ISSUE BRIEF
DISASTER RISK IN THE FINANCIAL SYSTEM
I.
Stock taking
Dedicated disaster risk reduction measures can save lives and livelihoods, and reduce and
avoid losses in the economic, physical, social, cultural and environmental assets of societies.
However, unless disaster and climate risks are revealed in all financial transactions and
throughout the financial system, the realization of the expected outcomes of the current and
post-2015 frameworks for disaster risk reduction will be fundamentally, if not fatally,
challenged. Institutional investors alone held over USD 83 trillion in assets in 2012, of which
less than 1 percent was invested in climate resilient infrastructure. The overwhelming
majority of investment continues to be blind to disaster and climate risk and therefore
contributes to the growing stock of unmanaged risks.
Simply put, disaster risk needs to be included in all financial transactions and decisions,
dedicated disaster risk management mechanisms are not enough. At the 2014 UN Climate
Summit, global leaders from States, business, finance, insurance and civil society recognized
the relationship between the wellbeing of individuals and communities and the resilience of
the wider financial system. To this end, it is now essential to find practical and consistent
approaches that can be scaled across public, private and mutual sectors to avoid or reduce
the creation of new risk, and to manage or reduce the existing stock of risk.
There is a growing recognition that financial regulation, accounting practices, ratings and
improved integration of multi-domain scientific information are central to addressing this
challenge effectively and proportionately. The guiding principles and established techniques
to reorient the allocation of capital toward resilient investments exist. Yet the incentives and
short-term rewards enjoyed by both public and private investments amplify, rather than
reduce, vulnerability to natural disasters. The consequences of inaction for exposed
populations, economies, investors and institutions are potentially catastrophic.
The transitional pathway from risk-blind to risk-sensitive investment practices must be
carefully managed so as to avoid penalizing companies, cities and countries that adopt a longterm, risk-informed perspective using innovative approaches. The current requirements for
public and private institutions to evaluate and disclose disaster risks are limited. Many
organisations and individuals remain unaware of their exposure and, importantly, almost all
are oblivious to the interdependencies between hidden risks which carry the potential for
systemic destabilisation. For example, the risk that your business suffers direct damage in a
disaster scenario, but that damage to the surrounding infrastructure exacerbates the
problem and increases the recovery time / cost. Consequently, the true scale of disaster and
climate risks are largely invisible within the financial system; they are largely ignored in
investments and are inadequately incorporated into economic decision making, with real
world consequences for companies, cities and countries beyond the financial system.
Prevailing practice demonstrates that natural disaster risks have been difficult for the
financial system to quantify and integrate into decision making. This continues to be
compounded by the relatively short time horizons of public and private sector decision
makers, and the accompanying incentive frameworks. Unless this systemic market failure is
addressed, personal, private and public finance will continue to flow towards vulnerable
investments, increasing the stock of risk within the global financial system and with it, the
likelihood and magnitude of potential losses and macro-level instability in core provisioning
and infrastructure systems in the future.
II.
Overview
From a policy perspective, while there have been significant achievements in many areas
under the Hyogo Framework for Action (HFA), it is in reducing underlying risks (Priority for
Action 4) that the least progress has been made. This has prompted increased demand for
simultaneous action to reduce existing, underlying risks to populations and assets, to prevent
the creation of new risk, as well as strengthening societal resilience. Populations are
increasing, wealth is growing and the climate is changing, and unless appropriate reforms are
made, natural disaster risk will grow significantly in the decades to come. The cost of which
will be counted in the millions of lives and livelihoods that are unnecessarily jeopardized,
and trillions of dollars in loss and damage.
With growing awareness of the nature of the systemic response required, so is recognition
growing of the opportunities that this presents for States and the private sector for increased
certainty on future returns on investment and macro-level stability that is so essential for
achieving sustainable development and building community level resilience. A growing
coalition of relevant and aligned stakeholders from the public, private and mutual sectors
have converged around this opportunity over the last year. The broad set of initiatives
working towards integrating risk into the financial system have been publicly and privately
discussed in a series of forums including both the Abu Dhabi Ascent in May 2014 and the UN
Climate Summit in September 2014, resulting in commitments to the 1:100 Initiative and the
development of a Climate Smart Investment Framework. Further related discussions have
been held at the launch of the UN R!SE Initiative in May 2014, the World Bank Understanding
Risk Forum in July 2014, the WEF Annual Meeting in January 2015, and the First and Second
Sessions of the Preparatory Committee to the third UN World Conference on Disaster Risk
Reduction in July and November 2014 respectively.
The following question defines the systemic nature of the challenge and the opportunity:
“How can the capital, science and policy communities work together more effectively to
improve the pricing of disaster risk into all investment decisions prior to the event, so as to
reduce the creation of new risk, increase the certainty of returns on allocated capital,
accelerate collaboration across sectors, reduce social vulnerability of communities at scale
and create incentives to promote a longer-term perspective?”
