Page 88 - India Insurance Report 2023- BIMTECH

76 India Insurance Report - Series II

Value-added tax has great potential to finance disaster resilience via taxation. Unlike contributions
through progressively higher rates on income tax, which are widely perceived as a “tax on honesty” due
to widespread evasion, a value-added tax is broad-based and falls uniformly on the rich and the poor.
Being built into the price, the value-added tax cannot be evaded, and taxpayers do not feel the pinch as
much because the amounts are small.

This type of tax can generate substantial revenue when imposed on essential goods and services and
is considered equitable when levied on luxury or harmful items. However, since the taxpayer is unaware
of paying this tax, building public awareness about natural calamities and incentivizing risk mitigation
would both be detrimental.

4. Complementing with Insurance

As society’s risk managers, insurers have a critical role in the web of climate change complexities,
providing financial stability in the process. The industry is uniquely qualified to assess and price risk
through differential premiums and setting deductibles. Price signalling can incentivize policyholders to
reduce risk and limit the impacts of extreme weather.

Sovereign insurance can take different forms. One is where the government transfers some of its
contingent liabilities by directly paying a premium to the insurance or reinsurance companies. This
helps reduce the volatility of financial losses and helps governments manage their economic consequences
in a non-inflationary manner. Another is where it creates a pool for aggregating risks from a diversified
portfolio and contributes to its capital. In this arrangement, the government retains some risk through
reserves and capital and then transfers the rest to the reinsurers. Such arrangements, through portfolio
diversification, help in negotiating preferential premium rates with insurance and reinsurance companies.

Transferring risk comes at a price. A risk layering concept needs to be promoted. In a typical
insurance arrangement, for every $1 of premium paid to an insurance company, one might expect to
receive, on average, between $0.20 and $0.70 in claim payments over the long term. The return depends
on the details of the contract, such as the type of insurance purchased and the statistical characteristics of
the portfolio insured. The remaining $0.80 to $0.30 covers administrative costs, capital costs, and profit
for the insurance company.

If insurance companies are made to pay for the more frequent losses, then the insurance premium
can become very expensive. Therefore, only the losses that are severe and less frequent should be covered
by insurance companies. Other, more frequent losses should be covered by risk-sharing arrangements or
reserving arrangements.

Experience shows that for more frequent events - where the insurance premium is quite large relative
to required reserves - retention is typically cheaper than risk transfer. However, for large, infrequent
events, the reverse typically holds true. The cost of retaining risk for a pool is the cost of capital minus
the investment return achieved on investing that capital in liquid assets. This might typically lead to a
cost of $0.10 $0.50 for every $1 of retention through reserves. Comparing retention with reinsurance,
therefore, requires a comparison of a cost typically expressed as a percentage of the reinsurance premium
$0.30–$0.80 with a cost expressed as a percentage of reserves (1%–5%), which in turn depends on the