Shining the light on mis-selling in Indian banking
By Sucharita Mukherjee, IFMR Holdings
Even as the city of Chennai was grappling with the after-effects of the devastating floods of December 2015, exactly a year later, Cyclone Vardah unleashed its fury, leaving behind a trail of destruction and devastation. At least 16 lives have been lost and more than 12,000 trees have been uprooted due to heavy winds.
The impact has significantly hit the agricultural sector, destroying banana plantations, papaya groves and paddy-fields, causing widespread damage worth up to $1 billion, according to Assocham estimates. An estimated ₹1,000 crore was lost on a single day owing to the unscheduled closure of businesses across the State.
Need for protection
The threat of natural calamities looms large in nearly 60 per cent of the Indian subcontinent today, with as many as 38 disaster-prone cities/towns. While little can be done to prevent natural disasters such as cyclones or drought, we can be prepared to mitigate their effects and minimise losses to a great extent.
Catastrophes such as drought, floods and earthquakes not only impact the economy of a nation but also affect the very subsistence of poor and vulnerable communities. Typically, it is the low-income households that are particularly susceptible to the risks. With little or no insurance on their assets and their livelihoods in particular, they have nothing to fall back on. The urgent need is to build catastrophe risk protection markets in India, so that households can manage risks and rebuild their lives and businesses in the aftermath of natural disasters
Natural calamities can severely impact physical assets such as farmland, crops, commercial vehicles, shops, livestock and other sources of livelihood of low income households, in addition to affecting power, transport and communication infrastructure. To make it worse, families incur exorbitant hospitalisation expenses due to injuries and death. The destruction of homes further impairs the household’s ability to use the asset as collateral for emergency loans or to revive other income generating assets.
Over the past decade, local financial institutions or ‘originators’, such as microfinance institutions (MFIs), have played an important role in providing access to finance to nearly 35 million low-income customers. But when it comes to protection against calamities, households in earthquake or flood-prone areas of the country are generally financially excluded by lenders owing to higher risk. For the few who do operate in the areas, a single catastrophe has the potential to erode a significant portion of their networth. The absence of catastrophe risk mitigation products forces the originators to self-insure by either bearing the risk themselves or geographically diversifying. This, however, is not always feasible given that even some of the largest and most diversified originators in the country have 30 to 50 per cent of their capital at risk to a single district.
When cyclone Phailin hit Odisha in 2013, flash floods destroyed large swathes of farmland, the primary source of livelihood for many low-income households. In the days to follow, loan repayments to local originators were affected severely due to hampered communication and heavy rains. Had catastrophe risk insurance been available to MFIs in the area, households would have been able to avail themselves of moratoriums for their existing loans or emergency liquidity support required to rebuild their livelihoods.
Catastrophe risk insurance transfers the risk from the household to local insurers either directly or via an originator like an MFI or a small business lender. It is similar to a typical insurance product where the premium is paid by the household in exchange for the cover. When calamity strikes, the insurance provider pays either the loss amount or a pre-agreed amount of compensation to the household. If the insurance cover is at the originator level, the premium may be priced into the financial services they provide and the household may receive an insurance linked payout or better loan pricing. Households could also receive loan moratoriums or credit access in areas that the originator would typically not service. The local insurers can then transfer part of the risk to re-insurers who benefit from the ability to pool risks across households in different geographies. Re-insurers are also able to further de-risk their portfolio by issuing Insurance Linked Securities (ILS), also known as cat bonds, to the capital markets.
Protective gear
Globally there are many products, public, private and via public-private partnerships, that exist to protect against the risk of catastrophes. In 2007, CCRIF or Caribbean Catastrophe Risk Insurance Facility was the first multi-country risk pooling facility, established by the Caribbean governments, to provide quick short-term liquidity to limit the financial impact triggered by a hurricane or earthquake. The idea came from the devastating impact of Hurricane Ivan in 2004 which caused losses in Grenada and the Cayman Islands amounting to 200 per cent of the national annual GDP.
Since inception the facility has made 13 payouts totalling over $38 million to 8 member governments for hurricanes, earthquakes and excess rainfall. In 2012, a bank in Peru purchased an insurance product to protect 3,560 agricultural loans of their farmer clients worth $27.3 million against the extreme weather phenomenon El Niño. Subsequently, late last year, the Peruvian government established a catastrophe insurance facility to protect 5,50,000 hectares of crops against El Niño that protects against losses up to $156 million. Ghana has a 2011 drought index insurance to cover all the growing stages of maize. Mongolia has an index-based livestock insurance programme that protects livestock against particularly strong winters. Of the 14,000 policies sold in 2009, local insurance companies made payments to all 2,117 herders eligible after the qualifying harsh 2009-10 winter.
The market for catastrophe risk insurance has matured in more developed financial markets, growing from $700 million in 1997 to $15.4 billion in 2012. However, the ILS market is dominated by catastrophe bonds that cover risks from North and South America. Not even 1 per cent of the market covers South Asia. The opportunity this presents is that cat bond issuances covering South Asian catastrophe risk clearly offers diversification in a global catastrophe risk market dominated by the Americas and the Pacific.
Understanding the geography
One of the key principles is that geographically specialised local originators that have a deep understanding of the customer base and the regions they serve can better help achieve the national goal of complete financial access. Currently, the risks they face in geographical areas vulnerable to catastrophes are increasingly too large to justify entry and even for the less risk-averse ones that do, the catastrophe risk may impact their survival as well as that of the households they wish to serve.
India’s 7,500-km long coastline poses multiple threats in the form of floods, cyclones, tsunamis, to millions of people living along the coastal areas. As we battle the adverse effects of climate change, our sensitive ecosystem faces further imbalance with 57 per cent of our land prone to earthquakes and 12 per cent vulnerable to flooding hazards. Given this context, building robust catastrophe risk protection markets, an important missing piece of market infrastructure, would undoubtedly benefit the whole economy.
Building resilience, where it matters the most, is particularly critical to making the road to recovery a less rocky path and ensuring that the BOP population which forms a significant part of our economy’s backbone can bounce back. The storm must not last forever.
This article first appeared in The Hindu Business Line.