Disasters caused by natural hazards and climate change increasingly threaten Asia’s most disadvantaged with debilitating economic impacts. To cope, people turn to savings and small loans from microfinance institutions (MFIs) to help absorb the short-term economic shocks. Financial assistance from families, communities, non-government organisations and local governments also helps.
Yet, disasters frequently hurt the same MFIs that these low-income households rely on, as borrowers struggle to repay their loans. A credit crunch, too, often ensues just as vulnerable households and communities need help.
The proactive use of financial products, including insurance, can change this dynamic and allow individuals and MFIs to prepare better by protecting losses of assets, livestock and crops, from low and moderate frequency events. It can help pay off loans on death or disablement of key family members or cover loan payments due to hospitalisation.
A suite of financial products can give MFIs and individuals a ‘leg up’, enabling finance when needed most. Broadly, these include disaster reserve funds, portfolio insurance, disaster insurance funds and microinsurance.
Credit squeeze – a vicious circle
However, for now, households and micro, small and medium enterprises (MSMEs) have limited insurance coverage in the form of credit life insurance. Such insurance effectively cancels death-related debts and relieves surviving family members of part of that financial burden. For most MFIs, such insurance lowers loan default rates and collection costs and is the least expensive for borrowers, who rarely have insurance for the loss of income, assets and healthcare shocks or needs.
As a result, as disasters hit, MFI balance sheets can suffer. These institutions often do not maintain adequate liquidity reserves to sustain operations with cash inflows suddenly stopping when clients stop depositing savings – or, indeed, withdraw their savings altogether. Micro borrowers also opt to reduce loan repayments to the minimum required and request additional loans in most cases. MFIs may also suffer a significant medium-term loss of capital when a large number of clients default on loans.
Notably, while group-lending methodologies can ensure high repayment rates under normal conditions, they can also magnify capital losses amid economic distress. Further, MFIs incur higher administrative costs from loan restructuring, and exercising rights on collateral, to name a few.
Since MFIs are not adequately protected, it reduces their net income, and net losses on the income statement translate into equity losses on the balance sheet. Funders, overwhelmed by liquidity requirements, reduce credit supply to them. The demand for loans surges after disasters as clients strive to rebuild livelihoods. Yet, MFIs can do little but reduce lending after that very same disaster, as credit supply contracts amid a perceived increase in credit risk and impaired balance sheets.
Poverty and vulnerability are intertwined. Low-income populations have fewer resources to cope with climate risk. Thus, their resource base is diminished with every extreme weather event, deepening their poverty. Ensuring MFIs access to insurance against disasters can provide effective means for transferring this risk and greater credit supply to restore livelihoods quickly.
Market failure follows due to inadequate insurance coverage and this mismatch of demand and supply of credit.
With reliable access to liquidity and capital after a catastrophe, by contrast, MFIs can actively participate in recovery by rapidly restructuring existing loans and deploying new loans into affected communities that support the rebuilding of livelihoods.
Disaster reserve funds
To ensure adequate liquidity after a climate hazard, some MFIs have established disaster reserve funds. They provide emergency liquidity which helps in repairing balance sheets and fund client support, such as through grace periods and by absorbing modest credit losses.
Clients can quickly re-establish income streams, get funds for medicines, food, and temporary housing, and MFIs can reduce the risks of delinquent clients and loan loss reserves.
Large MFIs typically have access to dedicated disaster recovery reserve funds that they have created by setting aside a fixed percentage of total income. Other MFIs directly factor the contributions into the clients’ borrowing costs: either through a fee, a set-aside of a percent of the loan amount, or a higher interest rate. These funds can be owned by a single MFI or shared by various MFIs.
These disaster reserves, however, are useful for mitigating losses arising out of idiosyncratic risks and may not respond well to large-scale catastrophes’ adverse impacts. Natural catastrophes produce covariant risk by their very nature and, without linking to insurance, such funds sooner or later become unsustainable.
Portfolio insurance
MFIs with significant portfolios of loans exposed to climate risks can purchase loan portfolio insurance at the institutional level to protect against loan default after disasters.
Insurance pay out protects the MFI’s capital base, and puts it in a stronger position to lend after the disaster – an essential objective for policymakers. It also improves an MFI’s financial performance, expands financial services, lowers interest rates and reduces credit access volatility. By putting the onus on MFIs to conduct due diligence in demonstrating risk reduction, it also helps in improving the resilience of the MFIs.
Disaster insurance fund
By combining climate science, financial modelling, portfolio insurance, disaster funds and fintech, a disaster insurance fund is another response mechanism that can meet the MFIs and their clients’ needs. It can have two components.
