This post is the latest in our special issue: “Climate Change and Financial Markets – Risk, Regulation, and Innovation.” To learn more about the special issue and the work of the Global Financial Markets Center around climate change and financial markets, please read the special issue’s introduction here. And to review all The FinReg Blog posts that touch on climate change, go here.
Small island developing states such as those in the Caribbean face a world of pain in the wake of COVID-19. In the islands in the Eastern Caribbean Currency Union (ECCU), which include Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, Saint Kitts and Nevis, Saint Lucia, and Saint Vincent and the Grenadines, the health impacts so far have been limited, with the World Health Organization reporting 186 total cases and three deaths as of July 12, 2020.
For these tourism dependent economies however, the economic effects will be widespread and long-lasting. A recovery that focuses on effective risk management, sustainability, blue and green investments, and “building back better” could provide the chance to generate economic growth while at the same time addressing the impacts of climate change.
In the face of the twin challenges of pandemic and climate change, an essential approach for effective risk management and financial stability is for individuals and small businesses to make greater use of insurance as a tool for micro-level risk management. Insurance can also deliver benefits at the macro-level by protecting against declines in remittances, and by helping businesses and households to better manage climate risk, thus fostering the economic growth necessary to attract investment.
Prior to COVID, economies in the ECCU were expected to experience lower growth rates relative to other emerging market economies. Pre-COVID GDP growth for 2020 in the ECCU was expected to be 3.3%, compared with growth of 4.4% for the broader emerging market and developing economy group, according to the IMF. Lower growth rates across the world and COVID-caused disruptions to local tourism will mean that attracting the necessary investments for growth will remain a challenge.
The impact of COVID on these economies has been severe. Small island states in the Caribbean comprise 10 of the 20 most tourism dependent economies in the world. As a result, member states in the ECCU are expected to see declines in GDP of between 10% and 16%. Growth in the Caribbean region, excluding Guyana, is expected to contract by 3.1%. In addition to lost tourism revenue, remittances to the Latin American and Caribbean (LAC) region are expected to fall by 19.3% over 2019 levels. Compounding these challenges, 2020 foreign direct investment (FDI) in low and middle income countries is expected to decline by over 35%.
Remittances are an essential component of emerging economies, providing funds from migrant workers abroad and helping to sustain consumption and government taxation revenues in their home countries. Remittances primarily drive spending on personal consumption, and some economists believe that as a result, this boosts imports at the expense of domestic manufacturing.
Remittances tend to be counter-cyclical; that is, they represent funds from migrant workers abroad sent to provide support to their home countries during times of economic shock. However, in the case of COVID, the shock has been global, affecting migrant workers abroad at the same time that economies in their home countries were decimated by COVID lockdowns. This has meant that vulnerable communities have seen a critical source of funds dry up just at the time that they are needed the most.
Historically, climate events that affected the Caribbean region have been localized, and therefore counter-cyclical relative to migrant workers abroad. However, as the negative effects of climate change accelerate and intensify, there is increasing likelihood that extreme weather events will result in simultaneous disruptions which could affect multiple parts of the world at once. This could mean disruptions to remittance flows like those that have been experienced in the wake of COVID.
According to an August 2019 study in the FT and based on reporting from the World Bank, remittances overtook FDI in 2019 as the largest source of capital inflows for emerging economies, well ahead of private capital flows and aid. But while remittances primarily drive spending on personal consumption, FDI tends to drive capital investments in businesses. The displacement of business investment by consumption-driven spending, lower regional growth rates relative to other emerging economies, increased risks from climate change, and declines in FDI as a result of COVID means the region faces many obstacles to attracting the investment necessary for growth.
Insurance as a Critical Tool
Households and small businesses in high-risk areas like the Caribbean must have effective risk management tools to prepare for the impacts of climate change—tools that are not solely dependent on remittances and that foster and encourage economic growth and investment. This means that there must be affordable insurance options that protect homes, livelihoods, and assets, and provide ready access to cash in the aftermath of a climate event.
In addition to functioning as a critical tool for micro-level risk management, insurance provides significant macro-level benefits as well. According to the authors of the book “The Economics, Regulation, and Systemic Risk of Insurance Markets” (Oxford University Press, 2016), there is ample evidence of a correlation between insurance penetration and GDP growth. A survey of seventy-seven advanced and emerging economies for the years 1994 – 2005 found that a 1% increase in total insurance penetration led to a 4.8% increase in economic growth per year.
The book’s authors note that insurance provides a wide array of macroeconomic benefits. Insurance lowers businesses aversion to risk, allowing managers to make decisions like hiring new workers, investing in new technologies, or building a new factory or warehouse. Insurance also can reduce precautionary savings that cause businesses to divert revenues into savings and away from investments that can create growth. And perhaps most importantly in the context of climate change and natural disasters, insurance acts as an economic stabilizer supporting consumer spending, protecting government revenues, and preventing disruptions to financial services in the wake of a climate event.
In spite of these benefits, the protection gap persists in the Caribbean region and emerging markets more broadly. According to S&P Global Market Intelligence, “the catastrophe risk coverage level is 35% in advanced economies versus 6% in emerging economies — but they are far more pronounced in emerging economies.” S&P quotes Wynne Lawrence, a senior associate at London-based law firm Clyde & Co as saying that emerging economies “are most vulnerable to climate change and the most at risk of having the development gains that have been hard won be lost because of extreme weather events.”
The IFC indicates that insurance is still a nascent risk management tool in emerging markets, accounting for only about 16% of the global insurance market. In order for households and businesses in places like the Caribbean to increase their adoption of insurance as a risk management tool, there will need to be greater education on the part of consumers, innovations that help manage climate risk while also lowering premiums, greater transparency and trust in insurers, and changes in the regulatory framework to protect consumers and foster innovations.
Some of these alternatives are starting to emerge in innovations such as microinsurance, which provides coverage to low-income households in emerging markets and can provide protection for lower value assets. As the IFC notes, cellular and digital technologies are making it possible to deliver a wider range of insurance products to more countries in emerging markets at a lower cost. Other innovations such as parametric insurance, which pays out based on the occurrence of a triggering event, can provide an effective way of managing specifically targeted risks. Innovations in financial technology such as mobile payment platforms and blockchain are also being used to reduce costs and disintermediate traditional market players.
Taken together, these innovations have the opportunity to provide affordable risk management solutions to vulnerable households and small businesses and provide them the financial resources to recover from climate events more quickly. Given the challenges posed to the livelihoods of communities in the Caribbean region specifically, and emerging markets more broadly, by lower growth rates, COVID, and climate change, innovations in insurance are essential. Innovations in risk management and wider adoption of insurance will deliver benefits to households and businesses directly, and to the economies of the region more broadly, by allowing economic activity to return to normal more quickly and attracting much needed investment for growth.
Brent Barnette, Duke MBA 2002, is the Economic Development Director for the Climate Resilience Execution Agency for Dominica.