Microinsurance and natural disasters:Challenges and options

Daniel J. Clarke a,*, Dermot Grenham b

aDepartment of Statistics, University of Oxford, 1 South Parks Road, Oxford OX1 3TG, UKbDepartment of Social Policy, London School of Economics and Political Science, Houghton Street, London WC2A 2AE, UK

e n v i r o n m e n t a l s c i e n c e & p o l i c y 2 7 s ( 2 0 1 3 ) s 8 9 – s 9 8

a r t i c l e i n f o

Article history:

Received 16 December 2011

Received in revised form

15 June 2012

Accepted 18 June 2012

Published on line 20 July 2012

Keywords:

Microinsurance

Index insurance

Indemnity insurance

Migration

Disaster risk financing

Natural disasters

a b s t r a c t

Providing disaster microinsurance to low income individuals is far from easy. Designing and

structuring products so that they can be sold at low cost raises a set of challenges, and even

then the level of voluntary purchase can be disappointingly low. Recent innovations in

providing agricultural insurance could have broad implications for other disaster micro-

insurance products. If a market is to be viable governments will have key roles to play,

including: approving insurance policy small print and product designs; supporting or

leading industry-wide investments in data collection, index design, and loss adjustment

capacity; financing sustained public information campaigns; nudging or compelling pur-

chase; and committing to limits on post-disaster financial assistance to the uninsured. If

disaster microinsurance prices do not accurately reflect the risks faced, the presence of

disaster microinsurance can distort incentives to migrate. However, in the presence of risk-

based pricing, it seems plausible that disaster microinsurance could make it easier for

people to stay where they are even as their environment becomes more fragile, yet increase

post-disaster migration through increasing post-disaster wealth.

# 2012 Elsevier Ltd. All rights reserved.

Available online at www.sciencedirect.com

journal homepage: www.elsevier.com/locate/envsci

1. Introduction

Natural disasters can be devastating, particularly when they

affect vulnerable, low income households. Disaster micro-

insurance could in principle substantially increase welfare by

offering people a way to smooth out the worst years. However,

in practice many of the people who need protection the most

are either not offered appropriate products or, if they are, they

do not purchase them.

Whilst low income people are typically exposed to a variety

of shocks, this paper will focus specifically on natural disasters,

providing a conceptual overview of how microinsurance can

and cannot help in mitigating the impact of natural disasters on

low income people in a changing and potentially riskier world.

As disaster microinsurance is already in place in a number of

* Corresponding author. Tel.: +44 1865 272867.E-mail addresses: clarke@stats.ox.ac.uk (D.J. Clarke), d.j.grenham@

1462-9011/$ – see front matter # 2012 Elsevier Ltd. All rights reservedhttp://dx.doi.org/10.1016/j.envsci.2012.06.005

countries as a means of protecting low income people from the

adverse effects of disasters, it is natural to ask whether it has the

potential to provide protection to an increased number of low

income people if climate change increases the population

exposed to the adverse effects of natural disasters. We

introduce issues in the supply and demand of disaster

microinsurance, present evidence for broader linkages between

disaster microinsurance and migration decisions, and offer a

critical analysis of policy options that could be used to stimulate

a market for disaster microinsurance in developing countries.

We restrict attention to non-life microinsurance products

which provide, for example, agricultural or building insurance

for a short, typically annual, period. Such short-term disaster

microinsurance offers protection against unforeseen disasters

but does not offer protection against long term changes to the

underlying risks faced.

lse.ac.uk (D. Grenham).

.

e n v i r o n m e n t a l s c i e n c e & p o l i c y 2 7 s ( 2 0 1 3 ) s 8 9 – s 9 8S90

The compelling rationale for disaster microinsurance as a

mechanism for reducing vulnerability, combined with inno-

vations in the design and delivery of products, has led to a

plethora of pilots across developing countries (Hess et al.,

2005). However, many of these pilots have not matured into

sustainable scaled-up programs, and the effects of those that

have scaled up on migration or climate adaption decisions are

not well understood. Cummins and Mahul (2009) offers an

extensive review of disaster insurance programs currently in

place across developing countries, including some disaster

microinsurance programs, but does not consider in any degree

of detail the effects of climate change on disaster micro-

insurance or the potential impact of disaster microinsurance

on migration decisions.

In this paper we will first describe what microinsurance

looks like, the various types of product available, and how

microinsurance could protect against the effect of cata-

strophes. In particular we look at recent innovations in

markets for agricultural insurance, and discuss how these

could be applied more generally to natural disaster insurance.

We will then consider supply and demand issues before

looking at how climate change may affect the risks that

insurance typically protects against and how microinsurance

could respond to these changes. We address links between

migration and microinsurance, and the special case of Asian

megacities before concluding with various options for future

developments. We leave others to discuss the actual extent to

which climate change is causing and will cause more and

worse natural disasters and the direct effects of climate

change on migration (see Overseas Development Institute,

2006 and Coleman, 2009).

2. Issues in the provision of microinsurance

2.1. Defining microinsurance

There are a variety of different definitions of microinsurance.

Churchill (2006) defines microinsurance as ‘the protection of

low-income people against specific perils in exchange for

regular premium payments proportionate to the likelihood

and cost of the risk involved.’ A peril in this context refers to

the type of event (such as health problems, death, and

property damage) that could have a financial impact on a

person. Under this commonly used definition, microinsurance

is simply insurance for low-income people. The Indian

Regulatory and Development Authority instead focuses on

the size of the premium and benefits provided when defining

microinsurance in its microinsurance regulations (IRDA, 2005,

paragraph 2(d)) as ‘‘any health insurance contract, any

contract covering the belongings, such as hut, livestock or

tools or instruments or any personal accident contract, either

on individual or group basis’’ with premium and benefits

within specific bounds. Yet other definitions understand the

‘‘micro’’ in microinsurance as applying to the locus of decision

making and delivery, for example, through local self-help

groups for social insurance which are not part of a national

health scheme (Dror and Jacquier, 1999).

