This chapter provides an overview of the main issues, policy options and recommendations presented in the report.
Financial Protection Against Catastrophic Risks
Floods, Fires and Other Major Risks
Abstract
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Individuals, households and businesses are exposed to a broad range of social, economic, technological and environmental risks throughout their lifetimes. The materialisation of these risks can have financial implications for those impacted, such as costs to rebuild damaged property, replace damaged equipment or household contents, fund health care needs or recover lost income or revenue. Should damage or disruption be significant, many individuals, households or businesses would struggle to absorb the resulting financial costs, leading to financial vulnerabilities.
Access to insurance can play a critical role in protecting individuals, households and businesses from potentially devastating financial losses, providing a secure source of funding to support recovery and facilitating their participation in economic activities, including through access to credit. Insurance can also contribute to mitigating the economic, social and financial consequences of large-scale events. Studies on insurance for natural hazard risks have demonstrated the benefits of this form of financial protection in reducing contractions in economic activity and accelerating recovery. Higher insurance penetration has also been found to reduce the disaster recovery burden on taxpayers and the downward pressure on sovereign credit ratings.
However, for many types of risks, the availability of private insurance is limited. For risks that occur infrequently but result in widespread and severe impacts, such as natural hazards, cyber catastrophes, or pandemics, private insurance and reinsurance markets may be unable to provide significant financial protection due to their inability to absorb large, simultaneous losses. In the context of evolving weather and environmental risks, fast-moving technological changes, and increasing geopolitical tensions and social unrest, the ability of private insurance markets to achieve broad financial protection is increasingly being tested, particularly where efforts to reduce risk have been insufficient to reduce ultimate losses. Inadequate private insurance coverage for these risks can leave individuals, households and businesses with unprotected financial exposures that could lead to financial stress and have broader social, economic and financial consequences.
This report aims to support government efforts to build financial resilience against catastrophic risks and mitigate the social, economic and financial consequences of unprotected financial exposures. It provides a framework to help governments assess the need for government-supported financial protection and an application of this framework to natural hazard, cyber and infectious disease outbreak risks. It then examines approaches to supporting insurance coverage for two increasingly critical natural hazard risks – wildfires and floods – highlighting how differences in insurance market dynamics can impact the choice of approach to broadening the availability of coverage.
Governments play an important role in ensuring that adequate financial protection is available to respond to catastrophic risks, whether by supporting the availability of insurance coverage or developing public compensation and financial assistance arrangements to address gaps in the availability of financial protection through insurance markets. A framework to assess the need for government-supported financial protection as well as the advantages and disadvantages of the main approaches to offering government-supported financial protection would help policymakers in undertaking such an evaluation (Chapter 2).
There are three main components to evaluating the need for government-supported financial protection (Figure 1.1)
Governments should identify risks of potential concern, focusing on identifying risks that have a non-trivial likelihood of occurring and that could have a high impact on a significant share of the population.
Governments should then assess the adequacy of financial protection for the risks identified as risks of potential concern. This assessment should examine the availability, affordability and take-up of insurance coverage for these risks as well as the sufficiency of the coverage available in mitigating the potential financial exposures of households and businesses. The assessment should aim to identify unprotected financial exposures to the risks of potential concern and the main drivers of those unprotected financial exposures, whether a lack of availability, affordability or take-up of financial protection. It should also determine whether the unprotected financial exposures are widespread or limited to a few segments of the population, such as those at high-risk that may have opportunities to access financial protection through increased investment in risk reduction.
Governments should then evaluate the need to offer government-supported financial protection by considering: (i) the likelihood, frequency and severity of the risk; and (ii) the potential implications that unprotected financial exposures could have on economic activities, such as through access to credit, and on the more vulnerable segments of the population who would have a more limited ability to recover without financial protection. A key component of this evaluation should be an examination of the potential for expanding financial protection through private insurance markets and potential impediments to private insurance market involvement in assuming such risks. Ultimately, the rationale for offering financial protection will be most compelling for risks that: (i) occur more frequently and are more severe; (ii) impede economic activity and access to credit; and (iii) are considered uninsurable by private insurance markets due to challenges such as establishing a pool of uncorrelated risks or quantifying potential losses.
Government-supported financial protection, where needed, can be offered through a public-private insurance programme or a public compensation and financial assistance arrangement. The two approaches have different characteristics in terms of funding, the certainty that would be provided for beneficiaries, the amount of discretion for governments in preparing their response, and the participation of private (re)insurance markets (Figure 1.2).
Given these different characteristics, the optimal approach will differ based on the nature and implications of the risk exposure on access to credit and for vulnerable segments of the population, as well as the potential contribution that private insurance markets can make to absorbing losses, providing quick payments and mitigating fraud.
