Proceedings of International Social Sciences and Business Research Conference
4 - 5 December 2014, Hotel Himalaya, Kathmandu, Nepal , ISBN: 978-1-922069-65-8
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Disaster management and insurance are of increasing significance in today’s world. Every year, natural disasters cause tens of thousands of deaths and tens of billions of dollars’ worth of losses. The figures available from international agencies such as the International Federation of Red Cross/Red Crescent
Societies (IFRC, World Disaster Report, Geneva, annual) and from major transnational insurance and reinsurance corporations meeting in Davos every year under the World Economic Forum show that mortality rates have been fairly consistent, whilst the number of recognized catastrophic events, and even more, the size of economic losses, have rapidly increased. This paper examines the difficult task to successfully mobilize the requisite financing for adaption. Traditionally, governments have endorsed ex-post financing instruments. The author argues that there is substantial value in shifting to a comprehensive disaster risk management approach that would accumulate preventive funds and implement positive actions for disaster vulnerability reduction before the next catastrophe occurs.
Theoretically supported by cost-effective analysis, the cooperation between the public and private sectors is considered as the most appropriate measure to supplement the conventional ex-post sources of funding.
Field Research: Risk Management and Insurance
One year ago, Typhoon Haiyan made landfall in Samar, central Philippines, and caused catastrophic damage. Typhoon Haiyan was reported by media outlets as one of the strongest tropical cyclones in recorded history. Nearly 6,000 people were killed, and millions more were affected and displaced after the tropical cyclone left a wake of utter destruction. The Philippines government initial estimates pointed to a reconstruction costs of $5.7 billion. Beyond this number, the economic impact for the victims was disastrous: hundreds of thousands of hectare of culture were destroyed and crucial irrigation equipment was rendered inoperable by the fierce winds and powerful storm surges. Natural disasters such as Typhoon Haiyan expose central governments and local communities to the mounting challenges of protecting lives and assets against extreme weather. Asia holds a propensity for natural disasters, including earthquakes, tsunamis, typhoons, and mudslides. This paper examines the difficult task to successfully mobilize the requisite financing for adaption. With their increasing economic development, population growth, and greater vulnerability to climate change, Asian governments cannot afford to ignore the challenging size of the financial costs of forthcoming disasters. This paper is organized as follows. The first section overviews the literature on natural disasters. It outlines the negative consequences of such extreme events. The second section highlights the importance of adopting a coherent financial protection.
Traditionally, too many governments have endorsed ex-post financing instruments. The third section discusses the implication and capacity that the private sector can provide to public authorities. Both private and public sectors contribute different strengths and perform different roles, but their partnership is vital to manage catastrophe expenses more efficiently. The last section introduces the
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International Doctoral Program in Asia-Pacific Studies (IDAS) - National Chengchi University. gregcoutaz@hotmail.com / +886 928-174-282
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Proceedings of International Social Sciences and Business Research Conference
4 - 5 December 2014, Hotel Himalaya, Kathmandu, Nepal , ISBN: 978-1-922069-65-8 measures embraced by the Taiwanese government to reduce public exposure and improve the country financial preparedness.
Small to large natural disasters have always affected societies around the world. But in recent times, the scale and scope of natural disasters have increased markedly. Since 1990, these events have afflicted more than 200 million people every year, and more than 300 million people now live amidst violent insecurity. The World Bank declares that over 160 countries hold more than onefourth of their populations in regions of high mortality risks from one or more natural disasters (Dilley et al, 2005). Scientists have concluded that the surge in natural disasters is due to both man-made and natural elements. There is convincing evidence that more extreme events would in general be an expected outcome (IPCC, 2012). Modeling indicates that in future continued increases in rates of urbanization, deforestation, environmental degradation, and global warming will drive more catastrophes. Natural disasters vary in frequency and impact, but all have the capability of influencing great damage and incurring high costs. According to a 2013 UN report, economic losses from disasters since 2000 are in the range of $2.5 trillion, a figure at least 50% higher than previous international estimates. UNISDR warns that these losses will continue to escalate unless actions are taken to reduce exposure to catastrophe risks (UNISDR, 2013).
