Further issues on global effects The allocation of catastrophe risk: financial instruments and the notion of optimal risk sharing World Bank/ECLAC workshop on Natural Disaster Evaluation René A. Hernández Washington, D.C April 2004

ECLAC methodology for evaluation of damages ECLAC’s experience in the evaluation of economic effects of natural disasters. Latin America and Caribbean vulnerability in the face of natural disasters, due its geographical location and structural-development characteristics. Greater vulnerability of population segments of lower income that tend to settle in areas of greater risk. Different type of disaster: natural (earthquakes, hurricanes, flooding, volcanic eruptions, etc.), technological and complex: “natural disasters do not exist; they result of man’s interaction with nature”. Importance of valuation:  to mitigate its effects and avoid repetition of negative impact,  to develop reconstruction programmes and strategies of mitigation and obtain necessary resources for disaster reduction (risk management and vulnerability mitigation).

Key figures directly and indirectly affected population at 150 million. the number of dead reached 108,000 and the total of those directly affected exceeded 12 million. million. between 1972 and 1999 amounts to more than 50 billion dollars. The true figure for human and material damages is much greater because ECLAC has only assessed damages when governments have requested it

Disasters: a problem for development or a development problem?  certain natural phenomena, tend to have greater effects on developing countries than on developed countries.  several structural factors associated with a low level of development exacerbate such effects.  the negative impact of natural phenomena on the prospects for long-term development is considerably greater in less developed countries.  A broader consideration of disasters as a development problem should include the repercussions that the policies followed by developed countries have had on some threats, such as climate change and the processing of radioactive waste.

. The full image should include the recurrent “small” disasters that don’t make the headlines but have a cumulative negative effect that is more pervasive and damaging to the development process since its economic, social, psychological and political impact is hardly perceived.

Global effects of a disaster Human suffering and deterioration of living standards disproportionate negative effects on most vulnerable groups loss of capital and investment that was made at great sacrifice postponement of development and investment projects to face reconstruction deterioration on macroeconomic results inability to face challenges of reconstruction without international co-operation expose country’s vulnerability and fragile economic and social equilibrium danger of setbacks in positive trends towards decentralisation, empowerment and active participation of society in decisions

Adapted from Mora, “El impacto de los desastres, aspectos sociales, polítifcos económicos, ambientales y su relación con el desarrollo de nuestros países (BID, 1999) THE “PERVERSE EFFECT” OF DISASTERS ON GROSS CAPITAL FORMATION IN A SMALL ECONOMY (Cochrane, 1997) Adapted from Mora, “El impacto de los desastres, aspectos sociales, polítifcos económicos, ambientales y su relación con el desarrollo de nuestros países (BID, 1999) * GROSS CAPITAL FORMATION TIME DEVELOPING COUNTRIES INDUSTRIALIZED COUNTRIES * DISASTER

Adapted from Mora, “El impacto de los desastres, aspectos sociales, polítifcos económicos, ambientales y su relación con el desarrollo de nuestros países (BID, 1999) THE EFFECT OF SUCCESSIVE DISASTERS IN CAPITAL FORMATION (modified, Cochrane, 1997) Adapted from Mora, “El impacto de los desastres, aspectos sociales, polítifcos económicos, ambientales y su relación con el desarrollo de nuestros países (BID, 1999) * * * * TIME GROSS CAPITAL FORMATION DEVELOPING COUNTRIIES INDUSTRIALIZED COUNTRIES * DISASTER

Policy implications Natural disaster exposure is not unlike other exposures to risk (financial and commercial) Risk exposure has a positive correlation with poverty: disasters are not evenly distributed neither in their occurrence or impact There is a regressive nature to economic, social and other impacts Measurement of natural phenomena’s strength and recurrence or direct asset losses does not give the real image of disaster’s perverse consequences The main stakeholders in a disaster are its victim (actual or potential) Imperfect or non-active markets require government intervention

The allocation of catastrophe risk (ACR) To what extent is catastrophe risk bearing shared (insured) and is the ACR consistent with optimal risk bearing? If not, what market imperfections prevent from the ACR? Are there government policies or private market solutions that could lead to a more efficient ACR?

