For years, scientists have been raising alarms about climate change, and the general population has come to understand the need to reduce emissions in order to stop climate change. However, there has been little discourse regarding the possibility that we will likely fail to stop it in time, and that contingency plans are needed to prepare for the inevitable destruction.
While the world’s leaders gather every few years to discuss climate change and then come forth with a vague statement saying that they pledge to reduce emissions in the next few decades, the tipping point is already nearing. Carbon dioxide concentrations in the atmosphere are at the highest they have been in 4 million years. Within 30 years, the Sonoran Desert in California lost 37% of its vegetation. An iceberg twenty times larger than Manhattan broke off from the Brunt Ice Shelf in February 2021, and a study published in Nature has suggested that between 50% and 70% of Antarctica’s ice shelves are at risk of collapsing. A meta-analysis of hundreds of studies showed that approximately 70% of more than 400 studied extreme weather events were made more severe or likely by human-caused climate change, with 92% of the studies on heat waves finding that human causes had made them more probable to occur and of greater severity. Whether it be the increased intensity of hurricanes in the Caribbean, or human-attributed flooding risk in Bangladesh, it is clear that the effects of climate change are already being felt quite severely, with the death toll mounting.
One type of extreme weather event which doesn’t seem to get as much attention in popular discourse is drought. This type of disaster is one of the most catastrophic types of extreme weather events, which can cause both widespread starvation and death. When crops fail and water reserves dry up, a ripple effect can bring a society to its knees, and is arguably more dangerous than hurricanes or flooding. For example, 4 droughts between the years 2000 and 2010 ravaged Northern Africa, wiping out nearly 85% of total herd stock in many regions. Even highly developed countries such as the USA lose between $6 billion and $8 billion a year from drought, primarily in the country’s southwest. Mapping out drought risk involves a mathematical calculation, which consists of multiplying hazard (probability of drought occurrence) by exposure (population and crops at risk) by vulnerability (how prepared a region is against drought). Not so surprisingly, India ends up being at most risk of drought out of all of the world’s major countries, primarily due to exposure factors such as high population density and lots of land under cultivation. This risk has already manifested itself in the country: India has been hit by drought at least once every 3 years for the past 50 years, and just the past 10 years have seen 350 million Indians affected by drought with $149 billion in cumulative economic damage.
With a population highly involved in agriculture and inhabiting a tropical latitude, rising temperatures and drought have already been wreaking havoc across India. Climate change will increase the frequency and severity of drought and cause disasters such as crop failure and water shortages, with the onus falling upon the Indian government and insurance industry when the next megadrought ravages the country.
To hedge themselves against the risk of systemic failure as droughts get more severe moving forth, Indian institutions must look beyond traditional methods of risk management, and instead tap the global capital markets to protect themselves in the form of catastrophe bonds.
The Drought Situation in India
The issue of drought is very touchy for many Indians. Despite making up only 13% of India’s GDP, the agricultural sector employs 60% of the population. However, the farming industry has been affected by farmer suicides, with a farmer committing suicide every hour on average. In the state of Punjab, farmer suicides have increased a staggering tenfold in only five years, with crop failures being a major reason. If a major drought destroys crops, 90% of farmers have been estimated to not have enough capital to start all over again, putting them in a very precarious position.
The entire country as a whole is very vulnerable to drought. The worst drought in 150 years hit India from 2015-2018, resulting in moisture deficits of 50% - 90% in many areas.
Entire villages in regions such as Bundelkhand were abandoned, with climate refugees piling into cities like Delhi, and drinking water across the country was threatened by aquifers drying up. The massive city of Chennai nearly ran out of water, causing widespread panic, and power plants were shutting down due to low water reservoirs. The drought problem in India will only continue to get worse, as global temperatures continue to rise, and weather patterns change. The monsoon season has traditionally brought plenty of rainfall in Southern India, where agriculture is still largely rainfed, unlike the more irrigated north. With monsoon patterns now changing, the Indian south faces the devastating possibility of no longer receiving the rains needed to grow their crops, which would put India’s food security in a very dangerous position.