Although extreme events have calamitous consequences, the study of the economics of natural disasters is a fairly recent branch of the economic research (Okuyama, 2007). Most scholars of disasters classify disaster impacts into direct and indirect impacts. Direct impacts have been described as the physical destruction from a catastrophe, and indirect impacts are considered the consequences of that destruction (National Research Council, 1999). In this way, direct damages refer to damages to structures, contents, and infrastructures that occur as a direct result of a catastrophe. Indirect damages refer to lost economic activity, such as business interruption, increased costs of production, loss in expected income, and other welfare losses. The approach of dividing disaster impacts into direct and indirect damages and summing them appears to be a theoretically straightforward accounting method for estimating the total economic impact of natural disasters; however, the difficulty in practice has led much of the literature to focus instead on the impact of disasters on macroeconomic variables (Kousky, 2012). The focus on macroeconomic variables is due to the fact that good data are available on them. Another motivation is that they facilitate cross-country and multiple-event analysis. Research on the impacts of natural disasters has generally provided contradictory results. There is as yet no agreement in the literature on whether catastrophes are important from a macroeconomic perspective. Most of the studies finds no or small negative effects on macroeconomic variables from disaster occurrences, although there are mixed results with some finding a small, positive effect on GDP or GDP growth. Research suggests that impacts are worse the more severe the event. Economic repercussions are more negative when examining smaller geographic areas, whether it is small countries or localities within countries. The studies also show that most communities have a lot of resiliency and rebound quickly, with most studies finding that effects disappear within a few years. That said, repercussions are worse and more persistent in developing countries, while disasters can usually be absorbed by larger developed economies.
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Proceedings of International Social Sciences and Business Research Conference
4 - 5 December 2014, Hotel Himalaya, Kathmandu, Nepal , ISBN: 978-1-922069-65-8
Despite contradictory results on the impacts of natural disasters, a review of literature suggests that there is agreement on two general trends: the number of natural disasters is increasing dramatically
(Hoeppe, 2007; Guha-Sapir et al, 2013), and the economic cost of these events is rising relentlessly
(Rauch, 2011; Mohleji and Pielke, 2014). The frequency and severity of natural disasters ask the question of the financing of these events. Natural disasters place huge burden on the public sector, which not only shoulders the cost of relief and recovery efforts, such as administering first aid, providing emergency supplies and clearing roads, but is also responsible for rebuilding damaged infrastructures. Since individuals and businesses are generally underinsured in many developing and emerging economies, the central government is often expected to support private rebuilding efforts by providing transfer payments as well. Traditionally, most governments officially rely on socalled national disaster management policies and planning, which include or should consider postdisaster financing. This may include in the short run or in the medium term increasing national or local taxes, reallocating public funding from other budget items, or negotiating additional loans borrowed from the general public (special treasury bills) or from domestic and/or international finance institutions. This approach may raise several major problems: (i) it can divert funds from key development projects; (ii) it can be costly to raise new domestic debt in speculative capital markets; and (iii) it can further weaken fragile economies especially in the developing world. There is substantial value in shifting to a post-disaster management approach that would accumulate preventive funds and implement positive actions for disaster vulnerability reduction before the next catastrophe occurs particularly in disaster-prone countries. The resilience of a country, or its ability to rebound from natural disasters, not only depends on the severity of the catastrophe, but also on available funding for relief, recovery and reconstruction – which have different spatial and time spans. The faster a country can return to its normal state of affairs, the smaller the long term impact of the catastrophe.
