USAID/OAS Post Georges Disaster Mitigation (PGDM) Project.

Contents

1. The Mitigation Role of Insurance Companies
2. The Mitigation Role of Lending Institutions
3. Possible Next Steps

Attachments:

1. Some Initial Premises on Vulnerability Reduction
2. Vulnerability Reduction Cost/Benefits
3. Illustration of Vulnerability Reduction Measures’ Impact on Insurers’ Catastrophe Liabilities.

Notes:

1. The term ‘Lending Institutions’ is intended to embrace both retail and wholesale lenders – i.e. those relying on building structures for loan collateral.
2. The term ‘Insurance Companies’ refers to those locally licensed insurers transacting property insurance against Catastrophe perils (hurricane, flood, earthquake etc.)
3. To keep a reasonable discussion focus, these notes primarily reference the windstorm hurricane peril (and associated flood/surge), acknowledging that the other catastrophe perils of landslide, earthquake and volcano deserve analysis by their distinctive characteristics.

The Mitigation Role of Insurance Companies

The succession of severe hurricanes over the past decade has greatly impacted the Leeward Island insurance business. Catastrophe peril insurers rely heavily on the availability and affordability of reinsurance from overseas reinsurers who customarily assume over 85% of the claim liabilities. Reinsurers are therefore essentially in command of the amounts of risk capacity available, the insurance coverage conditions and, therefore, the premium rate levels. This is true throughout catastrophe-prone areas of the Caribbean. Because of this dominant voice by the reinsurance industry, it is valuable to understand reinsurers’ attitudes and practices.

To determine catastrophe cover availability, reinsurers use the key factors of storm frequency and storm severity probabilities. As their risk management policies call for maximizing spread of risk, reinsurers attempt to limit their exposures by spreading that risk around the world and by avoiding concentration of risk within specific geographic zones.

For particularly hazard-prone zones, reinsurers insist on coverage restrictions to contain their liabilities. These include significant claim deductibles (2%–5%), and the requirement that policy sums insured represent the full value of structures with any shortfall in the amount of insurance acting to proportionately reduce a claim payment. Additionally, the premium rate in catastrophe prone areas is indeed high—and can considerably exceed 1% of the insured value.

A further factor, of key significance in promoting vulnerability reduction measures, is the reinsurers’ practice of insisting that their risk capacity levels, the coverage restrictions and the premium rate pricing all be applied on a ‘broad brush’ basis across a whole reinsured portfolio and/or geographic zone. This practice inhibits application of coverage and rate techniques to recognize individual structures with worthwhile vulnerability reduction protection—or to penalize structures with poor characteristics. Location or structural protection characteristics that increase or decrease the structural vulnerability are largely ignored.

Insurers and their reinsurers in more developed insurance markets, however, do recognize and encourage coverage and price discrimination by individual risk characteristics. They see these techniques as well serving their goals of improving the risk quality mix within their portfolios. In other areas, such as the Caribbean, where such practices are less developed, it is more difficult to implement policy programs that promote safer development practices.

It is clearly in the self-interest of Leeward Island insurers to emulate the practices accepted elsewhere, by developing sound, workable, disciplined mechanisms to classify individual risks by their true hurricane exposure characteristics. Attachment C illustrates how implementation of vulnerability reduction measures serves to reduce the risk position of insurers and reinsurers, while concurrently offering meaningful premium rate incentives to policyholders.

The cost/benefit return from vulnerability reduction measures (to property owners, insurers, reinsurers, lenders, and the community as a whole), is certainly positive. To promote the implementation of vulnerability reduction, insurers (with their reinsurers) will need to support vulnerability reduction measures that:

• Are perceived as fully effective in terms of increased protection.
• Are affordable and available
• Provide incentives and recognition to property owners.

The Mitigation Role of Lending Institutions

A natural hazard event, such as a hurricane, disrupts the normal rhythm of business and adversely affects all facets of a small island's economy—and of a lender's business. While insurance payments can cushion the effects of such events, lending institutions cannot solely rely on insurance claim recoveries to fully and timely restore the integrity of collateral building structures. The availability, affordability and adequacy of catastrophe insurance coverage cannot always be assured in hurricane-prone zones.

It is, therefore, in the self-interest of lending institutions to minimize the potential impact of natural hazards. Their self-interest is, or should be, entirely compatible with the self-interest of their loan customers, as well as that of the broader community interest. The challenge is to achieve a vibrant commonality of interest between lending institution and customer. Effective vulnerability measures do exist. To make these appealing to both lenders and building owners, certain conditions must be in place:

1. Vulnerability reduction measures are perceived as entirely effective.
2. Vulnerability reduction measures are both affordable and available.
3. Property owners who implement effective vulnerability reduction measures receive incentives and recognition.

A lending institution’s business is comprised of a loan portfolio with building structures as collateral. In the lending industry, a loan wholesaler assumes the default and late payment risks. The loan retailer originates loans and provides maintenance servicing of the loans. The retailer receives commissions/fees for these roles.