The Crop Insurance Scheme
Crop insurance has existed in India for decades; however, it was overhauled in 2016 to make it more standardized. The principle behind crop insurance is simple: the insurer promises to pay up to a certain amount of money to compensate farmers for any damage to their crops from drought, and in return, farmers pay the insurance company a premium, which is usually set at a certain percentage of the assured amount. Currently, the premium rate paid by farmers ranges from 1.5% to 5%. However, the government subsidizes 80% of the total premium paid to insurance companies, meaning that the real premium Indian insurers receive is 7.5% to 25%. Insurance penetration in India, as of 2019, was only 3.76%, while the global average during the same time period was 7.23%, with the American figure being 11.43%.
With the insurance market being relatively small compared to population, there is less competition in the market, meaning premiums remain relatively high when compared to risk. To understand premium pricing, it is important to understand the idea of expected value. Take the example of a consumer who wants to insure themselves against their house being burned down over the next 10 years, for a total value of $1,000,000. Assuming the risk of the house burning down is 1% every year, the expected loss that the insurance company faces from a purely mathematical standpoint is 1% of $1,000,000, which comes out at $10,000 a year. Although the insurance company would payout in a binary fashion (either pays out nothing, or pays out $1,000,000 in a single year), distributing expected payout continuously informs the company that to break even from a probability standpoint, it needs to charge a yearly premium of $10,000 a year. Of course, as a profit-making enterprise, the insurance company will actually price the premium higher, but as competition in the industry increases, these companies will ostensibly decrease premiums to approach the expected loss value. While the actual insurance industry functions in a far more complex manner, this simplified model shows what is wrong with the Indian insurance industry - there simply isn’t enough capital. Currently, public sector insurers, such as the Agricultural Insurance Company of India which commands a 30% market share, have been making losses overall, since they pay out more in claims than they receive in premiums. Meanwhile, private sector insurers like Bajaj Allianz and ICICI Lombard have been making hefty profits, in part due to high premiums.
Increased Systemic Risk
Despite insurance companies promising to pay out claims to farmers in case of crop failures, there is no full assurance that the system will work as intended in the case of a string of particularly severe droughts. First, expenditures in the case of drought disasters will go beyond simply crops. If water reservoirs dry up and hydro dams slow down power generation as they did a few years ago, the government will be on the hook to spend money to keep everything working as intended. If the aquifers dry up as they also did on multiple occasions, the government will have to spend lots of money to ensure emergency water supplies reach the cities, and that there is a secure supply of water to hundreds of millions of people. Additionally, the crop insurance scheme doesn’t actually cover all farmers, with around 50% to 60% still uninsured. Already handling a large budget deficit of around 320 billion dollars, the government would be very cash strapped in the case of a severe drought, and this could be disastrous for the population of the country.
Similarly, insurance companies are not infallible in the case of a massive disaster either. When insurers receive premiums every year, they invest them in a series of yield investments, such as bonds and stocks. In fact, most insurers in Western countries like Canada only make a profit thanks to their investments - intense competition has eroded premiums to the point that these insurers pay out more in claims than they earn in premiums every year. If claims are extraordinarily high in a given year, insurers will have to liquidate mass holdings of securities to pay off claims. However, in a scenario where the situation is this bad, the markets will likely have already tanked, with government paper and public securities trading at significant discounts, meaning that insurers might not be able to pay the farmers. As previously mentioned, 90% of farmers don’t have the capital to rebuild their farms, meaning the country would be on literal life support from imports of food, as local food production would grind to a halt.
A scenario like this is not unthinkable. Leading up to 2008, investments in mortgage-backed bonds, which offered strong yields and theoretically had low risk of default, were booming. However, many institutions essentially bought insurance on these bonds in case of default, through instruments called credit default swaps. Many insurers, such as AIG, were earning premiums from these swap contracts, never expecting that a huge crash was imminent. However, when the market went belly-up and the insurers were left holding the bag, mass liquidations of assets began, tanking the markets in a self-destructive feedback loop and causing solvency issues with major banks and insurance companies. At the end, the US government had to use taxpayer money to bail out these institutions.
