AON Re Hazards Conference
PPPs and Natural Disasters Risk Management
Rodney Lester
World Bank
Surfers Paradise
August 22, 2005
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A few months after joining the World Bank, and not long before my last appearance at
this forum, I found myself sitting next to a Bank old timer in a bus in El Salvador. When
he heard that I was working on insurance he advised me to find something else to work
on, as this topic would have no future in the Bank.
Well, 7 or so years on my team is fighting to have a voice in what is now one of the
hotter topics on the Bank’s agenda – namely that of country risk. The sub topics of
natural disasters and terrorism have become a matter of interest under a wide range of
headings, ranging from debt servicing capacity to country assistance strategies to climate
change to ensuring that reinsurance cannot be used for money laundering. I think it will
only be a short time before we are also fighting to retain the agenda on idiosyncratic risk
for the poor, given the rapid rise of micro-insurance.
Hence my main theme today - the time has come to mainstream comprehensive country
risk management, and risk management for the poor for that matter, into development
policy.
Sub themes involve overcoming the numerous factors inhibiting this agenda and the need
to develop a public private partnership, or PPP, mentality, including reserving a central
role for the reinsurance markets.
One reason for the growing interest in natural disasters in the World Bank is that it is
becoming increasingly obvious that our client countries, and low income countries in
particular, suffer disproportionately from natural hazards.
Slide 1
Small states average direct losses amounting to 9% of GDP from large disasters. While
this represents an improving trend it can be compared to a figure of 1.5% for more
diversified economies. Low income countries appear to have easily the greatest
frequency of major events, and the frequency appears to be increasing.
In addition there is very strong evidence emerging that the poorer sections of society can
be thrown back into poverty, or at least halted in their struggle out of it, by natural
hazards.
Slide 2
Studies carried out in Honduras in the aftermath of Hurricane Mitch demonstrate a very
clear income effect, with the poor who were affected losing on average 31% of their
productive assets, compared to 7.5% for the wealthiest group.
Perhaps the strongest evidence that this topic is becoming relevant under the development
agenda is that the regional and fiscal economists, the high priests of the World Bank, are
beginning to take notice. These people tend to be the gatekeepers to Country Assistance
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Strategies and to the lending and advisory work that emerges from these documents. My
experience until recently has been that many Poverty Reduction and Economic
Management, otherwise known as PREM, economists have largely discounted risk in
their analysis of country development strategies.
The initial context in which they took note involved the ability of low income countries
(LICs) that are subject to shocks and volatility to service their debt obligations.
Slide 3
Shocks and volatility come under 4 headings –
Financial crises – for example the 1997/98 Asian meltdown, which stole a decade of
development from a number of countries
Terms of trade shocks – small commodity producing country are particularly susceptible
to this threat and Australia lived with it for many decades
Natural disasters – today’s topic, and
Donor shock – which arises when countries become dependent on varying volumes of aid
and concessional credits.
While it is early days the economists have drawn some preliminary conclusions. In
particular they have recognized that natural disasters are different – they have an impact
on productive physical and human capital, and this flows through differentially to
different parts of society. The other forms of shock, whilst potentially devastating in the
short to medium term, do not normally have the potential to physically destroy a
country’s capital.
The economists are also recognizing that secondary effects such as impacts on GDP
growth can be different depending on the type of natural disaster and the lag involved.
The results obtained to date have been quite ambiguous – for example earthquakes appear
to be good for short to medium term economic growth if they lead to the replacement and
upgrading of physical capital. Hydro-meteorological disasters seem to have a beneficial
effect on human capital in some circumstances. Other data points to lower growth rates
in countries subject to reasonably regular natural disasters. For example there is evidence
that, while the number of people living on less than $1 per day is dropping in most
regions countries (Africa being a notable exception) there is some bunching below the $2
per day level in regions subject to periodic natural disasters.
The overall conclusion is that current data bases, models and techniques are inadequate to
the task of underpinning economic policy decisions and developing appropriate policy
and instrumental responses to natural disasters, although the demand is there, and this is
clearly relevant to the achievement of the Millennium Development Goals.
