Applicability of Corporate Risk Management
Techniques to Catastrophe Risk Management at the
Country Level
Rodney Lester
Lead Specialist
Contractual Savings and Insurance Business group
FSEVP
Financing the Risks of natural Disasters: A New Perspective on
Country Risk Management
World Bank
Washington DC
June 2-3, 2003
I sometimes think that there are as many meanings for the words ‘risk management’ as
there are pairs of ears to hear them. Every person who is conscious of their surroundings
and who can think ahead deals with risk. If there were any pie eyed optimists left in the
world by the late 1990s the recent combination of collapsing markets and man made and
natural disasters will have thinned their ranks considerably. Given that the somewhat
perverse genius of mankind has rapidly increased the potential for catastrophic losses in
the last century, and the last few decades in particular, there is little doubt that the world
as a whole, including governments, is more conscious of risk.
We also know that people are not consistent in their approach to risk. People, including
politicians, generally have trouble dealing with small probabilities, the area of risk where
most people in this room find their primary interest. On the other hand people tend to
overestimate risk where a dread factor exits, such as nuclear accident. Often people also
assume that they will be bailed out in the event they are struck by a major natural
disaster, a sometimes rational judgment given the typical knee jerk reactions of
politicians following natural calamities, and earthquake in particular.
In the World Bank we have been grappling with the question of natural hazard sourced
risk for upwards of two decades. In a paper written some years ago we pointed out that
by some measures the Bank is one of the World’s leading catastrophe reinsurers. This
arises out of a specific section of our operating rules which covers the provision of loan
funds post disaster. This may sound strange but if you accept the premise that cat. excess
of loss reinsurance is a form of inter temporal funding then the comparison becomes quite
valid. If I wished to be provocative I could argue that the Bank may in fact be a preferred
source of funding in this regard as its pricing tends to be more consistent over time!
Having said this I should hasten to add that, contrary to the presumptions of some, we do
believe in markets – whole heartedly in fact: if the markets are doing their job there
should be no need for Bank involvement. If we are present in a market in a way which is
obvious to the insurance sector it is because risk transfer markets are yet to develop, or
have become distorted in some manner. In fact the model for country level management
of risk which we have developed, and which will be disseminated in the coming months,
owes much to the private sector corporate risk management model which has been
developed in the last few decades.
I first became aware of this model in the hiatus between leaving the AMP in Australia
and joining the World Bank, when I had some free time and decided to bring myself up to
date on the latest thinking on risk, as well as losing some weight. In particular I
discovered the ARM certificate and the associated text books, which lay out a clear and
logical approach to risk management for large and complex enterprises. Subsequently we
have seen the publication of Neil Doherty’s book, Integrated Risk Management, which
providing an intellectual foundation for the common sense approach already in place, at
least for the more enlightened organizations. I should perhaps add as an aside here that
the reinsurance pricing cycle plays havoc with the introduction of good risk management
practices and Neil’s book in particular has been most timely.
The final pieces of the puzzle came together with Paul Freeman’s work in Latin America
on post disaster fiscal gaps, our own disaster insurance work in Turkey, India and the
Caribbean, and Bob Litan’s efforts at Brookings to develop an economic taxonomy for
the impact of natural disasters at the country or state level. These have all convinced us
that the concepts developed for large corporations can be adapted to country level risk
management.
The corporate risk management model, particularly as elaborated upon by Neil Doherty is
a complex animal indeed. It is effectively a new element of the prevailing corporate
finance model within shareholder capitalism, which feeds into such matters as optimal
leverage, the cost of capital, investment choice and valuation. For our purposes however
we are concerned about the process which leads to the optimal risk management
approach. This can be summarized by the following figure:
•
•
Risk Management
IDENTIFY RISKS - ASSESSMENT
DEVELOP STRATEGY
– RETENTION
– AVOIDANCE
– CONTROL
– TRANSFER
MITIGATION
Experience indicates that corporate management tends to be more risk averse than
finance theory would say is ideal – I should perhaps emphasize here that we are talking
about shareholder rather than managerial capitalism, its unhealthy offshoot. In any case
the key stage is the first one, identifying and measuring the risks. This is a subtle and at
times frustrating exercise, particularly where there are many interlinking processes, and
the ARM text books lay out a range of techniques to identify what can go wrong.
Deciding how much risk to retain is also not always immediately obvious as the costs
associated with mitigating and arranging ex ante funding will determine options. Those
of you have had to decide retentions when establishing annual reinsurance programs will
know exactly what I mean.
In the past we have presented this model many times to senior government officials and
received little response. In retrospect this was entirely predictable – if senior management
are a hard sell, senior bureaucrats who have to survive under politicians with short term
and often economically destructive agendas are going to be even worse. In addition there
are many countries which have broad tax bases, established insurance sectors and strong
borrowing capacities for which the do nothing strategy may in fact make sense. These
countries tend not to be World Bank clients by definition.
Thus we have often found ourselves in a similar situation to the poor corporate risk
manager trying to get the message up the line to the decision makers. However things are
changing. In particular the frequency and severity of major calamities is increasing.
This chart for India makes the point eloquently.
Reported Catastrophe Losses in India, 1965-2001
Nominal US $million at then applying exchange rates
5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
01
20
98
19
95
19
92
19
89
19
86
19
83
19
80
19
77
19
74
19
71
19
68
19
19
65
0
Source: CRED, International Disaster Database, Université Catolique de Louvain, Belgium.