In the case of a drought disaster, the Indian government would hardly have the money to bail out the insurance companies, which could lead to a major economic collapse deadlier than the Great Financial Crisis of 2008.
It becomes clear that to reduce systemic risk, some of this risk must essentially be transferred to international players who wouldn’t face the same meltdown as local institutions like insurers and the Indian government.
Securitization is one of the most important innovations in the history of the financial markets. Essentially, certain assets are turned into securities that can be easily traded, like stocks or bonds. Take the example of a house - by creating a company with several shares issued, and then buying the house with this corporation, it essentially becomes possible to buy shares in houses. Another example is the aforementioned mortgage backed security. Banks would lend a certain amount to homebuyers in return for promised monthly payments. To reduce their own risk, banks would then issue bonds to investors that were backed by these same monthly payments; in essence, the bank would get their money back plus some profit, and the buyers of the bond would be given the mortgage payments.
Securitization plays a large role in the insurance market as well - one such innovation is the catastrophe bond. Essentially, insurance companies realized that they had taken on too much risk when it came to insuring against natural disasters after Hurricane Andrew in 1999, where dozens of Florida insurers went bankrupt. To reduce this risk, they offered investors the catastrophe bond, where buyers of the bond essentially deposit some money in a Special Purpose Vehicle (SPV), and they are paid interest on this principal by the insurance company in the form of premiums earned from customers. If the insurer has to pay out a large amount of claims due to a certain natural disaster, they draw upon this principle to do so. Essentially, the buyers of these catastrophe bonds are indirectly insuring individuals and companies, thus decreasing the liability of insurers.
Reducing Risk through Catastrophe Bonds
Indian institutions can help hedge themselves against systemic failure through the issuance of catastrophe bonds. By tapping the global capital markets, which are far larger than the global insurance industry, both insurers and the government can have access to more competitively priced insurance for themselves, which ensures that in the case of a particularly devastating drought, they will be able to access the capital put up as collateral by these investors. In turn, premium rates for farmers will also become more affordable due to the hedging of risk. Around 88% of total catastrophe bonds have yields of under 10%, which simply underscores how much more affordable they are than current crop insurance premiums of 7.5% to 25% in India.
In addition to being affordable for the insured, purchasers of these bonds enjoy coupons higher than calculated expected losses, with these spreads being an average of 3.34%.
In addition to more competitive pricing, the use of catastrophe bonds also reduces the risk of failure to pay to almost zero. Unlike insurance companies, which only promise to pay out claims, a catastrophe bond means that money is already put into a secure SPV. As such, while insurance companies may go bankrupt and not have enough money to pay claimants, the buyers of catastrophe bonds have already put the insured amount into SPVs, so claimants have near-certainty that they will get their money back.
With climate change already a reality across the world, it is absolutely crucial that nations begin to develop contingency plans for how to deal with this risk. While the regular citizens of India, such as farmers, have been assured that insurance companies and the government will step in to help during disasters of epic proportions, there is the potential that these institutions that promise to pay out to regular citizens may themselves face solvency issues. In a very internal economic system like India, systemic risk is amplified, as every institution is dependent on each other, which could lead to a domino effect rippling throughout the country. A megadrought large enough to nearly sink the Indian insurance industry would certainly ravage the country’s financial markets, which would mean insurers would likely be insolvent and unable to pay out unless the government steps in. By transferring some risk to well-diversified international investors, such as hedge funds, via catastrophe bonds, India can take advantage of the deep global capital markets to reduce systemic risk at attractive costs. While there have been calls for years for Indian institutions to begin using catastrophe bonds, the sluggish pace of adoption of innovative financial strategies by India means that great risk remains on a systemic level.