Insuring for Disaster

Jeffrey Sachs

NATURAL disasters like the devastating earthquake in Nepal constitute a highly uncertain but quantifiable risk. No one can say for sure when a major earthquake will strike. But the fault lines are known. We need a new global system of disaster insurance, akin to how homeowners guard against calamity.

Relief teams and millions of dollars of aid are arriving in Nepal, but despite the best of intentions, emergency operations will be a desperate patchwork, and long-term rebuilding will be hampered by lack of funds, donor fatigue and red tape. That’s what happened in Haiti after the 2010 earthquake, in the Philippines after a string of recent typhoons, and in the West Africa Ebola epidemic. We need a better approach.

Even poor countries can take precautions, especially if international organizations help them to do it. Think of commercial airline safety, which, though not flawless, is high even in the poorest regions in the world. There is an integrated system that connects airplane manufacturers, airline companies, air-traffic controllers, global insurers and national and global regulators.

Catastrophes like earthquakes, typhoons, droughts, floods and epidemics pose quantifiable risks. These risks can’t be specified with the actuarial precision that underlies home and life insurance, but there is enough precision to allow for insurance coverage. For hundreds of years, Lloyd’s and other insurers have been diversifying the risks of even one-time events; natural hazards like earthquakes are not one-time events, but occurrences that return with calculable probabilities.

Suppose Nepal’s government could have gone shopping for earthquake insurance to cover the large-scale losses and public-sector response after a disaster. Potential underwriters would examine the probabilities of earthquakes at various magnitudes, using the historical record, seismic modeling and assessments of the vulnerabilities of the buildings.

The leading insurer, generally a reinsurance company, would then sell off its excess exposure to Nepal’s earthquake risk to other insurance companies, or even capital markets around the world via so-called catastrophe bonds and similar instruments. These risk carriers would receive part of Nepal’s premium payments, and be required to pay out to Nepal in the event of an earthquake. Nepal would be financially protected, and insurers would diversify the risk.

The original insurance underwriter would have made demands of Nepal, that it implement cost-effective earthquake-preparedness measures, like updated building and zoning codes; a disaster response plan; and emergency health systems. These steps would limit expected damages caused by natural disaster — and lower the premium and expected payout. Over time, underwriting benchmarks would be standardized around the world.

The article’s full-text is available on the website of The New York Times

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