While for many purposes the actual definition of micro-

insurance may not matter, it is important for regulatory

authorities who wish to regulate microinsurance products in a

different way to other insurance products. For this they will

need to be able to differentiate objectively between micro-

insurance and other insurance products.

Irrespective of the actual definition, since the target

consumers of microinsurance products are quite different to

the middle- and high-income people typically targeted by

developed country non-life insurers, one might not be

surprised to learn that successful microinsurance products

are quite different in many respects to insurance products sold

in the developed world.

Many of the perils covered by microinsurers, including life,

health and home fire, are insured in developed countries.

However, microinsurance products target perils that specifi-

cally affect low-income households. For example, with 900

million rural poor dependent on the uncertain business of

agriculture for their livelihoods, agricultural insurance is a

much more important line of business for microinsurers than

for traditional insurers.

2.2. Supply of microinsurance

The traditional risk carriers for microinsurance products are

insurance companies, reinsurance companies including the

large multinational reinsurers, and governments. NGOs and

some mutual organisations have in some places provided

forms of cover but these have been acting as informal insurers

with the risk that, as they are unregulated, they may not be

able to pay contractually agreed claims in the aftermath of a

disaster. Regulators are increasingly bringing in regulations

specifically for the microinsurance market in their countries,

as distinct from mainstream insurance regulation. For exam-

ple, India introduced regulations in 2005 (IRDA, 2005), the

Philippines in 2010 (PIC, 2010), and the International Associa-

tion of Insurance Supervisors is currently drafting revised

guidance on informal insurance.

Only if microinsurance products are profitable will it be

attractive for insurance companies to offer them in significant

volumes. To be profitable the premiums charged, absent any

subsidy, must cover the cost to the company of covering the

insured risk, its marketing and administration costs and the

cost of holding capital.

Increasing the reach of microinsurance will require

insurers to have suitable distribution and administration

capacity provided by themselves or in collaboration with

others (Churchill, 2006, Part 4). By definition, microinsurance

will be for relatively small premiums but potentially for large

volumes of policyholders. Insurers will therefore need to

develop cost effective means of reaching their customer base,

for example by partnering with community-based mutuals,

microfinance organisations, or other intermediaries and by

making use of developments in technology such as the

increasing reach of mobile phones for financial transactions.

Administering large volumes of small policies will, in order to

be profitable, demand low overheads and highly efficient

administration systems. In some cases the development and

implementation of these systems may need to be subsidised.

Insurers could try and make use of existing infrastructure

to distribute and administer their products thus reducing

the cost involved in introducing microinsurance products.

e n v i r o n m e n t a l s c i e n c e & p o l i c y 2 7 s ( 2 0 1 3 ) s 8 9 – s 9 8 S91

However, they will need to be satisfied that they are partnering

with organisations that are trustworthy and financially

secure.

There will also need to be a high level of trust in financial

institutions on the part of the potential purchasers of

insurance. On the one hand, purchasers need to be satisfied

that the insurer will be able to pay their claims without going

insolvent. However, often more importantly, they will need to

be confident that the insurer will not reject a valid claim for

spurious or legalistic reasons. The solvency of insurers can

largely be ensured by having appropriate regulations in place.

Ensuring insurers pay valid claims is more difficult to

guarantee although regulators have an important role to play.

Although microinsurance products may be small in terms

of premium or benefits sometimes they need to be relatively

sophisticated. Local insurers may not therefore have the

expertise to be able to price, administer and manage claims for

such sophisticated products. Immature insurance markets

usually start with car and employer liability and group life

insurance and may focus on urban areas. To sell agricultural

insurance in a rural area or disaster insurance anywhere could

be very challenging for inexperienced companies without a

significant amount of support from others, for example

reinsurers, international insurance companies, and other

organisations which have at least some expertise in these

areas.

Currently most microinsurance policies, including the

small number of existing disaster microinsurance policies,

are annual products where the premium is set at the start of

each policy year. Whilst this may be appropriate at present,

improvements in early warning systems such as those

described in Lenton (2013) could lead to adverse selection

on the part of the insurer, with insurance provided at

affordable premiums only in those years in which claims

are considered to be unlikely. Clarke et al. (2012) report on the

publicly funded weather index insurance program in India in

which private sector insurers, after competing to offer

subsidised contracts in a state, will choose the length of the

sales window depending on up to date forecasts for the

coming season, with shorter sales windows if payouts are

expected and longer sales windows if payouts are not

expected. Farmers and government would together pay prices

based on historical data for a series of years, only for cover to

be effectively withdrawn in years predicted to be bad. Without

proper regulation or the initiation of multi-year contracts, this

form of adverse selection on the part of the insurer could lead

to healthy profits, but offer little protection to policyholders.

Moreover, this type of product may not be sustainable over the

long term as farmers realise that the product is of relatively

little value to them.

2.3. Indemnity and indexed microinsurance products

A recent focus on agricultural insurance, particularly by

development economists, has stimulated innovations of some

significance for the current discussion on protection against

natural disasters. In particular, microinsurers have experi-

mented with offering indexed insurance products to their clients

rather than or in addition to indemnity-based products (Skees

et al., 1999).

Under a traditional indemnity insurance product the claim

payment to the insured depends only on their own loss; if the

insured incurs a large enough insured loss the insurer is

contractually obligated to make a claim payment. It may be

possible to offer indemnity-based insurance for some climat-

ic-related disasters. For example Turkey’s system of earth-

quake insurance for homes and the Philippines’ new scheme

for typhoon insurance for homes are both indemnity-based

(Gurenko et al., 2006; Morsink et al., 2011). However,

indemnity-based approaches to insurance do not seem

possible for some important perils.

