Financial Strategies for Managing the Economic Impacts of Natural Disasters
3. Basic Learning Materials
Presentations
Transcript, Session 2
Slide 1
Financing Mechanisms for Pro-active Disaster Risk Management for the Public Sector
Authors: J. L. Bayer and R. Mechler
Slide 2
In October 1998, Hurricane Mitch struck Central America and caused extensive damage in Honduras. There
was widespread flooding causing the death of 5,700 people and heavily affecting another 620,000. Over
60% of the transportation infrastructure was destroyed as well as 70% of the banana, coffee, and pineapple
crop. According to some estimates Mitch was an event with a return period of less than one in 100 years.
Direct losses amounted to around 2 billion USD, which is approximately 18% of the total capital stock.
Indirect damages were calculated at another 1.8 billion USD. Total direct and indirect losses as measured in
terms of GDP were in the range of 80%.
The charts in this picture show the macroeconomic effects of Hurricane Mitch. As we see in the upper left
picture, the GDP reductions shown by the red line were most visible in 1999, when the Honduran economy
went into recession. Alternatively, gross domestic investment (GDI), shown by the green line, increased
substantially. The rebuilding of the capital stock taking place after the disaster allowed for a lasting recovery
in 2000. Looking at the trade balance in the upper right chart, we see on the green line a strong decrease in
exports after the disaster (due to the loss of the crop) in export-dependent Honduras, and a recovery the
year later. Though GDP and thus income was reduced, the decrease in imports shown on the red line was
smaller, probably due to the increased consumption and investment needs following the disaster. As shown
in the bottom chart, the current account, which is the excess of exports over imports, increased due to the
strong fall in exports and only slight decrease in imports.
sources: (PAHO 1999), World Bank, 2002
Slide 3
If critical public infrastructure is damaged or destroyed in a disaster, severe bottlenecks can occur. For
example, the loss of roads and bridges can create serious transportation bottlenecks and hamper the
distribution and access to markets. In the case of Hurricane Mitch, market accessibility in Honduras was
seriously hampered due to the loss of infrastructure. These pictures illustrate the time needed to reach
markets before and after the disaster. Before Mitch, travel time to markets in the majority of regions
amounted to less than 2 hours; after Mitch, travel time went up to 16 hours in many regions (World Bank
1999). Such a large increase in travel time constitutes a severe barrier for the efficient functioning of an
economy. Thus, an important requirement for economic recovery is to quickly repair or rebuild the affected
infrastructure.
Slide 4
Rather than assessing the impacts on the current account and the flow of real goods only, it is insightful to
analyze the capital account and the financing sources that fuelled the recovery in Honduras. In general, the
governments’ financing obligations post-disaster are:
•Provide relief to poor and those in need,
•In some countries, rebuild private housing,
•Rebuild public infrastructure,
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•Rehabilitate the economy.
Honduras has a limited ability to finance losses by its own means and has traditionally relied on external
assistance to help with economic development in the event of natural disasters. As we see on the blue line in
the figure, in 1998, official development assistance or ODA (comprising grants or loans with a grant element
of at least 25% given to developing countries) amounted to about 6% of GDP. Thus, it is not surprising that
Honduras was in need of outside help after a severe catastrophic event. After Mitch, ODA rose sharply to
about 16% of GDP in 1999 or in absolute terms from 303 to 842 million USD. This large inflow of free or
concessional financing contributed considerably to the recovery process.
Slide 5
Although poor countries can still expect substantial bilateral or multilateral assistance after natural
catastrophes, there is a shift in the disaster management paradigm towards more emphasis on ex-ante risk
management measures:
International aid and development funding agencies have the strong view that hazard and vulnerability
reduction efforts, as well as financial planning, before a catastrophe pay excellent dividends in reducing
economic impacts. Mitigation expenditures are a very small fraction of the funds spent on reconstruction in
the aftermath of catastrophes (Pollner 2000: 44).
It is important to plan for these losses before the disaster strikes. Pre-event risk management for natural
disasters is a planned and structured approach that aims at (1) reducing the intensity and frequency of the
peril and the potential losses and (2) transferring or spreading the risks to lessen the burden on the victims
and to facilitate the recovery process. This comprises three interrelated tasks:
•Risk identification and assessment,
•Risk mitigation, and
•Risk financing.
Yet, since risk cannot be reduced to zero due to physical or financial restrictions (and due to the fact that the
costs of reducing risk may outweigh the benefits), ex-ante risk financing options should be part of the risk
management portfolio. In what follows, we will discuss the components of pre-event disaster risk
management and the conditions and tools necessary for transferring the risks of disasters faced by public
infrastructure.
Slide 6
How are probabilistic disaster losses to public infrastructure, households and businesses assessed?