A risk-sharing layer for moderate frequency events. Aggregating a network of geographically dispersed MFIs based on their risk similarities can reduce portfolio vulnerability if climate hazards in different locations are not related. This is akin to risk-sharing using an insurance pool and based on mutuality principles. Such arrangements can make insurance more affordable due to lower transaction costs and eliminate profit-seeking behaviour.
A risk transfer layer for infrequent and high impact events. Linking such risk-sharing pools through insurance and reinsurance to protect the MFIs’ portfolios from large claims. This can ensure that covariate risk is appropriately assessed and mitigated in communities regarded as too risky.
The risk-sharing layer can comprise portfolio-level insurance that protects the participating MFI against a pre-defined number (quantity/ amount) of delayed and/ or restructured loans exceeding a particular portion of the portfolio for moderate frequency events. The disaster insurance fund can charge a premium contribution by MFIs linked to a statistical distribution model capable of measuring the effect of poorly performing loans based on the frequency and intensity of an insured peril. MFIs located in high-risk locations will pay a little more, others much less. Assessing risk based on the claims experience of small pools of policyholders that know and presumably trust each other can also help extend protection by transferring the covariate risks via reinsurance.
Among the benefits of such an arrangement is the coverage against business interruptions and increased costs that a traditional insurance structure would not typically cover. By blending elements of risk sharing and risk transfer, the potential cost of insurance to the borrower would be within affordable limits, and will not hurt the MFI’s bottom line.
Government as part of the solution
While insurers can bring their risk management expertise and strong capital base, the government has a role in helping MFIs better match demand with the supply of credit after a disaster. This can be done by putting enabling policy and regulations in place, capitalising disaster insurance funds to remove the market-failure problems and incentivising the introduction of innovative financial products. Government guarantees, subsidies and fiscal incentives can also help make insurance affordable and accessible.
Financial regulators need a coordinated approach to establish standards for carrying out initial screening and qualification of participating MFIs, and coming up with prudent underwriting criteria and insurance coverage requirements of eligible loans. Increasing awareness will help in instilling public trust.
A public-private partnership between government, MFIs, insurers and fintech players is desirable to ensure a disaster insurance fund’s sustainability. Such a fund should include mandatory participation, risk-based premiums, and encourage risk-mitigation activities and the use of risk transfer mechanisms. With their structuring know-how, networks, and access to concessional funding, multilateral development banks can assist.
Microinsurance
So, the disaster insurance fund will take care of the credit requirements of MFI borrowers primarily related to immediate working capital. Meanwhile, local insurance players, through appropriately designed microinsurance products, can ensure additional financial protection against losses or damages to productive assets, in addition to taking care of expenses arising out of health, disability and death.
Because they can ensure rapid, cost-effective financial compensation to finance recovery, microinsurance can protect MSMEs, farmers, herders and fishers from financial losses. When explicitly tied to loans (for example, households agreeing to pay off outstanding loans with an insurance indemnity), it can also reduce default rates and provide some protection to MFI clients.
With reliable access to liquidity and capital after a catastrophe, MFIs can actively participate in recovery by rapidly restructuring existing loans and deploying new loans into affected communities that support the rebuilding of livelihoods.
It can also help governments make the poor and vulnerable, more resilient to disaster by immediately applying insurance principles and tools to complement social protection programmes. Such insurance policies can also serve as conditional loan collateral. Banks no longer run the risk from disaster losses within their portfolios and, therefore, should be willing to offer loans to such clients. As distributors of insurance products, it will also open avenues for additional fee income.
A path for the future
New risk-sharing and transfer instruments can create beneficial diversification and potentially promote liquidity. As long as MFIs face the same demands for depositors’ liquidity, credit risk transfer between banking and insurance will be advantageous because the two sectors would still hold different assets. However, if correlations increase, the benefits of diversification decrease, signalling increased tail risk co-movements between asset classes that can trigger contagion.
Poverty and vulnerability are intertwined. Low-income populations have fewer resources to cope with climate risk. Thus, their resource base is diminished with every extreme weather event, deepening their poverty. Ensuring MFIs access to insurance against disasters can provide effective means for transferring this risk and greater credit supply to restore livelihoods quickly.
Arup Chatterjee
Arup Chatterjee is Principal Financial Sector Specialist, Sustainable Development and Climate Change Department, Asian Development Bank. His current work involves financial, governance, risk management, and regulatory reforms across different industries. He has held stints with the Bank for International Settlements in Switzerland, and Insurance Regulatory and Development Authority of India.