Using the example of agricultural insurance, an indemnity-

based insurance policy such as a multiple peril crop insurance

(MPCI) policy would lead to a claim payment to a farmer if that

farmer’s yield for specified crops on specified plots was below

a contractually agreed threshold. Such individual indemnity-

based policies have been sold in many countries but are

plagued by a number of problems. There is a risk of moral

hazard, where insured farmers might take less care over their

farm than uninsured farmers on the expectation that any

reduced yield would be covered by an insurance claim. This

risk could be reduced, although probably not eliminated, by

imposing an excess such that the insured will only be covered

over a certain level of loss. The insurer might also be exposed

to the risk of adverse selection by its potential customers

whereby farmers who consider that they are more likely to

make a claim purchase insurance. This could lead to higher

than expected claims and higher future premiums which

would then further discourage lower risk farmers to take out

insurance. This risk could be mitigated by making the

insurance compulsory, for example, making it a requirement

for farmers taking out microfinance loans to take out a

microinsurance policy to cover the loan. A further potential

problem with indemnity insurance is that the high cost of

detecting and stopping fraudulent behaviour could mean that

insurers prefer to pay all claims and allow the fraudulent

claims to increase premiums. All of these problems with

indemnity insurance are a consequence of information

asymmetries, i.e. one or other party having access to

information not available to the other party. These problems

and the high contracting costs have been so acute in practice

that there have been very few, if any, successful MPCI schemes

for small-scale farmers (Hazell, 1992; Skees et al., 1999).

One exception is the Fondos system in Mexico. Fondos are

organizations of farmers who join together on a non-profit

basis to mutually insure each other against specific named

risks through risk pooling and reinsurance. The Fondos’

insurance operations are managed on normal insurance

principles including proper underwriting of risks, the use of

technical guideline for claims assessment and the use of

actuarial methodologies to calculate premiums. The Fondos

contains a number of automatic moral hazard limiting

controls so that individual farmers do not try and take

advantage of other farmers, and the Fondos as a whole does

not try and take advantage of the reinsurer (Ibarra and Mahul,

2004).

The controls put in place by the Fondos include limiting the

size of their membership so that the farmers have a high level

of knowledge of each other and would know if someone was

trying to gain an unfair advantage. The reinsurer has some

e n v i r o n m e n t a l s c i e n c e & p o l i c y 2 7 s ( 2 0 1 3 ) s 8 9 – s 9 8S92

protection as it can quickly cancel the reinsurance arrange-

ment and the Social Fund mechanism encourages good

behaviour among the farmers. Moreover, the joint reporting

mechanism whereby the Fondos jointly reports all farmer

claims to the reinsurer rather than each farmer reporting

individually relaxes the incentive compatibility constraint,

allowing a reinsurer to audit just a sample of farmers, only

worrying about fraud at the level of the Fondos rather than

at the level of the individual. However, it does not get away

from the other major problem with indemnity based

insurance schemes namely the potentially high cost of

assessing claims.

In contrast to an indemnity insurance policy, under an

indexed insurance product claim payments to the insured

depends only on the realisation of some index. The level of the

index is typically chosen to be objective and correlated with

the insured’s loss. Rainfall indexed insurance is one such

example of an index insurance policy that has been sold to

farmers. Under this type of product, the index is a measure of

the rainfall at a specified contractual weather station. Too

much or too little rainfall at the wrong time might spell

disaster for a farmer and so it is possible to design an indexed

insurance policy which would make claim payments in case

the rainfall index is too high, too low, or either. Since the

product depends only on the amount of rain at the contractual

rainfall station, the same product can be sold to a large

number of farmers working near the contractual weather

station, who will then all receive the same claim payment at

the same time (Gine et al., 2010).

A wide variety of indices can be used and they can be

tailored to specific crops, or other risks that are being insured.

Certain crops are sensitive to hours of sunlight, temperature or

humidity and indices have been developed based on these

parameters (Clarke et al., 2012). Rather than setting an index

based on hazards such as rainfall and sunshine, which act as

inputs to the agricultural process, a special category of indices

may be described as sample output-based indices which are

calculated as the mean from a statistical sample of outputs,

such as the yield on crops or the mortality rate of livestock. For

example, a sample output-based area yield index is the sample

mean yield for a particular crop in a defined geographic area,

where the sample of plots in which the yield assessment is

conducted is chosen to be representative of the area (Mahul

et al., 2012).

By conditioning claim payments on an objective, cheaply

observable index, over which policyholders have little control

or private information, indexed insurance can significantly

reduce the problems of moral hazard, adverse selection and

insurance fraud which can plague indemnity insurance

contracts. However, indexed insurance has one significant

disadvantage; it is only a hedge, and does not offer watertight

protection. Of particular concern, it increases exposure to

downside risk. For example, without any agricultural insur-

ance the worst agricultural outcome that can occur from the

perspective of a farmer is one in which the farmer loses his

entire crop. However, a farmer who has purchased weather

indexed insurance is exposed to the risk of an even worse

outcome: she could pay her insurance premium and then lose

her entire crop due to pestilence, disease or localised weather

conditions, yet receive no claim payment due to the weather

index not having triggered, leaving her worse off by the

amount of the insurance premium (Clarke, 2011).

Attractive indexed insurance policies offer low premiums,

relative to the level of cover, and claim payments that are

highly correlated with the losses of target policyholders

(American Academy of Actuaries, 1999). In particular, a good

index should trigger claim payments when the insured has

incurred a large loss on the insured asset. For example,

conditional on a home being destroyed a good indexed home

insurance policy will have a high probability of making a

material payout, and conditional on a crop being destroyed,

leading to very low yield, a good indexed crop insurance policy

will have a high probability of making a material payout.