Actuarial methods that rely on analysis of historical data (for example for car accidents) are of limited
applicability when confronted with very rare events. To arrive at a probability distribution over losses from
rare, extreme events, catastrophe models have recently become possible with improved computing
technology. These models are typically modular and employ simulation techniques. For example, a recent
flood catastrophe model developed for the Upper Tisza region in Hungary made use of historical data of
precipitation in the upper reaches of the river, where a runoff module translated this precipitation to inflows
into the river. A hydrology module, in turn, translated these inflows into a distribution of the water level of the
river. With information on the height and failure of the levees, this information could generate scenarios of
releases. Combined with a module of the topology of the region, and with further information on crops and
structures, the model ultimately translated precipitation into a probability of damages with the use of Monte
Carlo simulations. These modules can be carried out in great detail for a small area, for example, a stretch of
a river through an urban area, or in much less detail for a region or a country.
Developing countries can greatly benefit from these risk assessments in terms of improving the insurability
and management of their risks. However, risk assessments can be very resource intensive. For example, a
river flood catastrophe model developed for insurers by a consulting firm took more than 12 man-years to
develop. This was in addition to the costs of collecting the relevant data, which can be a main expense of
these models. In the U.S, physical models for the flood peril for all major flood-risk areas are available on the
internet through HAZUS, which is a program sponsored by the Federal Emergency Management Agency
(FEMA). Local policy makers can make use of these models by putting in their estimates of the value of
property and infrastructure at risk (if available) within their jurisdictions. In developing countries, however,
there may be little data on infrastructure lifelines, property values and vulnerability. To circumvent this
problem, it may be necessary to combine historical data with expert judgment on risks, which is the basis of
the following “top-down” approach. Sources:Ekenberg, et al., 200; Linnerooth-Bayer, et al., 2002; Risk
Management Solutions, 2001
Slide 7
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Using a top-down approach, disaster risks can be assessed for a whole region or an economy. This is
necessary for financial planning at the national or regional level. A top-down risk assessment for Honduras is
illustrated in this figure. The main hazards facing Honduras are hurricanes originating in the Caribbean and
on a smaller scale earthquakes in the western part of the country. For financial planning, it is important to
estimate the frequency and severity of these events in terms of their impact on the capital stock exposed. For
this purpose, a cumulative loss-frequency function can be established (as shown in the upper right graph)
indicating the annual probability (shown on the y-axis) for which a given fraction of capital stock loss will not
be exceeded (as shown on the x-axis). For example, with a probability of 0.99 (99%) a loss of approximately
12% of capital stock will not be exceeded. This is equivalent to saying that there is a 0.01 (1%) chance in a
given year, also called a 100 year event, of a catastrophe event destroying at least this amount of capital
stock.
These figures can be obtained from historical records and from assessments by experts. It should be kept in
mind, however, that these estimates are necessarily rough. For very rare events, there is little in terms of
historical data, and it is difficult to include dynamic changes in the system, for example, population and
capital movements, climate change, and so forth. These factors may be taken account of using expert
judgement. Combining this loss frequency function with an estimate of the total capital stock leads to loss
estimates in absolute terms as shown in the lower charts. These estimates have been made for the 10, 50,
100 and 500 year events (having an annual return period of 10%, 2%, 1% and 0.2%, respectively). More
detail is provided in case study 1.
Slide 8
Risk Control measures comprise mitigation and risk financing. Mitigation or loss-reduction measures reduce
the intensity of the hazard and/or its consequences. We cannot understate the importance of pre-disasater
mitigation measures. Experts attributed the large death toll in Turkey’s earthquake to a failure on the part of
the public authorities to implement the building code in the affected communities. According to the U.N.
Secretariat for the International Decade of Natural Disasters, worldwide, only one dollar is spent on
prevention for every $100 spent on rescue efforts (Geitner, 1999).
Mitigation is directed towards physical vulnerability, risk financing towards financial vulnerability of
governments, households or businesses. Risk financing measures reduce the losses incurred by a subject or
entity by transferring risk or sharing losses with others. Risk financing and mitigation measures are closely
linked. Incentives for mitigation can be linked to risk financing. As an example, insurers might offer lower
catastrophe cover premiums to households that take precautionary measures. Alternatively, households
might take less precaution if they are insured, what is known as “moral hazard”.
Slide 9
A central question for disaster risk management is how the government finances its risks. Three
sources of government risk can be distinguished: relief to victims, reconstruction of private homes and other
assets, and reconstruction of public infrastructure. Usually governments raise funds after the disaster occurs
(ex post financing), but there is increasing interest in arranging pre-disaster (ex ante) financing.
Post-disaster financing: One of the most common ways of arranging financing for relief and
reconstruction after a disaster is to divert funds from other budgeted projects or international loans.
