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. HernándezWashington, D.C. 14-15 April 2004

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

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 optionsCatastrophe bonds

Public policy responseProposals for allowing insurers to establish tax-

deferred catastrophe reservesState and federal government reinsurance programs

To what extent is catastrophe risk shared?

• Can insurers pay claims arising from a mega-catastrophe? i.e. Mitch, AndrewThe 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 derivativesThe 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 derivativesThe 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 bondsWith 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