Innovative insurance could prevent sovereign debt defaults in wake of climate disasters
Pooled funds from World Bank and International Monetary Fund could pay premiums for low-income countries.
Offering low-income countries insurance which pays out when one or more of a set of pre-agreed events, like floods or droughts, takes place, could stop them defaulting on debt in the wake of extreme weather events, according to IIED.
In 'Protecting against sovereign debt defaults under growing climate impacts: role for parametric insurance', researchers propose creating a global fund to pool climate and other debt relief funds from the World Bank and International Monetary Fund (IMF) to cover insurance premiums for low-income countries.
Unlike traditional insurance, this parametric insurance fund would pay out based on certain pre-agreed trigger events such as flood, cyclones or droughts of a certain intensity or frequency. It would cover debt repayment on behalf of the country during the period of climate crisis, allowing them time to recover, without worrying about servicing debts during that period.
Debt burdens are becoming increasingly unsustainable for low-income countries in the wake of the COVID-19 pandemic and with global food and fuel price rises. Sri Lanka, Ghana and Zambia have all defaulted on sovereign debt in recent months and the IMF has convened a sovereign debt roundtable to speed up its work on debt relief for countries in need.
IIED’s analysis of 30 of the least developed countries (LDCs) that negotiate as a bloc at UN climate talks, shows that if their exposure to climate hazards is almost doubled, their chances of defaulting on debt will increase by over 1,000%. Countries including Niger, Myanmar, Sudan, Mozambique and Mali would be most at risk.
Ritu Bharadwaj, a principal researcher for IIED, said: “Every time a disaster strikes for low-income countries, they have to take on additional loans on top of pre-existing debt to bring their economies back on track, provide urgent relief to people who have lost their homes and livelihoods, and help communities return to some level of normality.
“As the intensity and frequency of extreme weather events keeps increasing with climate change, poorer countries are more exposed every year, trapping them in an unsustainable debt cycle.”
Rising debt levels have other consequences for poorer countries. During climate disasters, while governments’ revenue and tax collections go down due to the disruption in economic activities, they have to continue servicing the debt. They are forced to reduce spending on poverty reduction, food aid and health.
Providing parametric insurance to cover debt servicing in the aftermath of disasters would go far beyond the kind of debt pause or deferment offered under some relief mechanisms, where the debt remains to be paid off later. In the proposed model, debt repayment would continue as normal through the insurance mechanism, allowing countries to focus on relief and recovery.
It could act as a safeguarding mechanism against droughts, floods and other shocks that require emergency borrowing, freeing up a country’s resources that would otherwise be used to repay debts. It would also help stabilise credit markets and improve the credit rating of countries by averting a debt crisis, enabling them to borrow money at lower cost in future.
The global fund could make insurance affordable by pooling the risks, where insurance premiums would be reduced on the premise that not all countries in the pool would be faced with climate crisis at the same time.
Tom Mitchell, IIED’s executive director, said: “Trapping those countries most vulnerable to the climate crisis in a debt cycle is completely unnecessary. We have shown that the international community has the tools to address both the impacts of climate change and those of the spiralling debt crisis at the same time.
“What we need to see now is a coordinated effort with support from G20 governments, other major developed countries, the IMF and the World Bank to make parametric insurance for sovereign debt a reality.”