Current thinking is that any useful models will need to have macro-micro linkages and
adopt a systems dynamics approach to allow for the complex feedback loops involved.
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In the meantime the urban, rural development and financial specialists in the World Bank
have not been idle and a lot is going on.
Slide 4
I will elaborate on some of the World Bank specific items on this overhead later, however
two of the PPP initiatives are likely to be of particular interest to this audience. The first
is the Global Index Insurance Facility or GIIF, which is intended to combine technical
assistance with underwriting capacity for indexed linked products. In this regard we are
not strictly talking about insurance as IFRS4 the new international insurance accounting
standard clearly excludes parametric instruments from the definition of insurance.
The second is a Small Islands catastrophe insurance initiative, which is likely to be
discussed at the small States forum in Washington DC in September and at the
Commonwealth Finance Ministers meeting in Bermuda around the same time. We have
had numerous visits from London brokers who wish to promote a particular structure and
are continuing to examine options for an effective business model. Whatever approach is
adopted is likely to involve some form of multi region pool. The Caribbean initiative is
more advanced and we are hoping that this will ultimately form the catalyst for a global
facility. The Caribbean project team will be visiting the Bermuda reinsurers shortly.
Climate change is now a major G8 issue following the recent Gleneagles heads of state
meeting, and there is a growing case for this work to be integrated with the disasters
agenda under a global risk management mandate. There will shortly be a high level
meeting on climate change in Washington between the World Bank leadership, some G8
heavyweights and some leading reinsurers. Like our little insurance group, the Bank’s
climate change people have suddenly found their topic being adopted, and possibly even
appropriated, by the mainstream of the Bank.
Our current country specific operations with risk financing components are mainly
earthquake oriented, although there is a growing agricultural risk element.
Slide 5
East Asia stands out through its absence from this list. However the good news is that
there are a number of EAP studies due out soon, including a regional study that for the
first time outlines a fully fledged country risk management methodology. This paper
notes the absence of financial mechanisms in the region and posits a number of possible
reasons, including poor regulatory environments, poor data and limited technology
transfer, and a general lack of insurance awareness.
The 5th publication in the Bank’s Hazard Management Unit’s Disaster Risk Management
series also recently came out – called the Hotspots Report it very effectively shows that
East Asia is one of the big three when it comes to rapid onset natural disasters risk
expressed as a proportion of economic size.
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Slide 6
Clearly the methodology involves what Dr Wiart would call an aggregate model and
demonstrates the benefit of a top down approach for strategic planning. EAP’s risk level
is hardly surprising given this region’s east coast orientation and the proximity of the
Pacific ring of fire. The other two sub regional hotspots, Central America and the
Caribbean and South Eastern Europe and the Middle East have had a lot more attention
focused on them, possibly because of their proximities to North America and Europe. As
Neil Britton has pointed out the two major sources of input in EAP to date have been
Japan and Australia, and they have somewhat different approaches. I have to say that as
a World Bank person I have noted a degree of a ‘keep off my turf’ attitude from certain
directions in this part of the world, and hopefully that is receding.
If one measures risk in terms of mortality rather than direct property loss South Asia also
enters the picture, largely through hydro meteorological hazards. Africa of course
features under both measures, but for slow onset drought, which tends to have quite
different characteristics at both the macro and micro levels.
When one examines basic exposure data the case becomes even more compelling –
Slides 7
Six out of the top 15 exposures to multiple hazards, based on land area, are in EAP and if
two or more hazards are considered the region accounts for 10 out of the top 25 countries.
The actual results on the ground reflect these exposure and hazard combinations.
Between 1970 and 1997 EAP accounted for 75% of the World’s natural disasters. In the
last two decades upwards of 90,000 people have died and there have been recorded direct
losses of $150 billion. The burning cots equates to around $12 billion per annum,
equating to 70% of the World Bank’s total annual lending. In terms of frequency the
region averages 15 major floods, 10 major tropical cyclones and 6 major earthquakes per
annum. Others have mentioned the environmental and rapid growth of major cities
which are increasing exposures and vulnerabilities, so we can expect to see the metrics
get worse unless something is done, and done soon.
