5 RISK TRANSFERENCE MECHANISMS AS THE INSURANCE COST OF NATURA...

2.2.5  Risk  Transference  Mechanisms  

As the insurance cost of natural disasters varies greatly and unpredictably from year to year, a national

insurance market may be jeopardised by a single event without sufficient financial risk transference in

place. Risk transference mechanisms can be upstream, in the form of purchasing reinsurance from

reinsurance companies. Reinsurance can help cover excessive compensation costs without putting at

risk the financial viability of the insurance market.

Risk transference mechanisms are also downstream to consumers. For example, underwriting tools

such as deductibles are used to transfer a variable proportion of the insured loss to the policyholder in

the event that they make a claim. According to Botzen & Van Den Bergh (2008), a principal way in which

flood insurance systems can contribute economic efficiency is through ex-ante and ex-post risk

transference mechanisms. These work to transfer financial risk associated with flood losses and to

provide incentives to invest in flood risk mitigation measures. Before a flood occurs, the system should

produce incentives that lead to initiatives that may limit potential flood damage. For example, through the

use of risk premiums, deductibles and other underwriting tools, flood insurance policies can be

constructed in such a way that they give policyholders financial incentives to invest in both flood

protection and damage limitation measures either themselves or to lobby political representatives to do

so collectively on their behalf. After a flood has happened, an insurance system should release funds

from a capital pool built up from premiums paid in each year. Such payments will reduce potential

economic losses through the replacement or repair of damaged assets and in particular circumstances,

provide financial compensation for lost economic activity