to recovery and reconstruction after a catastrophic event.

Chart 1

We believe these underpenetrated markets contain pools of risk for the insurance industry that, if accessed, could provide diversification of risk and new client bases that could affect competitive positions.

Preserving financial stability in the face of natural catastrophe depends not only on the sovereign's financial strength, but also on the level of insurance penetration (see table 1). Economies rely on insurance to support a quick recovery after a catastrophe event. Typically, the two go hand in hand; the wealthier the country, the higher the insurance penetration. That said, Japan's commercial insurance penetration is relatively low because companies typically invest in risk mitigation, such as increasing the resilience of buildings. In our view, risk awareness and mitigation partly explain why mature markets are attractive to investors.

Table 1

Quantifying Risks In Advance Is Key

Efficient disaster management depends on the nation being aware of its most prevalent natural catastrophes, and prepared for them. Governments can mitigate the consequences of these events by using tools such as land planning, infrastructure development, early warning systems, and improving the adaptive capacity of resident populations (for example, through raising awareness of adaptation measures taken during flood events). For example, Bangladesh uses an early warning system for flash floods and thunderstorms.

Financial planning is also vital because it ensures that sufficient funds to rebuild the economy will be available when needed. Some countries self-source these funds by accumulating wealth before the event; others transfer the risk to insurance or capital markets. Many countries have to make a choice; invest in risk reduction financial instruments or implement adaptation programs to reduce the impact of climate change on their economies (see "Sink Or Swim: The Importance Of Adaptation Projects Rises With Climate Risks," published on Dec. 3, 2019).

Insurance Can Play A Valuable Role

In our view, the insurance industry has the data and expertise to assess evolving risks to help price climate risk, thus allowing governments, companies, and individuals to make better decisions. Government-backed insurance solutions, supported by the global reinsurance industry, could provide some protection and stability to government budgets, mitigating the potential for instability and limiting the impact of natural catastrophes on economic growth (see "The Heat Is On: How Climate Change Can Impact Sovereign Ratings," published on Nov. 25, 2015).

Reinsurers can offer expertise in modeling and assessing catastrophe risk exposure, educating stakeholders on the level of their exposures, creating tailormade solutions that provide proper protection, and acting as an intermediary with the capital markets to pair buyers and sellers of protection.

Many insurance-based solutions already protect developing economies around the world. Governments have made use of pooling arrangements, structured reinsurance solutions, and bespoke insurance policies. Countries such as Turkey and Mexico have set up effective solutions, after learning the hard way following large losses. Some vulnerable nations are taking note of these solutions and looking for inspiration to reduce their own exposure before they suffer extreme weather events.

But Not All Countries Recognize The Value

In many developing economies, insurance is viewed as a tax, rather than a valuable protection, particularly if no major loss events have recently occurred in the region. When much of the population has irregular income, earned on a day-to-day basis, they do not tend to view a potential catastrophic event as an immediate concern. As a result, authorities are likely to underestimate or play down their catastrophe exposure. Even if they recognize the scale of their exposure to catastrophe risk, elected politicians must consider how the public assesses the value of any insurance-backed transaction.

Reinsurers will have to invest time and effort to change how politicians and the electorate consider the value of insurance. History shows that politicians are generally rewarded for acting after a major event, but not for thinking ahead and investing in risk management. Reacting well to an extreme event gives a politician a boost in the polls. Limiting the consequences of an event well after your term, through sound planning and foresight, does not.

In particular, if insurance only provides protection against an infrequent, severe event, the short-term benefit is likely to be perceived as significantly less than the premium paid. Indeed, if insurers are to make any money in these transactions, it is likely that, as with most insurance contracts, over the long term, the premium paid would likely exceed the value of the indemnification received. Any premium paid has to include the reinsurers' profit and cost-of-capital margins.

Authorities that take a longer-term view may be tempted to choose to self-insure, rather than purchase explicit, insurance-based protection. However, this choice would deprive them of the benefit of protection against very extreme events. A better option may be to choose a product that pays out after more-frequent events. If the protection kicks in for smaller catastrophes, the country will receive benefits more regularly. This can make it easier for voters and governments to recognize the value of the protection they are paying for.

Options For Addressing The Protection Gap

Developed countries have taken different paths in addressing the protection gap for natural catastrophes. Some countries have relied on the insurance market to determine coverage costs; others have combined state guarantees and the insurance market to foster risk mutualization across the country. Examples include:

• Flood Re: This is a joint initiative between the U.K. government and insurers that aims to make the flood cover part of household insurance policies more affordable.
• Consorcio de Compensación de Seguros (CCS): This is a private-public partnership that indemnifies Spanish insurance companies against claims arising from unpredictable events, including natural disasters. It provides nationwide, state-guaranteed cover for extraordinary risks.
• Caisse Cenrale de Réassurance (CCR): This benefits from its role as the only provider of unlimited coverage against drought, flood, earthquake, and terrorism risks in France, and is supported by a state guarantee. CCR differs from other private reinsurers because its business model relies on a government-determined program to formalize policy terms. CCR accepts catastrophe business in France on the basis of a national, law-driven natural catastrophe scheme that includes mutualized, uniformly set rates.