Alternatively governments can increase taxes, but more commonly they borrow the necessary capital to
meet their obligations. The sources of these loans can be (1) a central bank credit, (2) foreign reserves (3)
domestic or international bonds or (4) loans from international lending institutions, such as the World Bank.
Developing countries also rely heavily on the international donor and lender communities.
Pre-disaster financing: Many governments set aside funds into a catastrophe reserve in order to
meet their obligations after a disaster. This form of pre-disaster or ex ante financing has an opportunity cost
in terms of other uses of this capital, for example, it could be invested in higher-yielding assets or in public
services, such as schools and hospitals. Rather than holding large sums in reserve, governments can make
pre-disaster arrangements for receiving credit after a disaster at a pre-determined interest rate. Alternatively
the government can purchase insurance from commercial reinsurers, but it must be kept in mind that
catastrophe cover can be expensive. Catastrophe rates fluctuate greatly, but in general they reflect the risk
as well as the high cost of capital necessary to backup catastrophe insurance. To overcome the finite nature
of insurance capital, recent attention has been given to novel risk-transfer or hedging instruments, including
catastrophe bonds. A catastrophe bond is an instrument offered by the insurer or industry at risk, whereby
the investor receives an above-market return when catastrophes do not occur, but shares the insurer’s
losses by sacrificing interest or principal when catastrophes do occur. With these bonds or other capital
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market instruments, insurers can pay to transfer catastrophe risk to investors and, therefore, directly to the
global capital markets. To date, catastrophe bonds have only been marketed by the private sector, although
the California Earthquake Authority proposed, but never implemented, a large catastrophe bond (US$ 1.5
billion) to cover state expenses in the aftermath of a major earthquake. Since the trigger for these bonds
need not be losses, but can be a physical phenomenon such as flood waters reaching a certain stage, they
can improve the insurability of disaster losses.
Slide 10
If a government cannot raise sufficient resources after a disaster, a so-called financing gap occurs. In
practice, gaps in the necessary financing for disaster losses are frequently encountered in developing
countries. As shown in this figure, after the earthquake of 2001 in Gujarat, India, there was a significant
shortfall between the planned government expenditure, its planned funding sources and the actual funding
made available.
While government expenditure for infrastructure and housing for 2001 and 2002 was planned at 2.4 billion
USD, and planned funding from the state and other sources was 3.6 billion USD, actual funding received at
the end of 2002 amounted to only 0.7 billion USD.
The financing gap denotes the inability of a country to finance its reconstruction and other obligations from
traditionally available sources after a disaster. IIASA has developed a methodology to measure this inability
to potential events in order to allow planning for such contingencies. The methodology requires as input an
understanding of the country’s risk exposure. It also requires information on the government’s post-event
liabilities. These include financing the reconstruction of its own assets and also its responsibility to cover
private losses. Primary losses from natural disasters will be covered by other parties than the government,
but the concern here is with government responsibility. Finally, the capacity of the government to meet its
financial obligations must be assessed.
Source: World Bank 2003
Slide 11
This picture shows the financing gap assessed for Honduras. One can see in this picture that the financing
available to the government after a disaster (the red bars) is sufficient to finance simulated disaster losses for
events with a frequency greater that one in a hundred years. However, for the very rare events happening
once in every 200 or 500 years, the government’s post-disaster obligations (blue bar) are greater than its
financial resources. For these rare events, the government should consider the costs and benefits of ex ante
financing instruments.
How is the financing gap assessed? The first step is to identify the risk profile of the country, state or region.
Looking historically and discussing with experts may yield an assessment of the scale of losses to public
assets that can be anticipated for the 10- 50-, 100-year, and even less frequent, events, as well as the
requirements for government relief to private households and businesses. After estimating a probabilistic
loss profile, the next step is to assess the government’s financing capabilities for these events. How much
capital can the government raise through budget diversions, taxes and borrowing, and what can be expected
from donor aid? Does the government have a catastrophe reserve fund in place? There may be constraints
on these traditional financial instruments. For example, after a devastating event, the government’s
domestic bond rating may worsen, making it more difficult to raise capital in the bond markets. These
constraints should be taken into consideration in assessing the financing gap. More details on assessing
Honduras’ financing gap will be given in the case studies.
Slide12
In the case of a financing gap, what kinds of risk transfer instruments are available, and how do they work?
The three instruments readily available to governments are a catastrophe reserve fund, contingent credit and
insurance. Catastrophe bonds have rarely been put into place as an instrument for governments to insure
their assets, and they are not considered here.
a)Reserve fund: A government can set aside funds, usually on an annual basis and usually from tax
revenues, to a reserve fund. The fund accumulates over those years without catastrophes, and in the case of
an event it can be used to finance relief and reconstruction. There is a problem, of course, if the disaster
occurs before enough contributions have accumulated to cover the losses. Another risk is that the fund will
be diverted to other uses, especially if a disaster has not occurred in many years.
