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
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