Making The Economics Work

As commercial enterprises, the economics of these deals must make sense for reinsurers as well. Once a government has shown interest, the firm it works with will have to develop a product that takes that country's regulatory framework and decision-making process into account. This is likely to increase the time and cost required to develop and execute the protection plan. These costs may reduce the value of the structures for both reinsurers and states.

Although some aspects of these structures could keep the arranging costs high for reinsurers, we expect these limitations to ease over time. One of the main goal of the Insurance Development Forum (IDF), a World Bank and insurance industry-backed partnership, is to build greater resilience and protection for people, communities, businesses, and public institutions that are vulnerable to disasters and their associated economic shocks, through insurance. IDF will raise awareness on climate risks across the globe. We anticipate that it could help insurers find a way to pool resources, which will reduce costs.

Get The Basis Risk Right, Or Pay A Reputational Penalty

Reinsurers may face reputational damage if a major event occurs and the authorities and the public do not believe that the insurance performed as promised. For example, it is common to use simple, easy-to-measure parameters, such as wind speed or earthquake magnitude, as a basis for claims. Parametric triggers are important structural features that enable reinsurers to pay claims quickly.

However, if an event occurs that does not meet these parameters, the protection won't be triggered. This is known as basis risk and it means that payouts will be less than actual losses. Material differences may undermine the transaction's value and damage a reinsurer's reputation. Voters may consider that the reinsurer is avoiding paying the true cost.

For example, in 2019, during an outbreak of Ebola in the Democratic Republic of Congo, criticism was leveled at a parametric pandemic bond issued by the World Bank in 2018 as part of its Pandemic Emergency Financing Facility (PEFF). Despite the parametric triggers not being breached, market observers criticized the bonds for not paying out to aid with what Medicins Sans Frontiers defined as the second-largest outbreak of Ebola on record. The bonds faced further criticism in March and April this year for being too slow to respond to the COVID-19 pandemic. They were eventually triggered and paid $196 million to 64 of the world's poorest countries to help them manage the pandemic. The critique of the bond's structure and triggering mechanisms forced the World Bank to reconsider renewing the bonds after they matured in July.

Data Gaps Increase Protection Gaps

The cost of insuring bad risks could also explain the current size of the protection gap. Modeling for the key industry perils, such as U.S. hurricane or Japanese earthquake, is well developed, and helps reinsurers to build a robust risk view. Reinsurers may struggle where modeling is not as advanced. For some of the perils in developing markets, reinsurers have insufficient data on loss history or exposures to create effective models. This makes it harder to accurately price risk in these new regions and perils.

In our view, it will be important for reinsurers to demonstrate to buyers and investors that the models they use are sufficiently robust. The models are likely to be reinsurers' main tool for demonstrating the benefits of their insurance structures to their clients. Modeling uncertainty presents reinsurers with a difficult choice: build margins into their pricing to reflect the modeling uncertainty and reduce the value for their customers; or risk accepting underpriced risks.

Building Disaster Resilience Could Help Open Markets To Reinsurers

Insurers and reinsurers are increasingly looking for ways to expand their presence in emerging markets, which offer high growth potential because of their low insurance penetration. In our view, government-backed risk protection solutions can be a diversifying offering for reinsurers, can help to develop new markets, and could be key to entrenching the relevance of insurance in high-growth markets. Protecting a country's wealth and the stability of its economic growth will expand the pool of insurable assets, which will benefit the industry.

Various market trends--regulatory changes, insurance growth in emerging markets, and insurance-linked securitization--could also help to increase the profile of insurance-backed solutions. In many emerging markets, attitudes toward insurance and risk awareness are changing. Regulators are increasing capital requirements and mandating the purchase of insurance in some lines of business. As capital market capacity expands, demand to diversify risks by region and peril also intensifies. This could also make it easier to find capital to back solutions, based on partnerships between re/insurers and governments.

We consider that the reinsurance industry has a long-term and important role to play in developing awareness and acceptance of insurance-backed solutions for states' catastrophe exposure. In our view, reinsurers that take on this role and are able to demonstrate diversification of risk exposure and the ability to gain access to new markets and risk pools could experience competitive advantages and reinforce their relevance to clients. This is also an opportunity for investors--as the insurance industry takes on new risks, it is likely to increase its capital needs. The development of critical infrastructure will also require private investment.