A quarterly magazine of the IMF

March 2007, Volume 44, Number 1

Time to Master Disaster
David Hofman

Innovations in insurance can help countries manage the fiscal impact of natural disasters

With the 2007 Atlantic hurricane season approaching in June, those living around the Caribbean basin will be watching the weather forecasts closely. It is hoped that the atmospheric calm of last year will be repeated, but the large losses from hurricanes in 2004 (Charley and Ivan, among others) and in 2005 (Katrina and Wilma) are still fresh in people's minds. Moreover, scientific studies suggest an upward trend in the frequency and intensity of hurricanes (Webster and others, 2005).

Natural disasters (such as catastrophic hurricanes) can have far-reaching negative effects on macroeconomic conditions in affected countries, including on their public finances (Rasmussen, 2006). And nowhere is this more the case than in developing and smaller countries. Developing countries are often unable to marshal the substantial resources needed in the aftermath of a major disaster. Smaller countries (such as the island states in the Caribbean and the South Pacific) are typically unable to achieve the geographic redistribution of risk available to larger countries, which can subsidize the costs associated with catastrophic events by using revenues from unaffected regions. In these countries, therefore, the costs associated with natural disasters can quickly overwhelm the public sector's ability to respond effectively.

Catastrophe insurance markets, however, increasingly offer opportunities for the transfer of such risks. Thus far, developing countries have only tepidly begun to tap these opportunities, although more frequent and intensive use of insurance markets may be desirable. This article discusses available insurance modalities and a few recent initiatives in developing and emerging market countries, along with some key challenges for the insurance community, donors, and international financial institutions.

Ready or not

Natural disasters have been growing more costly over time (see Box 1). In the wake of a disaster, governments typically face a weakened revenue base and greater spending needs. Such pressures could come from short-term disaster relief operations or the need to restore key public infrastructure or provide financial support to the private sector. For example, a government will often be called upon—or even be bound by law—to restore damaged or destroyed housing.

To meet their immediate expenditure needs, disaster-prone developing countries often rely on postdisaster financing in the form of grants and loans from external donors. Their reliance on such flows, however, has considerable disadvantages. First, it takes a great deal of time before donor resources are committed and even more time before the funds are actually made available. Second, there may be competition for donor resources from other countries with relief needs at the same time.

But if countries insured themselves against disaster, they would secure at least some of the needed resources in advance. Such insurance is not a remote theoretical prospect. The experiences of high-income countries, in particular the United States and Japan, have shown that many natural perils are insurable, and markets for disaster risk insurance are well established there.

Given trends in catastrophe insurance pricing and the available resources in disaster-prone countries, these countries will probably need to receive donor contributions in advance to pay insurance premiums. But a shift in donor financing from post- to predisaster would still have important benefits for both parties. For the recipients, it would make postdisaster public finance conditions more predictable because the amount of insurance financing available would be known in advance. For donors, it would help smooth cash flow by converting "if and when" outlays into predictable insurance premiums. It might also give donors greater leverage over preventive policies (such as building codes). Last, but not least, it would reduce the perverse incentives that recipient countries face in their dependence on postdisaster donor financing. Indeed, vulnerable countries currently often have little incentive to set aside fiscal savings or take preventive measures for natural disasters, because such preparation might reduce donor support following an adverse event (the so-called Samaritan's dilemma). With predictable insurance payouts, countries retain incentives for fiscal provisioning and preventive structural policies.

Pick your insurance policy

Governments that seek to shield their public finances from the impact of natural disasters by securing insurance must decide the degree to which the risk is transferred and choose the entity that ultimately bears the risk. The various modalities differ crucially in the size of the pool of risk capital among which the risk is spread (see Chart 1).

Pooling. At one end of the spectrum, countries can pool their disaster risk with other countries—thus creating a form of cooperative insurance. Such a mechanism can be effective when the number of countries sharing the risk is large enough, and the correlation of risks between participating countries is low.

Commercial insurance and reinsurance. Insurance companies, however, may be better placed to absorb risks because they typically maintain a well-diversified portfolio of risks. Further, second-tier insurance is available through reinsurers, who act as the insurance companies of the insurers, allowing the latter to pass on risks that exceed their absorptive capacity. In fact, because of its peculiar loss distribution—with low payouts in most years but sudden spikes in disaster years—a large portion of catastrophic risk ends up with reinsurers. However, reinsurers, too, have at times had difficulty coping with peaks in insurance claims; this difficulty is reflected in highly volatile reinsurance premiums.

Capital markets. Capital markets are increasingly providing risk capital that both reinsurers and countries themselves can tap through the use of insurance-linked securities. The market for catastrophe (or "cat") bonds (see Box 2), in particular, has grown rapidly in recent years (see Chart 2). By allocating risks—and potential losses—efficiently over a large pool of investors, insurance through capital markets offers promising prospects of reducing the premium volatility associated with traditional reinsurance.

