Humanitarian Insurance: Risk Transfer 101
by Conor Meenan, Lead Risk Finance Specialist
Humanitarian organisations are taking a fresh look at how they pay for crises. Alongside tried and trusted approaches such as fundraising appeals and budget reallocation, humanitarian actors are seeking to better anticipate tomorrow’s crises, and prearrange funds to pay for responses that are still yet to happen.
There are strong practical and moral arguments for getting ahead of the next crisis. The evidence to support this approach is still relatively young, but there are promising examples of where anticipatory financing approaches have the potential to provide better and more dignified outcomes for crisis-affected people.
There are different ways to pre-arrange money to meet the costs associated with responding to future crises. Contingency funds such as the Central Emergency Response Fund (CERF), and the Disaster Relief Emergency Fund (DREF) are examples of ‘risk retention’ mechanisms. Risk retention is an easily explained concept - money is set aside for a rainy day. The picture starts to become a little more clouded when conversation turns to risk transfer.
While the concept of risk transfer dates back at least as far as the Babylonians, its application in a humanitarian context is still novel. Humanitarian organisations are increasingly experimenting in the design, purchase, and implementation of insurance-like instruments[1]. However, the question ‘what benefit does risk transfer offer to humanitarians’ is unlikely to be met with consensus across the sector.
This is the first in a series of three blogs which sets out to explore the role for risk transfer instruments - such as insurance - in a humanitarian context:
Firstly, we will cover off the basics: What do we mean by risk transfer, why and how it may be useful, and what problem might it solve for humanitarians?
The second blog will seek to address some of the “elephants in the room” and outline the key tensions that humanitarian organisations planning to use risk transfer will need to navigate.
Lastly, we recognise that using risk transfer to pre-arrange funds ahead of crises is a new way of working for many in the humanitarian sector, and organisations are still in the early stages of learning how best to approach this task. With that in mind, we’ll present a simple approach to help those actors who are new to the concept identify if pursuing insurance mechanisms is indeed a sensible option for them to consider. And if so, how they can get the most from it.
Risk transfer 101
Risk transfer is way of proactively managing costs associated with uncertain future events, in which financial responsibility is passed from one entity to another, usually in exchange for a fee (called a ‘premium’).
The most common example of a risk transfer instrument is an insurance policy. An insurance policy is a contract between a policy holder and an insurer (the buyer and seller, respectively). This contract outlines the circumstances under which an insurer will make an insurance payout to the policy holder. If the policy holder suffers the losses described in the insurance arrangement, then the insurer makes a payment to the policy holder to cover the costs. If no losses are experienced by the policy holder, then the only money that changes hands is the premium paid to the insurer at the start of the policy, which is paid regardless of whether there is a loss or not.
From a financial management perspective, risk transfer is simply a tool that allows an entity to control the size and timing of costs they expect to be on the hook for in the future. Risk transfer doesn’t change the frequency or severity of future crises, but it can allow risk holders to transform unpredictable and potentially unmanageable future costs for responding to these events, into a predictable and more manageable annual fee.
What is the value of risk transfer?
The value of risk transfer can be hard to pin down at the best of times.
Why would anyone choose to spend money on something that might not actually happen, when they could spend it on things they need today? The question is amplified when applied to humanitarian actors - how can donors or organisations justify spending finite donations on premiums, when existing humanitarian needs go unmet due to underfunded appeals?
The value proposition for using risk transfer falls broadly into two categories:
Cost Efficiency. It can be more cost efficient to purchase insurance to cover large unpredictable costs that don’t occur very often, than to hold funds back in a reserve, where there is a possibility that these reserve funds go unused. Humanitarian donors and organisations tend not to hold funds in reserve for extended periods and are left with the options to fundraise (which is often slow and unpredictable) or face tough choices in re-allocating existing funds across crises. The impacts on crisis-affected people who are the losers in this funding game are of course terrible. There can be significant cost inefficiencies in shuttering programmes, cancelling contracts, and laying off staff. Financing which is arranged in advance has the potential to arrive earlier, which in principle could deliver both better humanitarian outcomes and cost savings.