In designing an indexed insurance product care has to be

taken over the choice of index. To avoid disputes over when a

claim payment will be made the index has to be well defined

and measured independently of both the insured and insurer.

Even for seemingly manipulation-free automatic weather

stations care must be taken to prevent fraud. Clarke et al.

(2012) reports on cases of farmers placing ice cubes on weather

stations in India to trigger large claim payments for tempera-

ture indexed frost cover. The trigger point of the index needs to

be clear and payouts correlated with the losses which would

be incurred by farmers in the event of the index reaching the

trigger point. To enable the insurer to be able to set actuarially

fair premiums there ideally needs to be sufficient historical

data available for the index in the geographical locations

covered by the indexed insurance product. What constitutes

‘sufficient’ will differ by region and product. When developing

a new product in a new area there will be a lack of relevant

data and use will need to be made of whatever data is

available, such as from similar products developed in similar

areas. Insurers will therefore be taking a greater risk in the

early years that their premiums are incorrect and may

therefore tend to err on the side of setting high premiums

to avoid making a loss, which might make the product

financially unattractive. This could be an area where govern-

ments or donors could consider subsidising premiums so that

policies can be sold and data gathered. They can also invest in

the infrastructure required to collect relevant data.

Despite the growth in indexed insurance policies in

developed countries there has been very little analysis of

whether these products are objectively good for target clients.

Although such analysis has been conducted in developed

countries for indexed insurance policies and other derivatives

purchased by firms (for example see Cummins et al., 2004),

derivatives are typically not sold to individuals in developed

countries. Moreover, the available evidence for hazard-based

indexed insurance policies sold in developing countries is

somewhat negative. For example, Clarke (2011) finds that a

portfolio of weather indexed insurance policies sold to low

income farmers in 2007 comprised mostly of objectively poor

products, due to the combination of high premiums and low

correlation between claims and losses. Banerjee et al. (2011)

finds a correlation of 1% between wind speed indexed

insurance policies and losses incurred by rice farmers in the

Philippines. Clarke (2011) finds that weather indexed insur-

ance policies sold across one state in India do not pay anything

in one third of catastrophic years and the average correlation

between indices and losses over all products is only 13%.

e n v i r o n m e n t a l s c i e n c e & p o l i c y 2 7 s ( 2 0 1 3 ) s 8 9 – s 9 8 S93

Whilst this research is not yet conclusive, these findings are

concerning. There is little evidence on sample output-based

indices in developing countries, but evidence from developed

countries is much more positive. For example, Deng et al.

(2007) finds that sample-based area yield insurance may be

preferable to indemnity insurance, even for large farms in the

US.

One approach that may be appropriate for some perils is to

use indexed insurance contracts as a way of transferring risk

from community groups to formal insurers or, particularly for

the case of disaster risk, from local insurers to international

reinsurers. For the case of agricultural insurance, the pooling of

local agricultural risk through a community indemnity-based

mutual insurance group can provide protection to individual

farmers against individual shocks, whilst formal sector indexed

insurance can provide protection to the mutual against

aggregate shocks. Such a scheme could lead to reliable

protection at an acceptable cost (Dercon et al., 2011). Such an

economic arrangement could also be optimal for other

catastrophic perils. For example, it can take years for insurers

to agree to and pay indemnity claim payments to large number

of homeowners in the aftermath of a large disaster in a low or

middle income country. However, loss adjustment, that is ex

post claims processing including auditing and payment, is

typically much faster and cheaper for indexed products than for

indemnity products. If well designed the transfer from a

reinsurer to a local insurer in the aftermath of a large disaster

could be quite close to the amount that would be payable under

an indemnity-based reinsurance contract, but with reinsurance

claims paid quicker and at a lower cost. One complex technical

challenge is defining indices that accurately capture losses, but

as we propose in Section 3 sample output-based indices could

be a useful tool for the index designer.

2.4. Demand for microinsurance

There is a clear need for insurance for the poor. Having a low

income in a poor country is risky. Self-employment provides

unpredictable income, and the constant threat of health or

mortality shocks leave households vulnerable to serious

hardship (Dercon, 2004; Collins et al., 2009). Although the

financial size of shocks may be small compared to those in

developed countries, there is nothing ‘micro’ about the shocks

faced by the poor in poor countries; it is not unheard of for

households to respond to large income shocks by taking

children out of school and reducing nutritional intake,

particularly for girls and women (Ferreira and Schady, 2009;

Dercon and Krishnan, 2000).

If people wish to reduce the risks they face they can try and

transfer all or part of the risk or take steps to reduce the impact

of these risks. Farmers have traditionally had a number of

informal ways of reducing and transferring risk such as

diversifying the crops they grow, having more than one source

of income, sending family members to work in cities, or taking

part in some form of community based risk pooling process.

Insurance is a form of risk transfer that can supplement or

replace some of these more traditional methods especially

where they cannot provide sufficient protection against those

risks which are not diversifiable at the famer and community

level.

By affecting entire communities and extended families at

the same time, natural disasters have an even larger impact

than idiosyncratic shocks which affect one individual at a

time. Those affected are typically left with little in the way of

assets, and surviving the aftermath often requires selling any

remaining assets, such as jewellery, at fire sale prices. Friends

and families, whilst useful for support in the event of

idiosyncratic shocks, are all likely to be affected at the same

time and cannot offer substantial help. By providing income

from an external source in the event of natural disasters,

insurance can lessen their impact on the vulnerable.