A second key choice for governments is who the insurance taker should be and what should be insured. The inability of the private sector to cope with a disaster is often a key source of budgetary pressures following a disaster. Therefore, one useful strategy involves promoting, facilitating, or subsidizing the purchase of insurance by private sector parties (for instance, property insurance for homeowners or crop insurance for farmers) to limit the government's contingent liabilities. Alternatively, or as a complementary strategy, a government can also seek to insure itself directly against disaster-related outlays, or budgetary pressures more broadly, through predetermined lump-sum payouts.

Leading the way

In recent years, there have been several promising initiatives in low- and middle-income countries. They can be divided into three broad categories:

Schemes designed to limit government contingent liabilities. These schemes target the private sector to reduce the need for government support following disasters. A good example is the Turkish Catastrophe Insurance Pool, which is supported by the World Bank and pools and reinsures risks from a compulsory earthquake insurance scheme for private home owners.

Schemes to provide resources for disaster relief and reconstruction. With these schemes, the government seeks to secure resources to cover relief operations in the event of a catastrophe. A recent example is the World Food Program (WFP) project in Ethiopia, which uses a weather derivative to ensure resources in the case of a catastrophic drought. In this case, the insurance money is designed to be spent by the government and the WFP to relieve the plight of affected farmers, while donors contribute to the premiums. Another example is FONDEN in Mexico. This fund started as a means of earmarking resources for future disaster relief, to be spent by local governments on an as-needed basis. More recently, the fund got on more secure financial footing when Mexico became the first middle-income country to issue a cat bond to secure sufficient funds in the event of an earthquake exceeding an agreed magnitude, as measured by objective and verifiable parameters.

Schemes that provide lump-sum support to the government budget. Instead of purchasing insurance against specific outlays, governments can seek general, lump-sum support that is conditional on a certain disaster taking place. Such funds could then be spent at the government's discretion. Schemes of this type are less common. However, the World Bank will implement a scheme along these lines in the Caribbean in 2007. On current plans, this scheme will involve elements of both pooling and transferring of risks to reinsurance or capital markets, with financial contributions from donors.

Among these promising initiatives, the key area, in which exploration has only just begun, is the transfer of risk to capital markets. Thus far, only Mexico has directly tapped the international capital market with a successful cat bond issue. The WFP scheme in Ethiopia has also made progress in packaging the risks to Ethiopian farmers into a financial instrument that is potentially tradable in international capital markets—even though it was sold wholesale to a reinsurance company. The Mexican and Ethiopian schemes represent the cutting edge of insurance-based disaster risk solutions in low- and middle-income countries today.

Weathering storms on the horizon

The transfer of risks to international capital markets has substantial benefits because it greatly expands the pool of insurance capital available to developing countries. Nonetheless, a number of uncertainties are associated with the insurance of natural disaster risk. Even though there are well-established markets for insuring certain catastrophe risks, it cannot be taken for granted that all natural disaster risks can be insured in the market at an affordable cost. Specifically, the catastrophe insurance market faces two sources of uncertainty.

The first is global warming and its possible effect on the frequency and intensity of natural disasters. Although the insurance industry has coped so far, the insurance losses in the past two years, including the record-breaking $45 billion losses from Hurricane Katrina, have raised doubts about the way forward. Indeed, the insurance industry is paying increasing attention to climate change and its implications for risk modeling and management of risk. The increasing risk of natural disasters, or persistent uncertainty with respect to the effects of climate change, may make catastrophe insurance more difficult to obtain and more expensive.

A second source of uncertainty lies in the appetite for catastrophe risk in international capital markets. So far, issuers have had relatively few problems selling the innovative and relatively risky cat bonds to international investors seeking risk diversification. But the success of these new (and relatively low volume) instruments coincided with favorable global liquidity conditions and a quest for yield on the part of investors, which led to a decline in risk premiums. It may well be that cat bonds—much like emerging market sovereign debt—have benefited from these conditions. It remains to be seen whether a similar environment will prevail when liquidity conditions tighten.

These issues aside, the affordability of catastrophe insurance for developing countries may remain a concern even in more favorable scenarios. Indeed, in light of the frequent high cost and volatility of insurance premiums, the viability of catastrophe insurance mechanisms for developing countries, particularly low-income countries, may crucially depend on donor contributions. The mobilization of donor support for disaster insurance schemes is therefore another challenge. Although donor involvement so far is encouraging, it is unclear whether donors will be willing to increasingly engage in structural support arrangements at the expense of postdisaster relief. The latter may offer greater benefits in terms of public recognition and in satisfying the urge to show support after a catastrophe has taken place. Thus, the development of a sustainable model for collaboration among donors and recipients in disaster insurance schemes will be key.

The potential benefits of a change from post- to predisaster insurance financing are considerable. Although natural disasters are likely to remain a painful fact of life, such a shift would at least help reduce the second-round fiscal effects, thereby limiting economic disruption and promoting faster recovery while also providing better incentives for countries to adopt preventive policies.