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b)Contingent credit: Contingent credit arrangements transfer risk over time or temporally. In exchange for an
annual fee, the government has the right to borrow after a disaster at a pre-arranged rate of interest. This
loan will have to be repaid at contractually arranged intervals after the disaster.
c)Insurance: Generally re-insurance companies offer insurance to governments to finance their liabilities
after a disaster. By paying premiums before the disaster, the government secures post-event funding.
Slide13
Governments carry a large and highly dependent portfolio of infrastructure assets, and for the same reason
as firms, they may wish to reduce the variance of these losses by diversifying with insurance and other risktransfer instruments (Freeman and Pflug, 1999). Especially for unstable economies, insurance can increase
investor confidence in the country, as well as improve credit relations with lending organizations.
There are clear advantages to public risk transfer, but there are also costs. For the most part, insurance and
other pre-disaster financing instruments will cost governments more over the long run than relying on
traditional, post-disaster financing. However, in some cases governments are constrained in the amount of
capital they can raise after a disaster. Three questions should be answered to determine whether a
government should insure its infrastructure and other post-disaster liabilities:
• Is there a potential financing gap?
• What are the costs of insurance and other pre-disaster financial instruments?
• What are the benefits of insurance and other pre-disaster financial instruments?
Slide14
Important criteria for evaluating a pre-event financial strategy include the costs of available instruments, in
this case insurance, a catastrophe reserve fund and contingent credit, before and after the event. This table
shows selected costs and benefits from these three pre-event financing instruments. It is important to
recognize that all of these instruments have a direct or indirect cost. This cost can be in terms of premiums,
interest, or, in the case of a reserve fund, foregone benefits from alternative uses of this money for schools,
roads, hospitals and other public programs. For example, insurance has no costs after the event (except to
insure future events), but will also be a lost investment if there is no disaster. Alternatively, a reserve fund
accumulates in the absence of a disaster, but if not enough capital has accumulated the fund will not be
sufficient to meet the government’s post-event needs. The benefits also differ among these instruments. One
important consideration is that risk-transfer instruments, like insurance and contingent credit, will “buy”
foreign capital inflows after a disaster. Another important consideration is the incentives these instruments
place on governments to take risk-reducing measures. Insurance can create such incentives if premiums are
linked to the risks. However, the record of insurance companies in setting premiums to reflect mitigation
measures is not encouraging. At the same time, this instrument can actually result in fewer efforts to reduce
risk, what is termed “moral hazard”. With the exception of “excess of loss” insurance, all of these instruments
run the risk of not supplying sufficient capital. There are also complicating political risks, for example, of
diverting funds from a reserve fund to finance other government programs. Particularly in capital-scarce
economies, these funds are often depleted when disasters do not occur over a long period. Sometimes even
the budgetary process prohibits the accumulation of funds. Thus the long accumulation time needed to build
up substantial capital reserves is a problem.
Slide15
Because of the direct and indirect costs, insurance and other types of risk transfer inevitably involve a tradeoff between economic development and economic stability. If a government purchases a risk-transfer
instrument, there are fewer government resources for investments in capital and socioeconomic
development. Alternatively, without this purchase, there is no indemnity for infrastructure losses, which will
delay economic and social recovery. This is the important growth-stability tradeoff. IIASA has modeled this
tradeoff for El Salvador. In this figure we see simulations of El Salvador’s growth path without risk-transfer, in
this case insurance for public assets, and with risk transfer. In the top figure, which illustrates simulated
growth paths without insurance, we see higher average growth but with a great deal of variance or volatility.
The lower figure illustrates simulated growth paths with insurance, which shows lower average growth but a
more stable economy.
Ideally, El Salvador would have both high growth and economic stability. This suggests a role for the
international community in providing pre-disaster assistance in purchasing risk-transfer instruments to
complement post-disaster humanitarian assistance. The advantages of this shift would be many, and include
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a more secure economy for internal planning purposes and for attracting outside investment. Of course,
moral hazard issues would be important to deal with.
Slide 16
In the words of Kofi Annan,
Building a culture of prevention is not easy. While the costs of prevention have to be paid in the
present, its benefits lie in a distant future (Annan, 1999).
Building a culture of prevention and precaution is at the heart of disaster risk management, but it should
nonetheless be recognized that prevention and precaution come at a price. While the costs are deterministic
(to be paid at a set interval, e.g. annually), the benefits are only visible when the disaster strikes.
Accordingly, benefits need to be described in a probabilistic manner.
Probabilistic estimates are often expressed in terms of average or expected losses. However, natural
disasters are not average events, but rather follow extreme value distributions. In order to account properly
for the low-probability, high-consequence characteristics of disasters, other risk metrics, such as variance of
the probabilistic loss distribution, should be considered.
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