Operational Effectiveness. When compared to responsive funding models like fundraising appeals, pre-arranged funding models can provide greater confidence around the level of available funds for future crises, as well as discipline around who is responsible for responding and how. This clarity creates space to make credible, pre-funded, response plans before a crisis emerges, in a way that responsive funding models do not.
The other side of the cost-benefit coin
It is also important to recognise the limitations and challenges of using risk transfer to support humanitarian costs…
Risk transfer is not money for nothing. When describing the value of insurance, specialists often refer to technical terms like ‘leverage’ to discuss how small premium costs give access to much larger amounts of funds in times of need. This is true and is a part of why risk transfer can be a useful tool (relating to the cost efficiency point above). But… the buyer pays for this benefit - risk transfer is certainly not money for nothing, it’s just a way of changing how and when you pay for possible future costs. The premium cost of insurance is calculated so that on average, across thousands of years, the insurance buyer will most likely spend as much or more money in premiums than they receive in payouts. How much more is a combination of uncertainty, an insurers costs and profit margins, and actual real world events. Depending on how a policy is structured, since payouts are based on the occurrence of a crisis-level event, not only might premium payments exceed payouts, but it is also often more likely that there will be no payouts at all during the term of the policy.
Payouts won’t always align with funding needs. In an ideal world an insurance payout would match up perfectly to the funds needed to pay for the humanitarian response. Trigger structures can be tested and refined, but, especially where costs are ambiguous and payments are made based on parametric triggers, there is a possibility that payouts do not reflect the scale of costs experienced on the ground. This possibility needs to be recognised and planned for.
Risk transfer is a ‘new’ financing model for humanitarian actors. In principle, risk transfer mechanisms can offer considerable benefits to humanitarian responses. But putting these theories into practice does not come without friction. Using specialist financial tools, and working with new partners in the design and purchase of risk transfer, such as insurance, can result in teething challenges, for humanitarian actors and insurance providers alike. Implementing funds from risk transfer alongside existing funding approaches requires people to step outside of their usual roles, and legal, finance, and procurement departments will need to consider novel issues. Getting the best out of new financing approaches like risk transfer, requires humanitarian actors themselves to work a little differently.
When does purchasing risk transfer make sense?
Risk transfer is a specialised tool. It shouldn’t be the first choice across all costs related to humanitarian response. But it does offer an option as part of a financial planning toolkit.
At both the strategic and project level, considering whether risk transfer is a good fit comes down to defining what risk transfer offers to the delivery of better humanitarian outcomes that other financing models do not. And whether the fee paid to insurers is worth this benefit.
We will explore the challenges faced by humanitarian actors as they ask this question and propose some guidance for organisations though the next two blogs in our series.
Read part 2 now: Humanitarian Insurance: Ethical tightropes, trade-offs and unintended consequences
Read part 3 now: Humanitarian Insurance: Weighing the Options
[1] Although the term ‘insurance’ is often used as shorthand for risk transfer, insurance policies are in fact a specific subset of risk transfer instruments. While the risk transfer instruments available to humanitarian organisations can reasonably be called ‘insurance-like’, it is not strictly correct to call them insurance. However, for the sake of ease of reading in this series we will use the terms ‘insurance’, ‘insurance policy’, ‘risk transfer’, and ‘risk transfer instruments’ interchangeably. Note also that risk transfer instruments are themselves a subset of risk financing instruments (which are also confusingly referred to as any combination of [pre-arranged/ pre-agreed/ pre-positioned/ event-based/ triggered/ contingent] – [funding/ finance/ financing] – [instruments/tools/ mechanisms/ arrangements]), which also expand to cover risk retention instruments such as contingent loans. This series focuses explicitly on the role for risk transfer – i.e. those instruments that facilitate the transfer of risk from one entity to another.