However, need is not the same as demand. If one

extrapolates from decisions made about low impact, high

probability events, people should be willing to pay a large

premium for disaster insurance. However, even people in rich

countries with high levels of financial education consistently

underinsure against high impact, low probability events

(Kunreuther and Michel-Kerjan, 2008). One reason is that

personal experience is normally of little value for making such

decisions; once-in-a-lifetime events typically happen only

once in a lifetime.

For microinsurers, faced with low levels of financial literacy

within their target market, the problem is harder still (Gaurav

et al., 2010). Trust is likely to significantly suppress demand,

since an insurer alone may find it difficult to convince clients

that they will be able to make claim payments in the aftermath

of a large disaster. Even in the absence of trust issues, a

responsible microinsurer must provide information and

training programs, clearly defined products with simple rules

and restrictions, and easily accessible claims documentation

requirements, all without overselling the benefits of insur-

ance. Indexed insurance may be particularly difficult to sell,

since clients may be rightly worried about incurring large

losses but receiving no claim payment due to an inappropri-

ately designed index.

Another reason why effective demand for microinsurance

may be less than expected is that potential purchasers simply

cannot afford to pay the premiums in one go due to a lack of

cashflow or credit. In these cases allowing payments to be

made in instalments or at times of the year when potential

purchasers are not credit constrained may increase actual

demand. One such potential solution is the approach taken by

the Horn of Africa Risk Transfer for Adaptation project under

which famers can pay for the insurance either in cash or by

providing labour for climate change risk mitigation projects

(Oxfam, 2011). This has the dual benefit of providing insurance

and at the same time of reducing the risk of climate change

related disasters.

Another method that can be used to increase effective

demand is to make the purchase of a microinsurance product

compulsory. This could be as a result of national or state

government regulations, in much the same way as third party

motor insurance is a legal requirement for car owners in most

countries. Ensuring compliance with any such regulations will

be costly for an insurer and will lead to an increase in premium

rates as these should be set at a level to cover the insurer’s

expenses. An alternative method of making microinsurance

compulsory is to bundle it up with the purchase of other

products for example including it along with a microfinance

loan or when a farmer buys inputs for his farm. However, this

e n v i r o n m e n t a l s c i e n c e & p o l i c y 2 7 s ( 2 0 1 3 ) s 8 9 – s 9 8S94

approach is not able to guarantee that the microinsurance

product meets the actual needs of the farmer, for example he

may already be insured through some other means and so

could end up being over insured. On the other hand if the level

of disclosure is insufficient the farmer may not realise that he

is insured.

2.5. Insurance and climate change

Microinsurance will only be able to protect against the impact

of climate change if products covering the effects of natural

disasters are available at affordable prices. However, to the

extent that future climate change affects the overall level of

risk and volatility of a catastrophe, microinsurance providers

will respond by increasing premiums or deductibles, broad-

ening exclusions or withdrawing cover. If a microinsurance

provider did not do at least one of these and had insufficient

reinsurance it would be exposing itself to an increased risk of

insolvency and an inability to meet its claims.

Climate change could have a number of different effects on

the risks covered by microinsurance, including shifting the

average outcome and/or changing the frequency or severity of

extreme events. For example, Gosling (2011) reviews evidence

that suggests that tropical cyclone frequency could decrease

with climate change, whilst intensity (e.g. wind speed and per

event total precipitation) could increase. As well as how

climate changes affect the distribution of risk, the speed of the

change will also affect how responsive microinsurers would

be to the change in risk. Climate change could also affect the

demand for insurance, particularly if the beliefs of potential

clients change, although the beliefs of insurers might adapt

more quickly to a changing environment than the beliefs of

individuals.

Insurance premiums are broadly made up of a ‘risk

premium’ to cover the cost of the expected claims plus

loadings for the cost of holding capital, administrative and

marketing expenses, and profit:

Commercial Premium ¼ Risk Premium þ Cost of Capital

þ Expenses þ Expected Profit (1)

The risk premium is generally set using statistical analysis

of past experience, incorporating expert opinion and allowing

for noticeable trends in past experience. However, it will take

some time, or greater reliance on expert opinion, for

microinsurance providers to be able to determine how

changes in the impact of disasters relate to changes in the

underlying frequency or severity with which these disasters

occur. Insurers may be aware that the risks are changing but

not be able to determine by how much and whether the

change is in the frequency of disasters or in the severity, or

both. They may also be faced with different experience in

different areas that will make it even more difficult to assess

how widespread the effects are. This lack of knowledge will

tend to lead them to take a prudent approach in setting

premium rates or to being more restrictive in what they offer.

The cost of holding capital arises as a result of insurers and

reinsurers needing to put aside some capital as a buffer

against worse than expected claims experience. While

insurers may have their own view of how much capital to

hold, regulators set minimum standards. For example,

Solvency II in the EU will require insurers to demonstrate

resilience against a ‘1 in 200 year’ event. This can lead to high

capital requirements for insurance against events with

uncertain odds, such as climatic-related disasters. The cost

of holding this capital in the form of suitable assets is rightly

passed on to policyholders and can be substantial.

Adding loadings for expenses, capital costs and profit can

make the premium charged significantly higher than the risk

premium. For example, it is common for the premium for

catastrophic cover against natural disasters to be more than

four times the risk premium (Perry, 2009), a significant

constraint on the ability of providers to offer value for money

for disaster microinsurance.