During most of the twentieth century, governments adopted a disaster management approach focusing on crisis management. The latter concentrates on the management when or after a catastrophe occurs. The UN International Decade for Natural Disaster Reduction (INDR) made a major contribution to raising international community awareness of the need to move from reaction measures towards a more integrated disaster risk management. The decade was inaugurated in
1989 by the General Assembly with the purpose of mitigating the adverse consequences of natural disasters, particularly in developing countries (Resolution 44/236). With the enlargement of disaster impacts, governments begin to pay more attention to reduce risk and make disaster risk management through the implementation of decisions and actions in disaster risk reduction and response, and the enhancement of management capability. In present day practice of disaster risk management, government actions to cope with disasters have to refer to any purposive undertakings before, during, and after their occurrence. This paper, in accordance with the historical evolvement and international experiences of natural disaster management, recognizes the obligation to promote a comprehensive and holistic strategy that embrace not only disaster response, but also prevention, preparedness, and recovery. One consistent shortcoming of traditional national disaster management policies is the lack of planning financial protection against extreme events (Freeman et al, 2003). Too many governments rely on ex-post financing instruments. There is substantial value for governments to increase their efforts to alleviate the financial burden on the public sector and consider ex-ante instruments. Ex-ante instruments include:
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Proceedings of International Social Sciences and Business Research Conference
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(i) reserve funds (calamity funds); (ii) budget contingencies; (iii) contingent debt facility; and (iv) risk transfer mechanisms (parametric insurance, traditional insurance/reinsurance, ART). The main advantage of ex-ante options is that they are secured before a disaster and allow for rapid disbursement post-event, while ex-post options can take some time to organize. The speed at which funds is obtained varies depending on legal and administrative processes that drive their use. The global capacity of public officials and institutions impact the implementation of effective actions in disaster response. Good governance is necessary to establish initial financial planning and ensure the efficient use of resources. In order to reduce governments exposure, the design of financial protection should consider both ex-post and ex-ante instruments.
A comprehensive disaster risk management strategy emphasizes multilevel, multidimensional, and multidisciplinary collaboration among stakeholders, in achieving effective cost reduction. The economic impacts of natural disasters have become a growing concern of various sectors of the communities, including actors originally less concerned (e.g. Ministry of Finance) to have a meaningful involvement. With the immensity and complexity of financing disasters, no one stakeholder can successfully tackle the problem alone. Cooperation between the public and private sectors represent a rational and viable solution to combat the devastating effects of extreme events.
The role the public sector can play is considerable. Governments have the political and legal power to set framework conditions that facilitate adaptive responses. Such a framework not only grants access to international reinsurance markets, but also sets the stage for international insurers to offer a variety of risk transfer instruments. In some situations, governments have the ability to set codes and regulations that enhance the resilience of structures, delimit intelligent zoning to lessen perils in hazard-prone areas, and introduce compulsory insurance schemes. Developing such operational mechanisms demands technical skills and strong political commitment. Initiating a favorable environment for productive public-private partnerships stresses once again the importance of good governance. While the public sector plays a key role in setting the necessary framework conditions, it is the primary role of the private sector to take some burden off the government after a disaster, lower the volatility of the state budget and promote planning certainty for the public sector.
Functioning in a competitive private space, private actors have gained niche capabilities in risk assessment, mitigation, claims, and logistics. The private sector can play a positive role in helping governments adapt to the risks they face. Private actors have the expertise and knowledge indispensable for governments to build efficient public responses to disasters. Governments always assume the role of payer of last resort. The assumption behind this role is that governments can better withstand catastrophic losses. However, the cost of financing the impacts of natural disasters requires the need for increased pre-disaster focus and deeper, more coordinated involvement of the private sector. A critical element of financial protection is the use of risk transfer mechanisms. The goal is to ensure that risks are spread among capital bases sufficient with governments not serving as the sole risk bearers. Risk transfer allows governments to prepare for catastrophes and mitigate theirs effects on public budgets. In developed countries, entities other than governments absorb an important portion (30 - 40%) of the economic losses due to natural disasters. In lesser-developed countries, risk transfer mechanisms cover only 1% of losses (WEF, 2011). The insurance industry is in a position to connect resilience to financial preparedness. As the primary risk transfer tool, it has five advantages: (i) it permits the spreading of risk between parties; (ii) it reduces the variance of risk for each person; (iii) it allows the segregation of risk; (iv) it encourages loss reduction measures;
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Proceedings of International Social Sciences and Business Research Conference
4 - 5 December 2014, Hotel Himalaya, Kathmandu, Nepal , ISBN: 978-1-922069-65-8 and (v) it provides a tool to monitor and control behavior (Freeman and Kunreuther, 1997). In contrast to North America and Europe, insurance penetration rates in Asia remain low. It is no coincidence that insurance is an economic tool used by wealthy countries. In many Asian countries, the lack of institutional regulatory structures and confidence with potential customers hinders the ability to acquire insurance coverage. Therefore, public-private partnerships are critical to overcome these barriers. The active collaboration between governments and insurance companies is fundamental to establish proper financial and legal provisions, and increase trust between the community and the actors of the market. Traditional insurance is not the only option for transferring risk. Country catastrophe pools constitute another risk transfer mechanism which provides a backstop of risk coverage to support insurance and financial preparedness. In catastrophe pools, governments may act as: (i) an insurer and assume direct liability for losses without the private insurance sector bearing some portion of loss (e.g. National Flood Insurance Program in the United
States); or (ii) a reinsurer and provide financial support to the private insurance market. In this case, private insurance industry may be required to retain some risk (e.g. Japanese Earthquake
Reinsurance). Both approaches rely on the private sector to supply much needed administrative support. The private sector is paid a commission or fee for providing its services. The only way to achieve catastrophe pools is close cooperation between the public and private sectors. Another alternative is the use of insurance-linked securities (ILS) (e.g. CAT bonds) and exchange-traded insurance derivatives (e.g. catastrophe options and swaps) to transfer catastrophe risk to capital markets. There has been increasing interest for governments (as well as insurers and reinsurers) in the development of these innovative financial solutions. The use of funding from capital markets can be a more effective way of transferring risk with a broader capital base and more capacity than traditional insurance markets. The roles governments and the traditional insurance industry play need to be complemented by other stakeholders, including banks and investment companies.