The Pacific Islands if anything are facing more extreme challenges than their larger
neighbours.
Slide 8
This is no doubt largely due to their concentrations of productive capacity is relatively
small areas, but we are also seeing rising sea levels and an apparent rapid worsening of
hydro meteorological event intensities – peak and average cyclonic wave heights in the
Pacific for example are rising much faster than the climate change models have predicted.
As an aside, and in case any of you are planning on sailing around the world, I you
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should be aware that the 100 ft wave is now considered to be relatively frequent rather
than a once in many decades phenomenon.
The good news is that hazard related outlier mortality rates appear to be on a downward
trend in the Pacific probably reflecting good mitigation work over the last two decades.
However the direct loss potential is substantial
Slide 9
An average expected direct loss of 60% of GDP for a 1% exceedance probability are not
small potatoes and immediately beg the question as to why more comprehensive risk
management strategies, incorporating risk financing, have not been widely applied.
There are in fact a considerable number of factors inhibiting the introduction of rational
risk management strategies at the country level Slide 10
The most obvious issue is that the typical politician has a relatively short time horizon –
put another way they have very high discount rates, and low probability events tend to be
given low priority when fiscal resources are scarce and issues such as health and
education are pressing, probably with World Bank staff doing the pushing. The Bank
itself has very mixed feelings about allocating our grant funds (know as IDA money) to
country risk management, and for similar reasons related to prioritization. Sometimes
there are strong incentives for governments to ignore the risk, even if the information is
under their nose. Some of you may recall the battering I took in the parliament of this
great state for having the temerity to sponsor a study of cyclone risk at the time when the
government insurer was for sale and the tourist industry was taking off around the
cyclone bull’s eye at McKay. A number of Pacific Island states are concerned about
engaging in active risk management for fear of prejudicing any Kyoto agreement
entitlements.
The donors have also contributed to the inhibiting factors through the unintentional
creation of moral hazard - governments expect that grants and easy release credits will
become available after a major disaster and have little incentive to engage in risk
management. This often leads to increases is risk levels, for example through the
proliferation of illegal and highly vulnerable housing in areas subject to severe hazard
risk. Immediate post disaster situations are highly emotional, get lots of press and it is in
fact difficult to stand back, especially if the country involved has strategic significance.
Unfortunately the press does not usually highlight the slow and non delivery which often
follows all the great words, the New York Times perhaps being an honourable exception.
To exacerbate the situation there is a degree of moral hazard within the donors – post
disaster loans are easy to sell, tend to disburse relatively rapidly and can sometimes make
a bad loan look good by switching its purpose. The World Bank has issues US$14.
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billion of direct emergency response loans in the last
years, and this could probably
be doubled if converted investment loans, mainly for infrastructure, are factored in.
The donors have also been slow to factor risk management into their country assistance
strategies, or CAS, which for many countries have a major impact on their development
agendas. The reasons are similar to those mentioned earlier – a lack of data and models
which will convince the economist gatekeepers that this is a key development issue. The
proliferation of papers, reports, studies coming out of the World Bank alone points to the
need to standardize the terminology and agree a universal model and approach. As we
will see soon my own team, working with some of the regional infrastructure people,
believes that we now have a practical working model, which has the virtue of having
been tested. This may seem like putting the cart before the horse, given the lack of strong
economic models, but the need is there and we have little doubt that the economists will
ultimately support what we are proposing.
A further issue which follows on from the previous comments is that where it is
recognized, hazard management is generally left to relatively low level civil servants who
are not in a position to make effective changes, and is spread over a range of loosely
coordinated ministries and departments. Even if these individuals were in apposition to
effect change it is extremely unlikely that they would have a decent understanding of the
relevant technology.
I will talk about coordination of donors and regional organizations a little later, but
perhaps we need to become a little better coordinated internally before taking this on t
aggressively.
A major issue is the general population’s lack of understanding of and trust of insurance
instruments. Having worked in many developing countries with broken motor third party
systems, sometimes designed to enrich politicians and generals, I cannot blame them.