Public-private insurance programmes are likely to be more suited to protecting against risks that occur more frequently and for which certainty in the availability of financial protection is important for mitigating hindrances to economic activity. This approach will be most beneficial when focused on risks for which the private (re)insurance market can make a meaningful contribution to absorbing losses, improving payment speed and accuracy, and incentivising risk management and risk reduction.
Public compensation and financial assistance arrangements are likely to be more appropriate for addressing risks that are expected to materialise very rarely and where flexibility in response could be needed based on higher levels of uncertainty about their impact. Public compensation and financial assistance arrangements could play an important role in addressing unprotected financial exposures to risks for which there is unlikely to be significant insurance market appetite, or where highly exposed households and businesses are likely to face unaffordable premiums.
These considerations should inform decisions on whether, and how, to offer government-supported financial protection. However, governments, and societies more broadly, ultimately have different social and economic characteristics and values which lead to differing perspectives on the appropriate roles of governments and private markets, acceptable levels of risk and financial vulnerability, and thresholds for government intervention.
Natural hazards, infectious disease outbreaks and cyber attacks and incidents have the potential to lead to widespread and severe financial impacts and are relevant for most, if not all, countries. In many countries, private insurance markets have been unable to achieve broad coverage for all potential financial exposures to these risks. Therefore, they are the types of large-scale risks for which an evaluation of the need for and approach to government-supported financial protection is likely to be necessary (Chapter 3).
Natural hazards, cyber attacks and incidents and infectious disease outbreaks all have the potential to result in material impacts for a significant share of the population. Natural hazards can lead to major damage to homes and businesses and can impact a large number of households and businesses simultaneously. Cyber attacks and incidents can lead to relatively large business interruption losses for targeted companies while cyber catastrophes that impact critical service providers can spread losses to a significant number of dependent businesses. Infectious disease outbreaks, while relatively rarer, have the potential to impact entire populations and can have material impacts for individuals and businesses in sectors targeted by restrictions on economic activity.
There are gaps in the adequacy of financial protection for these risks that can lead to unprotected financial exposures. For natural hazard risks, the gaps are driven by challenges related to affordability for some households and businesses and a lack of take-up. For cyber attacks and incidents, the gaps result from inadequate insured limits, low take-up as well as the application of exclusions aimed at protecting insurers from large correlated losses. For infectious disease outbreaks, the availability of coverage for business revenue losses is extremely limited.
The rationale for offering some form of government-supported financial protection is likely to be higher for the natural hazard risks that occur with greater frequency and are more likely to affect access to credit. However, in some cases, unprotected financial exposures are driven almost exclusively by gaps in take-up of available and affordable coverage which may be better addressed through other policy and regulatory interventions, such as investments in risk reduction and efforts to improve risk awareness. There may also be a rationale for offering government-supported financial protection for cyber risks given the increasing impact of unprotected cyber exposures on contractual relationships and the potential that government support could mitigate a substantial impediment to the availability of insurance coverage.
Public-private insurance programmes might be more appropriate for addressing risks that would lead to more frequent funding demands, where certainty of financial protection is necessary for those exposed and where the insurance sector can potentially contribute to assuming losses, making speedy payments, reducing fraud and encouraging risk management and risk reduction. The insurance sector also has greater appetite and capacity to assume natural hazard and cyber risks and there is some evidence that they contribute to risk reduction for both of these risks, although that contribution appears to be more limited for households and smaller businesses. Insurance markets and reinsurance markets have more limited appetite for providing coverage for the revenue losses related to major infectious disease outbreaks, and their ability to incentivise risk reduction is likely to be more limited.
There has been limited government involvement in supporting the availability of insurance for wildfire risk. Insurance in countries with high levels of property insurance take-up has generally absorbed a significant share of past losses. However, increasing wildfire risks, driven by development in the wildland-urban interface and weather conditions more conducive to fire ignition and spread, have led to a dramatic increase in wildfire losses in the last decade.
The increasing losses are impacting the availability of affordable insurance in some wildfire-exposed countries, including Australia, Canada and the United States. As mortgage lenders will often require borrowers to have insurance coverage against fire risk, reduced access to affordable insurance could have implications for housing markets. Chapter 4 examines the implications of the increase in wildfire losses and government approaches to supporting the availability, affordability and take-up of insurance coverage.
Some highly exposed jurisdictions have taken steps to enhance the availability of property insurance coverage. In many wildfire-prone US states, residual insurance arrangements have provided an increasing share of the coverage for high-risk households and businesses, although the coverage provided is usually limited and expensive. Significant demand for coverage, driven by the broad applicability of mortgage-related insurance requirements in some regions, has led to insurance sector innovation in risk assessment and product design that has expanded availability for lower risk policyholders in high-risk regions.