Loan portfolio management is challenging in that it requires complex balancing of several factors. Fiscal prudence and regulations require lending institutions to adhere to key capital, debt, and liquidity ratios, which require close governance of the quality mix of loans within a portfolio. Satisfactory overall loan performance reduces the strain on capital, debt and liquidity ratios. A quality loan portfolio gives a lending institution a competitive advantage in such areas as interest rate pricing and loan conditions.

The key ratios for a lender to maintain satisfactory loan performance include:

• The cost of capital and other funds (e.g. debt) compared to the revenues and secured assets in the loan portfolio.
• Loan default ratio.
• Cash Flow, or the repayment schedule compliance.
• Expense Ratio (administrative/operating/acquisition costs)

These key ratios are maintained by proper attention to loan acceptance criteria, including:

• Credit worthiness of applicants, including the timeliness of payments
• Adequacy and negotiability of collateral
• Protection of collateral, which is principally achieved by insurance

Existing vulnerability reduction measures for hurricane mitigation.

Simply stated, vulnerability reduction measures for building structures involve the strengthening of the hazard-resistant characteristics of building components, including:

• Foundation (location is a key factor)
• Walls
• Openings (e.g. windows, doors)
• Cladding
• Roofing

Cost-effective measures to strengthen these building components do exist. Appendix B outlines the example of the reduction of the loss potential of an average commercial structure in a Class III storm (<120 mph winds) from 10% of the building value to 5%. This reduction is achievable by implementing specific, existing vulnerability reduction measures estimated to cost 1.7% of the building value. Similar examples with comparable paybacks are provided for other commercial and dwelling structures, for both new construction and the retrofitting of existing structures.

The availability and effectiveness of vulnerability reduction measure effectiveness needs advertising; one example for disseminating this information is a booklet produced by the United Insurance Company of Barbados, demonstrating such measures for vulnerability reduction of individual dwellings. To be effective, however, any vulnerability reduction measures must be properly implemented. In this respect, the government, building owners, banks and insurance companies all have a common interest in effective vulnerability reduction implementation and enforcement.

The cost (normally once only) of vulnerability reduction measures (per attachment B) typically ranges from 1.2% to 3.8% of a structure’s value. This cost can be offset by:

• A reduced annual insurance premium rate—perhaps up to 0.25% of a structure’s value
• An increase in property resale value merited by the vulnerability reduction measures.

Affordability will be greatly facilitated if lending institution show a willingness to provide the loan funds needed for vulnerability reduction measures—both for new and existing (retrofitting) loan customers.

Existing vulnerability reduction measures range from very worthwhile and inexpensive ‘do-it-yourself’ improvements to substantial and engineered structural improvements. Proper implementation of any measure remains paramount but this need should not inhibit self-help efforts. Any worthwhile vulnerability reduction measures merit encouragement and incentives. For example, roof-strapping and adequate shuttering are essential basics for home safety, as well as for lending institutions and insurers. Making these measures, and others, the rule rather than the exception can significantly affect the resilience of structures—and the loan and insurance portfolios that consist of those structures.

Finally, providing incentives and promoting recognition of vulnerability reduction will have a big impact on the speed of acceptance and implementation of vulnerability reduction measures. It would seem worthwhile for lending institutions to carefully scrutinize the risk and cost variances that exist between the collateral that has good vulnerability reduction measures and the collateral without such. These variances could be converted into both incentives and disincentives to loan customers. The insurance sector is being encouraged to do likewise.

Possible Next Steps

Without pre-guessing our Roundtable’s consensus, next steps to be considered include:

• We agree that Lending Institutions and Insurers publicly adopt and announce a proactive role in advancing the implementation of vulnerability reduction measures.
• We agree that more specific and practical information is needed to describe and promote the most effective, available and affordable vulnerability reduction measures.
• We see a close commonality of interest between the Lending and Insurance sectors in support of vulnerability reduction measures.
• There exist some vulnerability reduction measures that can be ‘sold’ in the short term (? by when), and these should be articulated into sector-wide programs and procedures.
• Identify research/development into and resource requirements of other (mid- to long-term) measures.
• We draft our agenda for our next Roundtable meeting.