However I have also lived in an Indian hamlet and this more than anything has convinced
me that the working poor need insurance more than any other section of the population.
As Dr Shah said yesterday – we need to show some imagination and to put pressure on
the regulators so that appropriate instruments and institutions can be created.
Finally we have the issue of corruption – in my view one of the major factors inhibiting
economic development in World Bank client countries. I never ceased to be amazed at
the efforts of senior individuals to enrich themselves in the chaos of post disaster
situations, when their countrymen are suffering grievously.
A present most donor reconstruction instruments are ex post and tend to be relatively
slow to disburse, partly reflecting onerous procurement rules. This is a real trade off –
stopping corruption, but getting the money out quickly and in an effective manner. In an
earlier slide I mentioned changes to O.P. 8.5 the set of rules dealing with Emergency
Response loans – these changes are designed to improve this trade off.
Slide 11
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Post disaster instruments are typically for relatively short periods, 2 or 3 years and often
take 5 to 7 months to negotiate and release. The IMF facility is the exception, but this
has to be repaid fairly quickly. Only the World Bank and IADB formally require post
disaster mitigation components, and even here they have often proved to be difficult
components to deliver. Many times this is because of inter ministerial lack of
coordination and the influence of vested interests, and the construction sector in
particular. This is a great pity as the cost benefits of applying building standards,
relocation and other measures are now being measured and come out clearly on the
positive side of the ledger.
The bias towards ex post actions is also reflected in the Bank’s own evaluations. Our
Operations and Evaluation Department, the Board’s internal auditor of the quality of the
work we do, recently produced a short interim statement (following the Indian Ocean
Tsunami) as a stepping stone to their full report due in 2006. This came up with a number
of policy recommendations that would not surprise you given my previous commentary.
Unfortunately they all assume an ex post approach, which based on our modalities to date
is hardly surprising.
The more detailed operating recommendations are of more interest to this audience as
they appear to open the door for ex ante activities.
Slide 12
In particular they point to the development damage that can be wreaked by diverting
infrastructure loans to post disaster activity, the fact that people need to be made busy
immediately after a disaster and to be paid for it and that this implies quick release of
funds.
However we still have a way to go to get a fully integrated risk management model in
place. Neil Britton has pointed out that SOPAC’s inclusive CHARM approach has
gained far wider acceptance than other technology based top down methodologies.
Slide 13
The CHARM model is in fact highly consistent with the World Bank Infrastructure/
Financial sector approach, given that it identifies a clear initial need to assess the risk and
then use this as the basis for decision making. My only concern is that it appears to
nowhere mention risk funding and relevant instruments such as reinsurance. This is
important because CHARM is seen as a key policy input into national development
planning and a number of countries in the region.
My own experience is that the Finance Ministries are often the most progressive in their
thinking – they pay the bills after all – and it is the Interior Ministries which are most
reactionary. Thus, while CHARM has many very appealing features it is an incomplete
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risk management approach. It is looks at the first two elements, risk retention and risk
avoidance or mitigation, but omits the last, risk transfer and risk funding.
The World Bank has in fact been quite active in the second of the three risk management
elements over the last few decades in EAP.
Slide 14
The operations summarized here cover a wide range of sectors and activities, but they all
contribute to risk management or post disaster recovery in some way. China is clearly
the major recipient of funds, with Vietnam now coming up close behind. The only EAP
disaster related operation which has a financing component is not shown. This is the
Mongolian livestock index insurance scheme, which was recently approved and goes into
pilot mode next year.
Thus to summarize, and quoting from the soon to be released East Asia regional study –
‘Despite the high costs of disasters, risk transfer and other ex ante risk financing
mechanisms remain the least explored and adopted [mechanism] in the region.’
This may in part reflect the diverse but mainly mitigation, relief and recovery oriented
agendas of those working in the region.
Slide 15
I mentioned earlier that the World Bank needs to become a little more coordinated
internally in this area - and we are working on it - before giving advice to others.