To what extent is catastrophe risk shared? Evidence indicates that a large amount of catastrophe risk is retained by individuals and businesses When it is insured, most of the risk is retained by the primary insurer instead of being reinsured (Froot, 1999, 2000)

To what extent is catastrophe risk shared? Cummins et al.’s (2002) indicates that “insurers’ ability to pay promised catastrophe claims has improved substantially over the course of the 1990s, and that as of 1998 the vast majority of catastrophe claims from a mega- catastrophe in the US (about $100 billion in insured losses) would be paid by insurers”

To what extent is catastrophe risk shared? Concern about the ability of insurers to pay promised catastrophe claims has led to:  Private responses (includes financial innovations) Catastrophe options Catastrophe bonds  Public policy response Proposals for allowing insurers to establish tax- deferred catastrophe reserves State and federal government reinsurance programs

To what extent is catastrophe risk shared? Can insurers pay claims arising from a mega-catastrophe? i.e. Mitch, Andrew  The consensus amongst analysts in 1994 was that the insurance industry was undercapitalized  Cummins et al (2002) indicate that in 1991 insurers would have expected to pay about 80% of the claims from a $100 billion loss, compared to 93% in 1997

Market imperfections Insurers and reinsurers’s limited ability to pay catastrophe claims arises because of limited diversification of catastrophe risk and/or limited capital Principal-agent problem: moral hazard and adverse selection problems limit the extent to which insurers trade and diversify catastrophe risk

Market imperfections In addition to moral hazard and adverse selection problems in the reinsurance market, there are tax and agency costs of holding capital Froot (2000) includes also behavioral explanations, market power on the part of the reinsurers, and price regulation at the state level

Financial instruments Financial instruments to reduce disaster risk should be similar to other risk reducing tools (insurance, bonds, derivatives, etc.) Instruments should be sensitive to differentiated impact (in terms of decentralization, regionalization and social stratification) Instruments should include redistribution mechanisms to promote equity and development Instruments should aim at mitigating both assets and flow losses Restoration (and development of more coherent and sustainable) social fabric is basic to mitigation Instruments are to be developed and implemented “owned” by the main stakeholders Market instruments and government interventions to be seen as mutually reinforcing

Financial innovations Catastrophe derivatives  The payoffs are based on an index that cannot be influenced by the actions of market participants  Niehaus and Mann (1992) argue that catastrophe derivatives should involve lower transaction costs (less monitoring is needed) and more complete shifting of aggregate risk (since risk-sharing is not needed to control incentive conflicts)

Financial innovations Catastrophe derivatives  The payoffs are based on industry-wide losses, not a specific insurer’s loss, which implies that there is basis risk.  Based on existing research, basis risk does not appear to be the main impediment to the use of catastrophe options

Financial innovations Catastrophe bonds  With these securities, investors agree o forgive some of the principal and/or interest payments on a debt instrument if a specified catastrophe occurs. If it does not occur, then investors receive a principal plus a coupon that is normally well above LIBOR  Provide advantages over reinsurance and equity capital, but its use is hindered by regulatory constraints

Public policy proposals The underlying economic rationale for government insurance/reinsurance of disaster risk is based on the notions that  disaster risk cannot diversified cross- sectionally and therefore needs to be diversified over time  Governments can enforce inter-temporal risk sharing arrangements more efficiently than private parties (Lewis and Murdock, 1996)

Public policy proposals There are also potential inefficiencies with government insurance programs, as they often respond to political pressure and in turn, distorts loss control incentives An alternative to government insurance would be to address the source of market failure for high layers of catastrophe reinsurance coverage

Conclusions Catastrophe models to measure catastrophe exposures and the increase in capital supporting catastrophe insurance/reinsurance is better understood and the market’s capacity to bear catastrophe risk has increased The impact of catastrophe bonds is uncertain, they are used infrequently, although they provide competition for traditional reinsurance

Conclusions The impact of catastrophe options has been minimal An unresolved issue is the pricing of catastrophe risk in a portfolio context. The common assumption is that catastrophe risk is essentially a zero-beta risk, i.e., catastrophe losses are not correlated with returns on other assets