Figure 1 shows the situation consistent with the vision for better financial preparedness.
Figure 1: The Vision for Increased Financial Preparedness
Current
Insurable
Insurance
Uninsurable
Government
Insurance
Vision
Insurable Uninsurable
Government
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Proceedings of International Social Sciences and Business Research Conference
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International
Community
Cat
Bond s
Cat
Pool s
International
Community
Source: WEF (2011)
The combinations of ex-ante instruments and a broader distribution of risk must be identified as the most appropriate strategy to reduce public exposure. The capacity to embrace such a strategy reveals a higher level of financial preparedness. This assertion is theoretically supported by costbenefit analysis. Several studies have demonstrated that pro-active measures can bring important benefits. For instance, FEMA examined 4,000 disaster risk reduction programs and found an average benefit-cost ratio of four, suggesting that investments in risk reduction can be highly effective in reducing future disaster losses (MMC, 2005). The World Bank (2010) estimates that for every $1 spent in disaster preparedness, $7 are saved in reduced costs of response and recovery.
The costs of conducting a strategy that would reduce risk or transfer risk to other actors willing to accept it are not negligible. They include the creation of expensive capital reserves, the purchase of insurance, and the payment of capitalization. The example of the first Mexican CAT bond issuance proved to be not only a complex operation, but also a costly investment. The expenses of the transaction amounted to about 2% of the coverage, which is far greater than traditional reinsurance, which normally approximates 1% (Lane, 2004). The Mexican government had to consider payments to outside consultants for modeling risks, a myriad of legal fees, costs of the rating agency, and other administrative expenses (Cardenas et al, 2007). With these high costs, it is pertinent to ask whether governments have sufficient resources to implement such a strategy. However, mitigation measures are a tiny fraction of the funds spent by governments in the aftermath of a disaster. Large scale disasters seldom occur, but once they hit a great number of individuals, businesses, and institutions are deprived a large amount of wealth simultaneously. Governments bear the majority of the costs of these extreme events. More careful investments and development planning is called for when considering loss-increasing trends, such as increased urbanization and population growth in areas, which concentrate crucial assets that are at risk, and a possible augmentation in the frequency and severity of natural disasters due to climate change. This paper asserts that the benefits of action on financial preparedness far outweigh the costs of not acting.
Taiwan is heavily exposed to environmental catastrophes. Typhoons, floods, landslides, draughts, and earthquakes are the most happening natural disasters on the island. According to Natural
Disaster Hotspots – A Global Risk Analysis published by the World Bank, Taiwan is an area at high risk for natural disasters in the world. About 73% of land and population is exposed to more than three natural hazards while 99% of land and population is exposed to two or more natural hazards
(Environmental Protection Administration – Executive Yuan 2009). Taiwan lies on the western edge of the Pacific-rim earthquake belt, which is an extremely active tectonic region. Earthquake occurs
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Proceedings of International Social Sciences and Business Research Conference
4 - 5 December 2014, Hotel Himalaya, Kathmandu, Nepal , ISBN: 978-1-922069-65-8 frequently, and the 921 earthquake is well-known to the world. On September 21 1999, an earthquake measuring 7.6 on the Richter scale struck the central region of Taiwan. The death toll was 2,400, and some 10,000 people were injured. Thousands of houses collapsed, making more than 100,000 people homeless. The 921 earthquake caused an economic loss of about $11.5 billion, which was approximately 3% of Taiwan GDP in 1999. In Hsinchu Industrial Park alone, an estimated loss of $400 million was reported, and most of which was incurred in semiconductor and silicon wafer production activities (Moh and Yao, 2005). Prior to the 921 earthquake, the government and local population had underestimated the potential losses that would be caused by such dramatic events. Less than one percent of the residents on the island were covered by earthquake insurance. The catastrophe urged the central government to set up an earthquake insurance pool system and build consensus to strengthen the earthquake insurance mechanism.