One of the possible mechanisms by which climate change

could affect farmers is by causing a slow but continual

deterioration in their environment, for example, a slow

increase or decrease in the amount of rainfall. Such a gradual

change may not be severe enough, in the short term, to trigger

a claim under an insurance policy. By the time the environ-

ment has deteriorated to a level where the farmers could make

a claim, the insurance companies, having already identified

the trend may have changed the trigger point. If the

deterioration continues then even if there is a claim under

an insurance policy, farmers may not be able to remain where

they are as the conditions may be such that they can no longer

adapt and produce sufficient food to support themselves and

their families. Their situation may have come to such a pass

that even with the insurance payout (all of which may be

needed to repay outstanding loans) they may have insufficient

assets to enable them to invest in alternative livelihoods or

even to migrate except as paupers. Whilst longer term

insurance contracts could protect against longer term

‘changes in the odds’, the capital requirements for such

products are likely to be even more significant than for annual

disaster microinsurance products, rendering them even more

expensive.

2.6. Microinsurance and migration

Migration, whether from a rural area to an urban centre or

from one country to another can be a response to changes in

perceived risk or part of a coping strategy in the aftermath of

catastrophic disasters. It is therefore pertinent to ask whether

microinsurance could have a role to play in increasing or

reducing migration before or after disasters.

Migration is relatively easy to define but much harder to

measure. At one extreme a migrant is simply someone who

moves. This could be within a country, typically from rural

areas to urban areas especially in developing countries, or

cross borders. Trying to count migrants is difficult because of a

lack of reliable data on who is moving where, even in countries

where migration is a politically sensitive topic and where one

would therefore expect efforts to be made in trying to monitor

the levels of migration. Many countries lack administrative

registration systems and do not carry out regular censuses

which would give them at least some indication of previous

levels of migration. Even figures on legal cross border

migration, which perhaps ought to be the most reliable, can

be lacking, for example where there is free cross border

e n v i r o n m e n t a l s c i e n c e & p o l i c y 2 7 s ( 2 0 1 3 ) s 8 9 – s 9 8 S95

movement such as within the EU. Trying to quantify the

degree of illegal migration is even more of a challenge.

There are many different types of migrant, from those

moving to another place to study, in their own country or

abroad, after which they intend returning home, to those who

are forced to leave their usual place of residence as a result of

conflict or natural disaster.

There are many theories explaining why and how people

migrate and the effect they have on home and host societies.

Reasons for migrating are often divided into push and pull

factors. The former include poverty (actual or foreseen),

population pressure, lack of services, insecurity, and discrim-

ination. The latter include seeking the ‘bright lights’ of the city,

potential for improved standard of living, freedom, family

reunification, return migration as a result of nostalgia or

homesickness. Migrants often move following well-trodden

routes, using networks that have been established by earlier

pioneers. This would be the case whether migration is well

planned or is a response to a disaster.

As microinsurance products have only been developed

over the past couple of decades and have as yet only achieved

low levels of market penetration in developing countries,

there is a lack of empirical analysis carried out on the direct

effect of the availability of microinsurance on migration

decisions.

If disaster microinsurance premiums do not accurately

reflect the actual risks faced then the availability of disaster

microinsurance could distort decisions to migrate. For example,

government caps on insurance premiums may provide incen-

tives for people to move to, and stay living in, high risk areas.

In the presence of risk-based pricing, it seems plausible

that disaster microinsurance would make it easier for people

to stay where they are even as their environment becomes

more fragile. This is because affordable insurance makes

outcomes more predictable, effectively reducing the welfare

cost of risk and making staying in a risky environment less

unattractive. However, if the effects of climate change on

livelihoods become so severe such that people cannot adapt

and sustain themselves and their families then no amount of

short-term insurance protection will enable them to remain

where they are and they are likely to migrate elsewhere.

Whether people in this situation will migrate within or across

borders will depend on many factors such as immigration

policies in potential host countries and the ability of the

affected people to afford the high cost of international or

intercontinental migration.

There is a body of evidence that suggests that migration is

costly, and positively associated with wealth and social capital

(Skeldon, 1997). This could imply that if microinsurance claims

are settled promptly, an individual would have more wealth

post-disaster if they had previously purchased disaster micro-

insurance than if they had not and so, at the margin, the

purchase of microinsurance could actually increase post-

disaster migration through an increase in post-disaster wealth.

Finally, the effect of macro or meso-level insurance for

governments and businesses could reduce post-disaster

migration. This is because individuals affected by a disaster

are probably more likely to stay if governments are able to

rebuild key infrastructure and continue to offer basic services

and businesses can continue to offer employment. This is

more likely where these governments and business had taken

out disaster insurance.

The continual increase in urbanisation is leading to the

growth of a number of extremely large ‘‘megacities’’, most of the

largest of which are in Asia. In this new context it is again a valid

question to ask whether there is a role for microinsurance in

such places, given the many challenges that these cities have to

provide services to their inhabitants. These ‘‘megacities’’ have

different exposures to natural disasters (for examples, earth-

quakes, storms, tsunamis) and to the impact of climate change.

They will also have different adaptive capacities. What they do

share is the large number of people at risk.

To the extent that climate change increases the frequency

or severity of storms, hurricanes and tornadoes which hit

urban areas, megacities, will be at increased risk of natural

disasters happening. For example, those megacities which are

coastal will potentially be at an increased risk from flooding

due to increased average sea levels. Of China’s estimated

urban population of 400 million, an estimated 130 million live

in coastal cities that are vulnerable to sea-level rise (Prasad

et al., 2009).

These large cities have the potential to have their population

increased to the extent that climate change leads to migration

from rural areas. While this migration is not itself an insurable

event, the influx of large numbers of migrants could have a

serious negative impact on the cities’ infrastructure which may

in turn increase the incidence of insurable events. For example,

if the cities’ sewage system is overwhelmed by the influx of

migrants this could increase the incidence of disease.

Some of the risks described above, which could become

more pronounced as a result of climate change, are potentially

insurable using traditional or microinsurance products.