Someone once described running a consulting shop as like herding cats. Well the World
Bank is one third bank, one third consultant and one third university – if anyone has any
good ideas let me know. However, at the risk of getting my knuckles rapped by other
donors and NGOs I can see some techniques and structures which could help pull things
together. These include standardizing the risk assessment methodology and the
presentation of results, agreeing a universal model and language and getting country risk
management into the development banks’ country assistance strategies.
Now the time has come to talk about risk financing, and how to get it mainstreamed into
the agenda.
There is of course an active and long established insurance sector in the Asia Pacific
region. However it has only recently begun to deal with natural disaster risk in a
systematic way and to understand that this inevitably involves public private partnerships,
or PPPs as they are known. The original Indonesian and Chinese Taiwan catastrophe
pools provide examples of two very different contemporary approaches. The Taiwanese
model is probably closer to the model which has been worked up by the World Bank and
I believe that it borrowed some ideas from the Turkish Catastrophe Insurance Pool. The
Indonesian model was less of a PPP and I am not convinced that its design was driven
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entirely by good risk management thinking – sometimes the perfume of the premium still
overcomes the stench of the risk. The Indian terrorism pool provides another example of
such behaviour. One thing that is becoming clear is that without government support and
involvement and probably technical input from the key donors and international
reinsurers, catastrophe funding arrangements have little chance of being sustainable, as
we have recently seen in Algeria.
In fact Governments are theoretically the ideal catastrophe insurers. They are supposed
to be risk neutral because they have the ultimately diversified income steam and are in a
position to replicate complete insurance markets – which the economists say is better
than offering subsidies. In addition they can avoid tax and accounting rules and the short
term capital market thinking that prevent the accumulation of long term catastrophe
reserves.
Well that the theory, lets see the practice.
Slide 16
This is extracted from a World Bank report that I and a colleague did for the Indian
government and is based on some work that RMS did for us. The key issue for this
forum is that in many countries and states, the direct costs of extreme events are very
large compared to the overall annual burning cost of disasters. In this situation
government can not deal with natural disasters risk through budget processes. Despite
this Asia and the Pacific has a number of governments that have attempted to use a
budgetary process, including India, Bangladesh, the Philippines and Fiji. Elsewhere
Mexico is a good example of where this leads – the budget item has had to be increased
every year reflecting both increased exposures and bureaucratic ingenuity at extracting
funds, and Mexico is now looking to issue the first completely sovereign catastrophe
bond to short circuit all of this.
Thus there is a clear need for markets and donors to enter the picture.
I have already mentioned some of the challenges that donors are facing with their current
approach – moral hazard, slow or non delivery and having to deal with corruption.
The markets have their own challenge – unlike governments they have to allocate capital
when they assume risk, and this demands a return. Those of you familiar with
catastrophe reinsurance pricing will know that the cost of capital can be many times the
pure risk premium for upper layers.
Thus both donors and the markets need to find ways of becoming more efficient
contributors to the emerging disasters methodology. In what remains of this address I
will discuss some emerging ideas.
First of all we need the meta model.
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Slide 17
This is a 5 pillar structure, and was finally laid out in detail in a recent Europe and
Central Asia catastrophe survey carried out by some colleagues to identify countries most
at risk in that hotspot region. As in the CHARM approach, risk assessment is central to
the methodology. In addition we see the mitigation and institution building agendas
being represented. Raising public awareness and developing a response capacity is given
its own pillar, but again this will not be new to those working in this region.
The Catastrophe Risk Financing Pillar will be new to many practitioners in EAP, and lists
some of the instruments and mechanisms that have been developed elsewhere.
Unfortunately this slide does not catch the key linkages between the various pillars and it
is on this that we have been working in the last two years.
However we should first address what is meant by risk assessment – the core of the
methodology and the starting point. While the social scientists will want to look at a
whole range of issues such as the gender impact of disasters the financing pillar has a
very straightforward definition.
