Indeed, insurance is a tool used to help buffer financial shocks. It provides needed funds to governments, businesses, and individuals after they have suffered losses. By paying a small amount every year, when disaster strikes, those with insurance can receive payments when they need it the most. Insurance is a key safety net and an enabler of continued business and consumer activity.
The challenge today, however, is that most insurance is not designed to help in a global pandemic. There are no physical losses, which typically determine when payouts are made and how much the insured receives. The impacts are international and insurance is simply not designed for systemic risks. Even if a modest share of the businesses and individuals that are suffering financial harm around the world were insured for this risk, the total claims could still bankrupt insurance companies.
That is not to say, though, that risk transfer cannot be useful in a global pandemic. These products will just need to be properly designed and supported by complementary public sector programs. While insurance typically provides financial assistance in response to a damaging event, innovative risk transfer solutions are now starting to be used to actually prevent a disaster or to halt cascading impacts in the economy.
These are often called parametric products. They provide payment, not based on total damage, but on the physical measures of the disaster. A parametric hurricane product might pay when wind speeds hit a certain level in a certain location. Parametric policies can be cheaper and be paid rapidly, since they do not require the time consuming and expensive loss adjusting. They are also quite flexible in design. However, the downside is that actual losses could be more or less than the amount paid.
The World Bank turned to parametric risk transfer in 2017 in the form of a catastrophe bond, which transfers risk into the financial markets. If it is triggered, then it would help provide funds to lower income countries to cover response costs. Prior pandemics have shown that government aid can be slow to arrive. The hope is that payouts from parametric products could arrive faster and help limit spread of the disease.
But critics have argued that the bond profited investors while failing to payout when needed. This bond should trigger for the coronavirus since the mortality triggers have been met, but there is an additional trigger that at least 12 weeks have passed since the World Health Organization reported the start of the epidemic. This will not happen until the end of this month. Bonds could be designed to pay faster or for smaller events, but this of course would also make them more expensive.
Parametric products could also be designed to slow cascading impacts if businesses lose revenue and therefore cannot buy from suppliers, sell to customers, or pay employees. This impacts entire supply chains. Families with out of work members can be forced to make hard financial trade offs. There are business interruption policies, but most are not designed to pay when there is no physical loss and many have such specific exclusions for infectious disease. So while there are innovative options, the challenges for using risk transfer for a global pandemic are multiple.
First, risk transfer in this case is not cheap. The more comprehensive the coverage, or the more likely it is to provide payment, the more expensive it will be. Many small businesses and poorer countries, the ones most in need of assistance to weather a shaky economy, will find they are not able to afford the protection. For catastrophe bonds, investors see they can be triggered for payment at the same time the overall markets are declining. This correlation may make investors shy away from the bonds completely or demand higher returns, meaning higher prices for issuers.
Second, research has shown that people tend to ignore risks when not confronted with an immediate disaster. When pandemics are not news, insurance purchases are unlikely. Insurance also has to be purchased in advance. Finally, the scale of what we are experiencing can stress all risk transfer markets. Systemic risk cannot be held by the private sector alone. We need a smart public private approach to financing that can mobilize resources and deploy them where they are most needed.
The United States could consider a federal program that gives business interruption insurance to small businesses, drawing lessons from such programs as our terrorism risk and insurance program or unemployment insurance. Such a program could be both privately and publicly funded, to assist those small businesses most in need, and provide immediate liquidity to lessen the impacts and stop a downward spiral.
Risk transfer solutions are best for more localized disasters. The scale of this crisis is now causing a downturn that requires a substantial stimulus, a necessary response beyond insurance payouts. Managing a pandemic will always impose costs to society. With thoughtful financial planning, however, we can design systems that protect our most vulnerable, while also limiting contagion in the economy and of the disease.
Carolyn Kousky is the executive director of the Wharton Risk Management and Decision Processes Center located at the University of Pennsylvania.