However, whoever is providing the insurance would need to

ensure that they are not overly exposed to the potentially large

numbers of claims from a single event. This can be achieved by

rationing, limiting the amount of insurance they provide in a

single city, by selling insurance across diverse geographical or

climatic regions or by accessing, through reinsurance, the

greater level of diversification available to international

reinsurers. Alternatively, governments or supranational orga-

nisations could act effectively as a reinsurer of last resort. But

even so, calculating premium rates for products that will cover

the impact of climate change related disasters will be

challenging due to a lack of data and appropriate models.

Innovative marketing and distribution methods as well as

premium collection and claim payment systems would be

required to reach low income households who will often be

living in the slum or areas of the city. As with crop insurance,

indexed products could be designed which would reduce the

cost of claim assessment, such as the property indexed

insurance product currently being sold in Jakarta which pays

claims when the water level rises above a certain fixed point

on the Manggarai Flood Gate in the city.

3. Policy options

Parties interested in providing or supporting the provision of

insurance for climatic-related disasters would do well to bear

the following points in mind.

e n v i r o n m e n t a l s c i e n c e & p o l i c y 2 7 s ( 2 0 1 3 ) s 8 9 – s 9 8S96

First, it seems unlikely that any disaster insurance scheme

would be successful without significant government involve-

ment. As already mentioned, people seem to consistently

underinsure against low frequency, high impact events. At

one extreme, governments have the power to compel disaster

insurance purchase, as is the case for farmers who take out

loans for agricultural purposes in India (Mahul et al., 2012). As

a softer alternative, governments could nudge individuals

towards purchasing disaster insurance by, for example,

requiring that standard building insurance policies or stan-

dard loans for agricultural investments included insurance

cover for disaster, even if opt out was possible if explicitly

chosen by the client. Nudging or weak compulsion is common

for homeowners earthquake insurance; in California every

insurance broker selling homeowners insurance is compelled

to offer earthquake insurance through the publicly managed

California Earthquake Authority (CEA), and in Turkey home-

owners are compelled to purchase earthquake cover through

the Turkish Catastrophic Insurance Pool (TCIP), albeit with

limits to enforcement. Governments can also nudge through

publically funded promotion of disaster insurance purchase,

as exemplified by the high profile long-term marketing

campaign of Turkey’s TCIP (Gurenko et al., 2006). Such

government intervention might be justified on public goods

grounds, since basic education about the value of insurance

against disasters is likely to be undersupplied by private sector

organisations due to concerns about free riding from compe-

titors.

Governments should also have a technical role in approv-

ing disaster insurance products based on international best

practice, to protect policyholders against inappropriate small

print and could require standard information disclosure. In

many developed countries lenders must publicise the Annual

Percentage Rate (APR) of their products to allow a simple, if

somewhat crude, comparison between products; govern-

ments could require insurers to provide objective estimates

of the insurance multiple, the ratio of the premium to the

expected claim payment, and a reasonable measure of the

actuarial cost of the product, or the historic claim payments

that would have been made from a given indexed product.

Insurance indices are a public good in the economic sense,

requiring a coordinated long term investment. Governments

are likely to have an important role to play in the collection

and validation of long term data series to form the basis for

trustworthy indices, such as the weather or yield data

underlying weather or area-yield indices.

Second, thinking more broadly, if insurance cover for

climatic-related disasters is to be available at reasonable

prices, there may also be a role for an appropriately designed

supranational body in offering reinsurance for specific

climatic-related perils. As described above, sensible insurance

regulation naturally leads to high capital costs, and therefore

high premiums, for insurance against catastrophic events

with uncertain odds. The way in which the private sector

packages this risk, for example through cat(astrophe) bonds or

other risk transfer instruments, does not affect this capital

cost very much: behind all the financial wizardry regulators

require someone to hold substantial assets that could be sold

quickly to pay claims as they fall due, and this liquidity is

costly. To substantially reduce capital costs for catastrophic

risks with uncertain odds, one needs access to liquidity

without having to hold large amounts of liquid assets.

Creditworthy governments, or groups of governments, could

provide liquidity without having to hold large amounts of

liquid assets, since they can offer lines of credit secured

against future tax revenues, and could therefore facilitate

disaster insurance at a much lower cost than sensibly

regulated private insurers or reinsurers.

There are many practical challenges to creating a ‘World

Re’, or expanding the remit of existing supranational institu-

tions to offer reinsurance for specified climatic-related perils,

but such a facility may need be investigated if climate change

increases uncertainty for economically important perils. Note

that the present suggestion is fundamentally different to a

‘‘Climate Change Insurance Mechanism’’ as proposed at the

2010 United Nations Climate Change Conference (COP 16), for

which governments would provide reserves, not guarantees

(see Adamson and Sagar, 2002).

Third, whilst indexed approaches to disaster insurance offer

speedy claim payment and (relatively) low premiums, designers

should take the risk of mismatch between losses and claim

payments seriously. One option would be to move from hazard

based indices, such as weather indices, to sample output-based

indices. For example, in the aftermath of an earthquake, before

and after satellite images could be compared to classify damage

to buildings in a predetermined objective manner. Loss

adjusters, hired by insurance providers and reinsurers but

audited by government, could then assess the damage incurred

by a statistical sample of buildings, with the sample weighted

towards buildings classified as severely damaged by satellite

images. The reinsurance claim payments to local insurers

would then be determined based only on the estimate of the

average building damage arising from this sampling procedure.