Slide 18
This is simply the loss exceedance curve for the asset class and location being
investigated. As you have heard there are now a number of firms, all US based, which
specialize in producing these and their methodologies recently gained academic
endorsement in a recent book produced by Howard Kunreather out of the Columbia
University Earth Institute (which also contributed to the Hotspots study). Once these
curves are produced, together with related data, some of which you saw a few minutes
ago, a basis for policy decision making exists. Government and gatekeeper economists
have less excuse to adopt the default, or do nothing option.
However the insurance sector needs to do its part – it is not so long ago that the reinsurers
applied one cat excess rates to the whole of Australia, while the reality is that rates need
to vary between different portfolios within the same city. The Queensland cyclone study
I mentioned was based on two insurer’s property books, one distributed through life
insurance agents and the other through more conventional non life channels. They had
amazingly different profiles, particularly in Brisbane.
Howard Kunreuther has been a leader in developing the risk financing/ mitigation link
and recently presented the results of some work he did with RMS at the World Bank.
They developed a model insurer/ city combination for Oakland California and then tested
for the impact of mitigation and the availability of capital market support, using metrics
which would be of relevance to any insurer.
Slide 19
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These results, which indicate that mitigation can reduce risk and hence capital allocation,
are of course very preliminary – the model is not particularly granular and some heroic
assumptions are involved – but they point to a methodology. Perhaps more importantly
they point to scope for direct insurers to increase returns to capital through encouraging
mitigation and reducing the cost of capital market support.
Ultimately it is up to the direct insurers to be the link between risk management and
financial markets. If they are prepared to measure risk properly and charge accordingly,
they can drive the reinsurers to price risk according to individual portfolio characteristics
and hence start a virtuous cycle. In addition if insurance can be linked to other financial
services at the institutional level, for example through mortgage lenders, the consumer
can be co-opted into the process.
All of this notwithstanding the reality is that catastrophe reinsurance contracts are like
savings instruments in the long term. You either have money in the bank or you owe the
bank. The one exception is the mega disaster when everyone is forced to recapitalize the
reinsurers. This means that reinsurance pricing tends to be very volatile and the marginal
countries – World Bank clients – often find themselves without coverage. In addition, in
their early stages, catastrophe pools can benefit from low cots stable backing while they
build their capital and reserves. Thus the Bank is provided contingent debt facilities to
smooth the pricing cycle and foster pools in the early days. The Turkish earthquake pool
now has in excess of $100 million in reserves after 5 years of operation and has seen a
reducing rate on line when rates were firming. It is perhaps not widely known that the
Bank will also lend to countries or sovereign guaranteed institutions to pay reinsurance
premiums.
Slide 20
This slide describes our ultimate ideal product, on which we have been working for the
better part of 2 years. The key points are that it would be rapidly disbursing and subject o
minimal post disaster interference from donors, but would only be available if a country
has established a viable disaster response capacity. It could be used in a number of
contexts but would probably be most useful for the replacement of lifeline infrastructure
immediately after a major event. Indonesia could clearly have benefited from such a
facility after the tsunami. There is in fact an existing instrument, designed for financial
shocks and called a Deferred Drawdown
, which could be converted to this
purpose. Our main challenge is to convince our own risk management people that the
commitment fee should be reduced in the case of natural disasters - and these people are
no cats.
Finally, we have a model as to how the 5 pillar approach should be operationalized.
Slide 21
The basic idea here is that private sector risks should be handled through private sector
insurers, and thence reinsured into the global markets. Lifeline infrastructure risk on the
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other hand could be directly transferred out of a country. This would all be supported by
technical advice from donors and the reinsurance sector, and ideally supplemented by the
development of a local risk management capacity, ideally with one peak body handling
the coordination, as for example in the Philippines.
Slide 22
Finally, I should say that while most of you are driven by returns to shareholders, there is
a lot of personal satisfaction to be gained from disasters work. This is pastureland near
Chingis Khan national park in Mongolia and with any luck the livestock you see will
soon be insured – at which point we will need reinsurance support. The timing will
ideally be in three years, after the pilot stage is completed , but if the Mongolian
government decides to make the insurance compulsory immediately we will need your
help in a hurry.
Thank you.
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