The reasons for this increase in loss potential can be debated over the next two days,
however an increase in exposures and vulnerabilities must almost certainly be an
important part of the picture. The potential for loss has now reached a stage where many
countries cannot adopt the null position and effectively ignore loss potential from natural
disasters. The technical economic argument for countries to take a null position was set
out by Arrow and Lind when they argued that the natural economic portfolio of a country
ensures that governments only need to set aside the expected cost of natural disasters
each year in the budget process and that variability will not cause too much trouble. This
in fact is what many countries have done, either implicitly as in most jurisdictions, or
explicitly as in Mexico, India and some European countries.
The unpleasant emerging fact is that even the United States is not large enough for the
variability of current potential natural disaster losses to be lost in the economic or fiscal
noise. There are economists who even argue that natural disasters can have a positive
economic impact, presumably through replacement of outdated physical capital, but the
funds need to be there to do so.
Another factor we have discovered in ex post situations is that politicians cannot resist
handing out money, even if the economic returns are meager. The classic case is middle
class housing, which should ideally be dealt with through private insurance markets.
Typically around 50% of World Bank ex post disaster lending goes on housing, when
much of it would have been better spent on building essential infrastructure and
improving the lot of the poor. Finally we find that the tax ratio, the ratio of tax
collections to GDP, in many client countries is pathetic – typically around 17% or less.
Thus even if the GDP impact is not huge the impact on government finances of a
suddenly crystallized obligation can be significant. In India we estimate the burning cost
of direct natural disaster losses is running at about 12% of federal government revenues,
with high variability.
Thus we have a basic product and an emerging need – where to from here?
At this point I should make a confession – when we designed the Turkish earthquake
pool, known as TCIP, with the Turkish Treasury we were all under enormous time
pressure and only had sketchy historical loss data available. In fact we modeled the
earthquake risk based on some back of the envelope assumptions which now make me
blush – although it is amazing how close the back of the envelope can get to what pops
out of the sophisticated black boxes now available from the modeling companies. In
addition we did not have a country risk management model available at the time –
essentially we intuited that it was wrong that the Government of Turkey should be using
scarce government funds to rebuild houses for those who could afford to buy insurance,
and that we needed to build a mechanism to get disaster insurance to the people
effectively , at the lowest possible cost and with the widest possible distribution. Given
the circumstances it turned out pretty well. However there have been some lessons
learned, the first of which is to never take an opportunity away from a politician to look
like a good guy. And post disaster situations are the ultimate in this regard. So there will
need to be something there to deal with this reality if TCIP is to remain a success.
In addition we underestimated the need for people to have fairly constant reinforcement if
they are going to buy an intangible like insurance, and it is not to be seen as a tax. My
colleague Eugene Gurenko will elaborate on this shortly.
Our thinking has moved on considerably since the Turkish TCIP was designed and we
are about to publish a study on India which includes a fully fledged risk country risk
management model. This is similar to the earlier corporate model with some additional
feedback loops (see Figure below). In particular the country risk management model
conceptually recognizes that there will be both short and longer term fiscal and economic
effects which are dependent on the risk management approach adopted. For example if it
is decided to fund reconstruction through debt rather than taxes there will be timing
effects and there are also likely to be re-distributional effects between sections of society.
Given the manifest problems in measuring broad economic effects our current model
focuses largely on fiscal issues, which are much more tractable. We are hopeful that a
full economic risk management model will emerge at some stage but the challenges are
considerable, and we have found that civil servants react well to a fiscal approach in any
respect.
Country/ State Risk Management Model
STATE OF ECONOMY – Stocks
(Capital), Flows (GDP)
IDENTIFY LOSS POTENTIAL
DEVELOP STRATEGY
 RETENTION
 AVOIDANCE
 CONTROL
 FUNDING
Mitigation
Direct Losses
and ST Revenue
and Cost Effects
Redistributional
and LT Debt
Effects
The key tools are similar to those that would be used by a corporate risk manager,
although perhaps a little more formalized. These include the development of loss
exceedance curves for the major hazards and centers of exposure. These curves provide
potential loss levels by cumulative probability level (usually called return periods in the
insurance world) and these in turn can be fed into relatively simple table.
Then, based on the fiscal stance of the government concerned decisions can be taken
about required levels of expenditure on mitigation and the extent to which ex ante
funding mechanisms, including insurance, should be adopted. We have begun to prepare
some policy notes on the trade offs between the various ex ante funding tools and can
perhaps discuss these in the next few days.
This table includes a forced ranking of post disaster priorities and you will note that
housing for the non poor comes a distant last. Whether this can be enforced in practice is
debatable, but a formalized approach may at least reduce the prospects of politicians
creating moral hazard amongst those sections of the citizenry who should be able to look
after themselves.
Funding Gap Reconstruction and Rehabilitation
50 Year Event
100 Year Event
150 Year Event
Government’s post disaster
commitment
1.Lifeline infrastructure
replacement
2.Provision of living needs of the
poor
3. High return and sustainable
mitigation investment
3.Other infrastructure
4. Other housing
Ex post sources of funds
Aid
Central funds transfer
Budget reallocation
Tax surcharge
Domestic credit
Development Banks
Other external Credit
Ex post funding gap
Thus in summary we now have a fairly well developed country risk management model
in place and are looking forward to working with our colleagues in the government,
reinsurance and investment banking sectors as well as with colleagues within the World
Bank, on making the approach operational.
We look forward to your contributions to further developing this approach in the coming
sessions.