Securing risk financing before a disaster – not afterwards

Given the huge impact of natural disasters on society and the economy, comprehensive national disaster management policies have grown in importance around the world.

These policies address disaster preparedness and relief, as well as disaster prevention and mitigation. “Ex-post” risk financing, in other words financing risk after the event has occurred (e.g. by issuing debt, raising taxes, relying on international aid) is becoming unsustainable given the magnitude of disasters and the growing risk exposure. This has led to a widening gap between available funds and post-disaster requirements. As a result, proactive risk management and mitigation strategies have become the top priorities in managing natural disasters in order to minimise losses and related funding requirements.

Understanding the overall risk landscape is important. Disasters are classified as either low risk (i.e. “high frequency/low severity”) or high risk (i.e. “low frequency/high severity”). For each category of risk, specific risk management strategies and potential risk transfer/financing solutions are needed. From a government perspective, natural disasters which fall in the high risk category need to be effectively managed. Governments can either transfer risk to traditional insurers and reinsurers or issue catastrophe bonds. They may also purchase derivatives and other financial instruments in order to hedge the risk. Figure 2 provides an overview of different loss financing mechanisms and instruments.

Re/insurance has always been a widely adopted tool for risk financing.  However, insurance markets in some emerging economies are still under-developed and will take many years to grow up – hence, government push on this front is much needed. 

Innovative ways of financing risk mitigation and management are now available thanks to the emergence of capital market solutions and various reinsurance arrangements. These mechanisms can be especially advantageous to emerging economies as they supplement traditional insurance which is still largely under-developed. They: 

• Ensure availability of funds during recovery and rebuilding efforts.
• Protect financial budgets and reduce volatility; pre-determined premiums also allow for budget certainty, particularly in multi-year contracts. 
• Have no payback obligation (in contrast to loans) and limit the pressure to divert funds from other important projects to disaster-affected areas.

Public-private partnership in risk financing

The financing and effective reduction of disaster risks requires a joint response from the private and public sectors. As complexity and costs rise, neither group can meet the challenge alone. This is particularly true for emerging economies that lack funds, yet must also deal with the increasing frequency and severity of natural disasters. Moreover, as the underlying risk exposure increases, the inflation-adjusted costs of future events could far exceed the limited government budget.

Public-private partnerships, especially those involving reinsurance and capital market solutions, can improve disaster planning and prepare stakeholders for the consequences of climate change. They can also facilitate risk awareness and joint solutions using various risk transfer mechanisms. Solutions for risk prevention, risk transfer and financing include: 

• Partnerships for risk prevention: Insurers have the expertise needed to identify risk prevention measures and can offer more attractive premiums if such measures are implemented. The public sector, on the other hand, is better able to enforce and finance risk prevention measures, such as building codes, fire prevention regulations, etc.
• Partnerships for risk transfer and financing: Government can play a significant role by creating a legal framework that enables market mechanisms to function. Given the insurability challenges, the public sector can assume different roles in each transaction. For instance, the public sector may be involved in: 
• The development of risk transfer solutions that involve the collection of critical exposure data. In doing so, governments can also draw on the support and know-how of re/insurers. 
• Expanding the availability of risk transfer solutions for individuals and corporations. 
• Becoming the de facto insurer of last resort; it can support protection coverage on a national basis and can partner with the private sector to transfer the risk using international reinsurance or capital market solutions.

The public sector can transfer the expenses stemming from immediate relief and emergency efforts.  The main benefit is improved budgeting certainty and lower debt levels after a disaster.

Overall, such partnerships play an important role in managing the increasing cost of disaster relief, and enable the public sector to fund disaster relief proactively. This can be an effective way for governments to provide relief at lower costs, without creating a significant burden on public finances.

October 2009