The answer is not straightforward, but there is relevant, practical experience that can be
extrapolated and applied if the urgency and scale of the challenge, and the willingness of the
growing coalition to act, can be clearly articulated and understood by States and systemically
important institutions in the financial system, including regulators, exchanges, central banks
and ratings agencies.
The global insurance sector, together with accounting, regulatory and rating institutions, has
had to address this challenge, albeit in a specific industry context. Facing a systemic crisis
twenty-five years ago, the insurance industry has since engineered a shift to relative
resilience, even as risks and disasters have risen. The essential components of this
transformation were:
a. risk-sensitive investment capital which demanded that insurance companies were
able to quantify and demonstrate their ability to manage disaster risk;
b. the development of clear and consistent metrics to evaluate and communicate risk
between stakeholders and the development of an enabling analytical ecosystem;
c. the development of clear standards of annual disaster resilience applied by financial
regulators and credit rating agencies, based on these metrics, coupled with
transparency through requirements to evaluate these risks in annual accounts and
other financial reporting.
Over the last quarter of a century these elements have developed into a well-established
system that can bring societal benefit at a global scale. Together they represent significant
practical experience in how to effectively incorporate disaster and climate risks into
decision-making across all financial transactions and economic decision making, and provide
guidance on how to make risks more visible.
Representatives at this session are also involved in exploring the benefits from integrating
disaster and climate risk into the fiscal and planning process through preventative actions
and increased transparency.
This is a structural problem and it requires a systemic response. Such a response, if inclusive
of all relevant stakeholders in the wider financial system, can reduce or eliminate the
vulnerabilities that will be inherent in economic and social investments of the 21st century if
we fail to address these risks.
III.
Way forward
The post-2015 framework for disaster risk reduction is an opportunity to commence the
transitional process to eliminate the creation of new risk by integrating risk information into
the wider financial system.
To seize this opportunity, States and other stakeholders will need to:
▫
be more aware of the pervading invisibility of disaster and climate risk within the
financial system
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understand that practical and consistent approaches to overcome this challenge at
local and global scales across public, private and mutual sectors do exist, and
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be familiar with, and invited to contribute to, initiatives seeking to integrate disaster
and climate risk into the financial system, into every transaction, infrastructure
investment, bank loan, equity price on the world’s stock exchanges and into the
accounts of every country and city.
The role of science is critical in transforming the relevance and accessibility of disaster risk
information; reducing or eliminating the invisibility of information. Key groupings within the
global science community are beginning to enter into novel partnerships and collaborative
working groups with governments and the financial community to research, test and scale up
the understanding of how to increase visibility of disaster risk information in financial
systems. This welcome development is critical to overcoming key barriers preventing the use
of, and accounting and reporting of, relevant risk information.
There are a number of key challenges still to be addressed that have been discussed by the
broad coalition of interested organizations, these include the:
▫
need to overcome the short term focus of political and financial systems
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extent of hidden risks and their interdependencies preventing accounting of full costs
of decisions and understanding of diverse, connected impacts across physical and
organizational boundaries
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increasing uncertainty, especially of climate-related disaster risk
▫
undervaluing of indigenous knowledge in favor of institutional knowledge
Three key areas of focus that form the basis for activities post-Sendai
Alignment with implementation of the post-2015 Framework for Disaster Risk Reduction, HFA2
Building confidence and understanding of States and other stakeholders as to how to
integrate risk into the financial system supports the implementation of HFA2, particularly by
reducing or eliminating the creation of new risk and promoting the reduction of the existing
stock of risk. This includes the elaboration safe pathways to revealing risk and incorporating
relevant information into economic and financial decision making.
Inclusion of global financial system institutions in the DRR community
Exploring how institutions of the global financial system are a central part of the responsible
DRR community with an obligation, and an opportunity, to support the implementation of
the HFA2 and broader disaster risk management, climate change adaptation and sustainable
development post-2015.
Collaborative action on key initiatives supporting the integration of risk in the financial system
Through innovative collaboration, the experience of the insurance industry and proven
disaster and climate risk management techniques can be applied to manage these risks
across other categories of capital, both public and private, through the use of consistent and
practical metrics and stress tests. This creates an opportunity for States and other
stakeholders to contribute to, and commit to, supporting the initiatives currently under way,
including the 1:100 Initiative, the Risk Modelling and Mapping Forum, the Climate Smart
Investment Framework, the UNEP FI Design of a Sustainable Financial System, and the UN
R!SE Initiative.
This is a unique time to think and act systemically, to change the paradigm of the future
economic and social development of our communities. The approaches outlined are real, they
have been tested, and there is confidence in the potential to scale the response to meet the
magnitude of the challenge. Now is the time to re-wire the way that disaster and climate
information is used by decision makers. Now is the time to rethink the role of the institutions
in the global financial system. Now is the time to collaborate and catalyse the shift from riskblind to risk-sensitive investments in order to build resilient communities and strong local
and global economies.