Preparing for Disaster

As Canada’s property and casualty insurance industry continues to deal with the aftermath of last year’s extreme weather events, stakeholders are also looking ahead to how Canada can adapt to these more frequent and damaging natural catastrophes.

The way forward is to first understand the problem. To that end, Insurance Bureau of Canada (IBC) recently published a research paper on the economic and fiscal effects of natural disasters. Drawing on evidence from more than 30 academic and research studies worldwide, the paper shows insurance can lower the economic and fiscal costs of natural disasters, transfer risk from taxpayers and speed recovery.

IBC is currently sharing the paper with Canadian policy-makers in an effort to inform financial planning and risk management decisions in the public and private sectors.

NUMBER OF DISASTERS, COST PER EVENT INCREASING

In recent years, Canadians have experienced a steady increase in the number of storms, floods, droughts and other extreme weather events. In fact, the average number of natural catastrophes per year has risen 250% since the 1970s. At the same time, populations and economic activity continue to grow in vulnerable cities and regions.

The United Nations estimates that, by 2050, almost 70% of the world’s population will reside in cities – many of which are located near coasts, floodplains and fault lines at risk for natural hazards. As a result, disasters now tend to exact higher economic tolls. Indeed, the average yearly economic cost of disasters has quadrupled since the 1980s.

Here in Canada, these trends are clearer than ever. The recent floods in Southern Alberta and in the Greater Toronto Area are a stark reminder of the country’s vulnerability. The Alberta floods were the costliest natural disaster in Canadian history and the Toronto floods were the costliest natural disaster in Ontario’s history.

The question is not if large catastrophes will occur, but how extensive the damage will be and whether we, as a country, will be prepared.

LARGE DISASTERS HURT ECONOMIES

Large natural disasters have a negative impact on economic outcomes. A typical disaster lowers gross domestic product (GDP) growth by approximately one percentage point and GDP by about 2%.

However, major catastrophes can have even more pronounced effects. The 1995 Kobe earthquake, for instance, reduced residents’ GDP per capita by 13% over the long term.

How quickly an economy rebounds depends on the extent to which losses are contained to avoid contagion to the rest of the economy. After Hurricane Katrina, for example, each dollar in direct losses led to an additional 39 cents in indirect losses.

Natural disasters can also negatively affect public finances and debt sustainability. When a catastrophe strikes, government finances are hurt two ways: tax revenues drop as a result of a reduction in economic activity, while at the same time, public spending increases to pay for emergency relief and reconstruction.

A recent World Bank study found that, on average, disasters lower tax revenues by 10% and raise government spending by 15%, leading to a combined 25% increase in budget deficits.

Governments in Canada are well-aware of the fiscal damage wrought by natural disasters. Over the last 40 years, federal Disaster Financial Assistance Arrangements (DFAA) have more than quadrupled. Annual DFAA spending has jumped from an average of $36 million a year in the 1970s, to $166 million annually in the 2000s, and well over $1 billion a year in the first four years of this decade.

The 2013 floods in Southern Alberta and Toronto continue this trend. The floods caused more than $6 billion in damage, cost the federal government $2.8 billion and raised the federal deficit by approximately $2 billion. As the frequency of severe weather increases, the fiscal impact on Canadian governments will also grow.

THREE STEPS TO A MORE RESILIENT CANADA

How can the country respond to the growing threat of natural catastrophes and strengthen Canada’s physical and financial resilience to disaster risk?

1 The first step is comprehensive risk assessment. To this end, actuarial modelling by insurers is a vital complement to traditional risk assessments performed by natural scientists, such as seismologists and climatologists.

A recent example of comprehensive risk assessment is the major study released by IBC this past October on what a major earthquake could cost Canadians. The study – conducted by leading global catastrophe risk modelling firm AIR Worldwide – revealed that a realistically probable 1-in-500-year earthquake could cost Canadians $75 billion in Western Canada and more than $60 billion in Eastern Canada.

In both cases, as much as 85% of total economic losses would not be insured, leaving governments and taxpayers to absorb an extremely large financial burden at the worst possible time. The findings put Canadians in a better position to discuss solutions for the way the country prepares for the financial impact of earthquakes.