Local insurers would be responsible for paying indemnity-

based claims to insured individuals, with their exposure well

hedged by a sample output-based index insurance product

purchased from reinsurers. Such approaches are already being

implemented for agricultural insurance, where crop cutting

experiments for India’s area yield indexed insurance scheme,

the modified National Agricultural Insurance Scheme, are being

targeted on a pilot basis based on remote sensing data (Mahul

et al., 2012). Whilst, to the authors’ knowledge, it has not yet

been attempted for other natural disaster perils, the sample

output-based index approach could be used for catastrophic

hurricane, windstorm or flooding insurance to allow inexpen-

sive, timely risk transfer from local insurers to international

reinsurers with claim payments highly correlated to losses.

Such schemes would require coordination and long term

investments in high quality indices and teams of loss adjusters,

but could facilitate the inexpensive transfer of catastrophic risk

from local insurers, allowing them to offer catastrophic cover to

their clients.

Finally, insurance for the poor does not necessarily require

microinsurance products to be delivered directly to the poor.

Regardless of how personal assets are affected, in the

aftermath of a large natural disaster individuals are much

better off if governments and firms are able to continue to

offer services and jobs. For example, tax revenues typically

fall significantly immediately following a large natural

disaster, and can leave governments unable to pay key

e n v i r o n m e n t a l s c i e n c e & p o l i c y 2 7 s ( 2 0 1 3 ) s 8 9 – s 9 8 S97

public sector employees offering critical services. Reinsur-

ance or a line of contingent credit could protect govern-

ments against such a short term liquidity crunch and

provide financing for the rebuilding of public assets, thereby

reducing the effect of the disaster on those affected

(Cummins and Mahul, 2009). By insuring assets or purchas-

ing business interruption insurance, firms can also offer

some degree of protection to employees and customers

from the financial repercussions of natural disasters. Low

income people therefore have much to gain not only from

personal microinsurance products but also from improved

risk management for developing country governments and

firms (Cummins and Mahul, 2009).

4. Conclusions

As the effect of natural disasters may be disproportionately

felt by people on low incomes it is a reasonable task to assess

the extent to which disaster microinsurance, that is insurance

against natural disasters for people on low incomes, could be

used to lessen the negative effects of disasters. In theory,

disaster microinsurance could play a useful role as part of the

risk management strategies of the poor. However, for its

potential to be realised, it will need support and coordination

by government and the private sector.

Just as insurance everywhere in the world has to be bought

rather than sold, demand for disaster microinsurance is likely

to be low due to a lack of financial understanding, low trust

that insurance companies will pay claims in the aftermath of a

disaster, and fears that purchasing insurance will crowd out

public support for disaster relief and reconstruction. Increas-

ing demand may require compulsion, nudging, or premium

subsidies, as well as government committing to limits on post-

disaster financial assistance to the uninsured.

The supply of disaster microinsurance may not be a

binding constraint as an increasing number of reinsurance

and insurance companies are keen to enter this market and

there are other types of organisation, more or less formally,

offering microinsurance products. However, the key issue is

ensuring that the right products are being supplied within a

regulatory environment which is fit for purpose, and that

local insurers can transfer risks to international markets at

low cost to avoid being overexposed to adverse experience in

the area where they operate. Regulators will have to assess

the extent to which they will allow exemptions from certain

regulatory requirements on the basis that they impose a

disproportionate burden on microinsurance products and

providers. We have also proposed two possible policy options

to support the supply of microinsurance, the first is the

sample output-based indexed insurance products and the

second is the creation of a supranational level reinsurance

pool guaranteed by national governments. We have also

noted that as early warning systems for natural disasters

improve, insurance contracts will need to be multi-year or

insurance will be unavailable or only available at very high

premiums in years in which catastrophic disasters are

expected.

As natural disasters have widespread financial and

infrastructural effects, governments have a key role to play

both before and in the aftermath of such disasters. There are a

large number of challenges in providing disaster microinsur-

ance products at affordable premiums. However, paraphras-

ing Sen (1995), it is important that insurance products

designed for the poor do not end up being poor products.

Disaster related insurance schemes implemented by the

private sector and supported by regulators, national govern-

ments and supranational organisations may be a cost effective

way of providing this protection.

There is little evidence available on the direct effect of

microinsurance availability on migration patterns. Nonethe-

less, it is possible to make some informed predictions that

could be empirically tested. In particular, if premiums reflect

the underlying risk it seems plausible that by enabling people

to protect themselves against natural disasters, availability of

disaster insurance could support their living in increasingly

fragile environments for longer. However, the availability of

disaster microinsurance which pays out in a timely manner

could increase post-disaster migration by increasing post-

disaster policyholder wealth.

Acknowledgements

This paper was originally commissioned as part of the

Foresight Global Environmental Migration Project by the UK

Government Office of Science. Without implicating them in

the shortcomings of the work, the authors would like to thank

Nora Ferm, three referees and the editor of the Foresight

Project for very useful comments on aspects of the paper.

Views expressed in this paper are the authors’ and should not

be attributed to the World Bank or the UK Government

Actuary’s Department.

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Dermot Grenham lectures on demography and development atthe London School of Economics. He is also a Chief Actuary (socialsecurity, demography and overseas pensions) at the UK’s Govern-ment Actuary’s Department. He has a doctorate in mathematicsfrom Oxford University and a MSc in population and developmentfrom the LSE. He was a member of the Council of the Institute ofActuaries in the UK and is currently a member of the UK ActuarialProfession’s and the International Actuarial Association’s micro-insurance working parties.

Daniel Clarke is an actuary and development economist whoworks on disaster risk financing and insurance both for peopleon low incomes and for low and middle income country govern-ments. He is based at the University of Oxford and has workedwith the World Bank and the International Food Policy ResearchInstitute on agricultural and disaster insurance in India, Ethiopia,Bangladesh, Mexico, Peru, Indonesia, the Caribbean region and thePacific region, and was one of the architects of the actuarial designand ratemaking methodology for the Government of India’s Mod-ified National Agricultural Insurance Scheme.