Addressing affordability challenges is usually more difficult. The most sustainable approach to improving long-term affordability is to invest in risk reduction and adaptation. Artificially suppressing premium rates through rate regulation could lead insurers to limit availability of coverage or exit the market. Risk-based premiums can provide incentives for household and business investment in risk reduction although insurers in some countries do not appear to be reflecting different levels of wildfire risk in premium-setting. For risk-based pricing to be an effective incentive for risk reduction, insurers must be willing to provide premium discounts for policyholders that make investments in risk reduction that can demonstrably reduce losses. The insurance sector is applying its risk management and modelling expertise to identifying effective risk reduction measures. In a few US states, insurance regulators are also requiring that insurers provide premium discounts for specific risk reduction measures. Holistic investments that incorporate home hardening, defensible space and community-level mitigation measures appear be the most effective in reducing losses and receive the most significant premium discounts from insurers.
Requirements to purchase insurance against wildfire risk could enhance the take-up of insurance. These requirements would likely have the greatest impact if applied in the rural areas where exposure is high and mortgage-related insurance requirements are not broadly applicable. However, mandatory insurance requirements will only have an impact on reducing wildfire losses if accompanied by measures to encourage or require investments in risk reduction.
Increasing flood hazard in the context of changing precipitation patterns and continued development in areas exposed to flooding has led to an increase in losses from floods. Average annual economic losses from flood events in OECD Members and accession candidate countries were almost 80% higher in the first few years of this decade (2020-2024) relative to the previous five-year period (2015-2019). However, the share of economic losses resulting from floods that is insured is low in many countries. In many countries, governments are supporting financial protection against flood risk. Public-private insurance programmes that provide coverage for flood risk are increasingly being established and have supported the availability, affordability and take-up of flood insurance coverage. These programmes have led to broader coverage of flood losses and contributed to reducing overall public sector exposure to flood risk and supporting risk reduction and adaptation. Chapter 5 examines the design of the flood risk insurance programmes that have been established.
Countries have taken different approaches to the design of flood risk insurance programmes, in terms of covered hazards, eligible insureds, type of compensation or (re)insurance provided, role of the programme in the market, approach to premium pricing and the role of government in providing financial support and oversight. While these different approaches can all be effective in addressing protection gaps in flood insurance, the different approaches to programme design can lead to different outcomes.
Programmes that play a larger and more direct role in assuming flood risk, for example by providing direct insurance for a broad scope of flood hazards and insureds, are generally able to ensure the availability of affordable coverage. However, broad coverage may not be achieved without the implementation of measures to support take-up, such as automatic inclusion of flood coverage or broadly applicable mortgage-related flood insurance requirements. Countries with lower levels of property insurance penetration are also likely to face coverage gaps, even where programmes make affordable flood insurance coverage broadly available. Programmes with a larger role in covering flood risk could, however, miss opportunities to leverage private market expertise and capacity to assume risks. They could also increase fiscal risks if premiums are inadequate, and the government provides a generous backstop for programme losses.
Programmes that are more focused on addressing specific market gaps in coverage are generally better able to leverage private market expertise and risk-bearing capacity. However, the establishment of programmes targeted at markets gaps will likely lead to a risk pool containing more high-risk properties which could lead to greater loss volatility. More narrowly targeted programmes are also likely to face more challenges in achieving broad coverage if the private insurance market is unable or unwilling to provide coverage for hazards or insureds that are not eligible for programme coverage, which could lead to demands for public compensation or financial assistance to respond to uninsured losses.
Requirements for insurers to offer flood coverage or for households or businesses to acquire flood insurance coverage are usually effective in supporting take-up of coverage. However, such requirements could have implications for policyholders if the required coverage is unaffordable or for insurers if they are required to assume risk that they do not have capacity to assume. Ensuring that coverage is affordable for all policyholders required to acquire such coverage will be critical, although this is challenging to achieve without some form of subsidisation for high-risk policyholders, which can have potential implications on fiscal risk and exacerbate moral hazard.
The application of risk-based pricing in programme coverage can provide important risk signals and incentives for risk reduction. However, the effectiveness of pricing incentives in encouraging risk reduction will depend on the capacity of policyholders to invest in risk reduction. Risk-based pricing can also lead to affordability challenges for those at high-risk, and political challenges if those at high-risk are obligated to acquire flood insurance coverage. Cross-subsidies, or greater risk mutualisation, among low and high-risk policyholders is commonly applied in flood risk insurance programmes, particularly those that cover multiple natural hazard risks, although this approach can blunt incentives for risk reduction and potentially incentivise development in high-risk areas. This risk can be mitigated through the implementation of effective land-use controls and resilient building standards. A number of programmes have incorporated risk management requirements, conditions or incentives to reduce the impact of limiting risk signals in premium pricing.
Supporting risk reduction and adaptation will be critical for addressing rising flood losses, whether flood insurance coverage is provided through private insurers, a flood risk insurance programme or both. Flood risk insurance programmes that have direct links to governments have sometimes demonstrated a greater potential to leverage that relationship to influence broader risk reduction, although a number of private sector programmes are also contributing to flood risk management.