The system of a collective pool of risk facilitates the development of insurance markets by spreading risk across insurers and helps them lower the cost of insurance premiums. In order to implement a comprehensive disaster prevention and risk management program, the Ministry of
Finance created the Taiwan Residential Earthquake Insurance Pool (TREIP), administered by a commercial reinsurer: the Central Reinsurance Corporation (Central Re). During the initial operational stage, Central Re was designed as the program manager. It was responsible for managing the co-insurance pool and overseas reinsurance placement. It also contributed to the establishment of earthquake underwriting and claim settlement guidelines and the careful selection of reinsurance placements and securities. As of December 1 2005, the Taiwan Residential
Earthquake Insurance Fund (TREIF) became the pivotal organization of Taiwan earthquake insurance system. The role of the TREIF is to collect premium for the earthquake risk from insurance companies and redistribute the premium to the various risk sharing (including itself). If losses occur the TREIF gathers the appropriate funds from the risk-sharing entities and reimburses the insurance companies for their payments to the insured. On July 1 2006, the TREIF became independent of Central Re. The combination of public and private resources has been a determinant factor in the development of this insurance scheme. The government legislative efforts to minimize the economic losses coupled with the insurance industry interest to enhance the public awareness of the destructive consequences of earthquakes have reinforced the coverage of residents on the island. Since the first residential earthquake insurance policy was issued in 2002,
Taiwan’s residential earthquake insurance business has been growing steadily. As the end of 2011, the participation ratio of earthquake insurance had risen to nearly 25% from 6% in 2002 (Kuo,
Chang, Wan and Sarabandi, 2012). In an effort to complement the TREIF, the central government also issued a landmark $100 million CAT bond covering the entire Taiwanese territory in 2003. The three-year bond operated with an indemnity trigger of NT$20 billion and expired in June 2006.
Under this first CAT bond in Greater China, Swiss Re structured and reinsured earthquake coverage for Central Re. During the three year contract period, the CAT bond was not triggered and the transaction was not renewed (UNISDR, 2009). These examples represent creative alternative sources of disaster financing. They are considered as significant achievements and as an important milestone in the development of financial preparedness in Taiwan. They have been made possible through the collaboration between the public and private sectors.
Natural disasters set in motion a complex chain of events that can generate considerable economic impacts. The figures available from international agencies such as the International Federation of
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Red Cross/Red Crescent Societies (IFRC, World Disaster Report, Geneva, annual) and from major transnational insurance and reinsurance corporations meeting in Davos every year under the World
Economic Forum show that the size of economic losses have rapidly increased over the last two decades. Natural disasters place a huge burden on governments. Public authorities need to develop appropriate risk management strategies to reduce exposure to catastrophe risks. It is imperative for governments to consider a comprehensive risk management strategy that can establish effective coverage using relevant financing solutions. Coherent financial protection will help governments mobilize sufficient resources to better manage the costs of forthcoming disasters.
The adoption of ex-ante instruments and a broader distribution of risk reveal a higher level of financial preparedness. As frequency and costs rise, governments can no longer meet these challenges alone. Public-private partnerships represent a chance to improve disaster resilience and provide economic and social benefits. The economic impacts of natural disasters require more coordinated involvement of the private sector. The collaboration between the public and private sectors is capable of reducing financing financial vulnerability. The merger of public and private resources is the most efficient way to lessen the costs of environmental catastrophes by enabling the reprofiling or the transfer of risks, improving public financial planning, and possibly providing incentives for risk reduction. Central governments cannot remain indefinitely the insurer/reinsurer of last resort. Developing public-private partnerships should become a priority for policy and decision makers.
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