Attachment A: Some Initial Premises

a. Focus on Building Structures. Natural hazards in the Caribbean, (hurricane, flood, landslide, earthquake and volcano) severely impact all sectors of society and the economy, which suffer from the destruction, damage, and loss of use of building structures.

b. Vulnerability Reduction. Vulnerability Reduction measures of proven effectiveness exist that enable new and existing building structures to significantly resist the physical forces of natural disasters. These vulnerability reduction measures range from the simple and inexpensive to the complex and costly. Within this range, priorities for vulnerability reduction measures can be assessed according to the following, interconnected characteristics:

1. Physical force resistance characteristics,
2. Affordability,
3. Availability.

Such categorization produces a rational basis for identifying short, mid, and long term vulnerability reduction implementation actions. The mitigation payback will be proportional to the effectiveness and extent of implementation.

c. Vulnerability Reduction Compared to Insurance. Vulnerability reduction and other hazard mitigation measures have been shown to reduce losses from natural hazard catastrophes, including the ensuing reconstruction debt, and other adverse socio-economic consequences. Insurance does not, per se, reduce damage nor improve the physical resistance of structures. The traditional insurance role is limited to providing monetary compensation for loss and/or damage after the occurrence of a catastrophe event. Furthermore, only a fraction of the insurance premium dollar is available to compensate for losses; the rest goes on administrative costs, operating expenses and taxes. Expenditures on vulnerability reduction measures give multi-year durable paybacks by both neutralizing potential for loss and by allowing the continuing use of structures through successive catastrophe events.

The insurance mechanism certainly has a valuable role in funding reconstruction. Compared to vulnerability reduction, however, it is relatively inefficient in mitigating losses to hazards. The insurance sector has an opportunity to enhance its mitigation role by spurring vulnerability reduction measures’ implementation through setting reduced premium rates and other incentives that reward actual catastrophe protection characteristics of individual building structures.

d. Complexities of Implementing Vulnerability Reduction Measures. Although the benefits of vulnerability reduction are clear, the adoption of effective implementation actions can be hampered by complex behavioral and institutional factors even where there exists a vibrant national commitment to hazard mitigation. Stated simply, the core challenge is to ‘fortify’ new and existing building structures to better resist, if not neutralize, the physical forces of natural disasters.

A variety of vulnerability reduction technologies exist, with varying payback characteristics, availabilities and affordabilities; these can be assessed and co-related to establish rational and phased action plans. The vulnerability reduction action planning necessarily involves many sectors and interests:

• Government Agencies
  • A Nation’s Disaster Mitigation Directorate
  • Building Code Administration & Enforcement
  • Regulatory Agencies (Insurance superintendent, Building code enforcement, Town and Country Planning, Environment)
• Property Owners
  • Private Residences
  • Commercial Properties
  • Public Properties
• Construction Sector
  • Builders & Remodelers
  • Suppliers of Construction Materials
  • Architects, Civil Engineers, Surveyors/Inspectors
• Insurance Sector
  • Portfolio underwriters to set risk acceptance, coverage conditions, and premium pricing criteria that discriminate by individual structure catastrophe exposure characteristics.
  • Risk inspectors to certify individual risk characteristics.
• Lending Institutions - Retail & Wholesale
  • Retail loan portfolio managers to set loan acceptance, loan conditions and interest rate pricing criteria that discriminate by the property collateral’s catastrophe exposure characteristics.

Besides these sectors, the community as a whole deserves a close awareness of, and involvement in, the spread of vulnerability reduction measures. Civic, Trade, Educational, and Media entities should all undertake proactive vulnerability reduction roles. Astute cooperation among all sectors can convert the adage; "Too Many Cooks Spoil the Broth" to "Many Hands Make Light Work".

It is this multiplicity of interests that complicates decisions and behaviors in support of effective implementation of vulnerability reduction measures. Each sector clearly has a dual concern—that of self-interest and that of community interest. Indifference by any sector to implementing vulnerability reduction measures is tantamount to playing Russian Roulette with natural disasters.

Attachment B: Vulnerability Reduction Measures’ Cost/Benefits

Empirical data do not exist, which definitively shows precise cost/benefit yields for vulnerability reduction measures for specific groups of buildings. However, a respected Barbados civil engineer[1] compiled the following table to summarize his estimates of the vulnerability reduction measure expenditures required to reduce by 50% the Estimated Maximum Loss (EML) from a Category III (<120 mph) hurricane:

For example, a $1,000,000 value Class B commercial structure, without deliberate vulnerability reduction measures, could typically be assessed at a 10 % ($ 100,000) EML for a CAT III hurricane. Mr. Gibbs’ estimates suggest that vulnerability reduction measures costing $17,000 (new) or $28,000 (retrofitted) would reduce the EML by 50% to $50,000.

[1] Mr. Tony Gibbs, who for several decades has made a study and practice of wind force/protection characteristics of distinctive Caribbean building structures.

Attachment C: Illustration of the Impact of Hurricane Vulnerability Reduction Measures On An Insurers’ Catastrophe Claim Liabilities (Risk Premium to Risk Amount Ratio)

Assumptions for the illustration:

1. Building Structure Hurricane PML:

• Before Vulnerability Reduction Retrofitting: 10%
• After Vulnerability Reduction Retrofitting: 5%

2. Claim deductible is 2% x sum insured of $500.000
3. Rating % x sum insured:

The example shows a Premium to Risk ratio 100% improvement (7.5% to 15.0 %), even after allowing a 25% CAT rate reduction for implementation of vulnerability reduction measures.