2 A second step in mitigating disaster risk is sound financial management. The most effective action that policy-makers can take is to enable and encourage the transfer of disaster risk to the party best able to manage it. This means making sure that most disaster losses are insured. Each dollar of disaster losses paid by insurance is a dollar saved by taxpayers.

Insurers have several advantages in managing disaster risk efficiently. They work with international reinsurance and capital markets to cheaply diversify risk across different locations and investors. They are experts in adjusting and settling claims, which reduces the time and administrative and transaction costs of post-disaster reconstruction and recovery. And while governments typically supply basic relief after a disaster, insurers provide more complete loss compensation, channelling funds to where they are needed most.

Without adequate risk transfer to the private insurance market, there can be only two alternatives. Either Canadians receive no financial aid after a catastrophe, or governments pick up the tab by self-insuring, which is hardly an efficient use of scarce public funds. When governments self-insure, taxpayers bear the full cost of disaster exposure, government spending is diverted from response and recovery to damage compensation, economic growth suffers and public finances are strained.

3 The third and final step toward building disaster resilience is risk reduction or mitigation.

Industry players know that risk reduction works. In the United States, for example, each $1 spent to mitigate flood risk reduced future costs by as much as $4. Unfortunately, implementing risk reduction measures is often hindered by a lack of incentives and inertia.

Insurance encourages consumers to reduce their risk – whether through retrofitting their homes, installing backwater valves or even moving out of disaster-prone areas.

By contrast, government-funded disaster relief provides no such incentive. To the contrary, expectations that governments will fund post-disaster reconstruction may encourage consumers to make riskier choices, such as building a home on a floodplain.

HOW INSURANCE REDUCES GOVERNMENT COSTS

Insurance is a fundamental tool for assessing, managing and mitigating disaster risk. It helps reduce the economic impact of catastrophes in four ways:

1. It transfers risk away from taxpayers, finances that risk more efficiently and encourages consumers to plan ahead to reduce their risk.

2. It allows governments to focus on their core business, which frees up public funds and speeds response and recovery efforts.

3. It allocates reconstruction dollars to properties and businesses that are deemed worthy in that they were valuable enough to insure
in the first place.

4. It quickly channels funds to the affected parties, which limits supply chain interruptions and leads to faster reconstruction and the resumption of economic activity.

The research into the relationship between insurance take-up and the macroeconomic impact of disasters is just beginning. However, what is currently available confirms that insurance minimizes costs of natural disasters.

A comprehensive study from the Bank for International Settlements looked at almost 2,500 major natural disasters between 1960 and 2011 in more than 200 jurisdictions.

It showed that the impact of natural disasters is smaller in countries with high levels of insurance take-up.

Study authors found that macroeconomic costs of disasters increase as a result of uninsured losses, while insured losses have little impact – even when controlling for differences in the economic development of countries.

The study also demonstrated insured losses increase growth most strongly in the three years following a catastrophe, which is the average length of time for insurance payouts. This suggests that insurance speeds reconstruction efforts.

Reducing the macroeconomic cost of disasters also improves government balance sheets. Immediately after a disaster, governments spend less on reconstruction and relief. And in the medium term, government tax revenues bounce back more swiftly because of faster recovery.

A 2011 study by the World Bank notes countries with lower insurance take-up suffer larger drops in GDP and larger deficit increases than countries with higher insurance take-up.

The researchers concluded “the availability of insurance seems to dampen the impact of disasters by taking some of the losses and helping the government to focus fiscal expenses on the remaining un-hedged risks.”

The global risk landscape is evolving. As severe weather increases and populations and economies cluster, the cost of natural disasters will rise. In light of these trends, policy-makers must re-evaluate how they mitigate the financial impact of disasters.

No country can escape the new normal of more frequent and damaging natural catastrophes. As we saw with the recent floods in Southern Alberta and Toronto – which added about $2 billion to the federal deficit – these trends are already hurting Canadians.

Canada should consider the demonstrated benefits of insurance as the country faces the coming storms.