Mitigating the risk of natural disasters to promote stability

Content available in
Eduardo Pedreira
June 22nd, 2012

There are two faces to natural disasters and neither of them is friendly. On the one hand is the bitterest face, the one that is irretrievable, none other than the loss of human life. To get an idea of the extent of this drama, we only need to remember that, between 1970 and 2010, natural disasters took away the lives of 3.3 million people.(1) Then there are the material losses which, although costly, can be recovered in the medium and long term. Over the same period of time, it's estimated that nature has caused damage to the tune of 3.2 billion dollars (more than 20% of the United States' nominal GDP).

The economic impact of a natural disaster, as well as the effort involved in the subsequent recovery work, differs substantially depending on whether it has occurred in a developing or a wealthy country. In general, the impact on emerging countries is much more negative. However, developing countries are only covered by some kind of insurance for 3% of their potential losses, compared with 45% in more industrialized countries.

In August 2005, hurricane Katrina battered the south and centre of the United States, producing a huge amount of damage in Florida, Louisiana and Mississippi. In spite of its seriousness, this disaster hardly affected the country's potential growth as a whole and things got back to normal within a short period of time. Undoubtedly this was possible thanks to the enormous resources available to the United States. We can find the other side of the coin in many developing countries. For example, the earthquake recorded in Haiti in January 2010 caused huge damage was structural in nature, cutting short the already poor economic growth and making the country almost totally dependent on humanitarian and financial aid provided by the international community. This is not an isolated case as, in general, when a natural disaster occurs in a poor country, external aid, for reasons of solidarity or charity, constitutes the basic pillar to alleviate the damage and subsequently reconstruct the country.

In order to improve this situation, important multilateral institutions (such as the World Bank) have worked on developing programmes(2) aimed at providing technical and financial assistance so that those countries more likely to suffer the impact of devastating climate-related phenomena can develop Disaster Risk Management or DRM strategies. The idea is to design instruments that help these countries to protect themselves, at least economically, from events that have been seen as fatal to date but that, with suitable preparation, can be turned into manageable misfortunes.

The development and implementation of a DRM provides governments with significant economic and social advantages. Firstly, they reduce the public accounts' exposure to the occurrence of a natural disaster, as certain risks are passed on to the international reinsurance markets or capital markets. Secondly, lower fiscal uncertainty improves the environment for authorities to help the population access better social services, as well as developing production infrastructures that can boost growth in the long term. Lastly, governments make sure that, in an emergency situation, they will have immediate access to the necessary funds to provide the population with aid and to rebuild the damaged infrastructures. A brief review of the experiences of two countries as different as Mexico and Malawi can help to clearly illustrate the potential benefits that can be gained from such strategies.

In 1985 Mexico suffered two earthquakes of 8.0 and 7.5 on the Richter scale, causing more than 10,000 deaths and destroying 100,000 homes. This situation forced the government to reallocate resources that had been aimed at developing public infrastructures to be able to meet the costs of rebuilding the private sector. In order to avoid a similar situation in the future, in 1996 the Mexican government decided to create the Natural Disaster Fund (FONDEN) at the same time as developing an institutional framework aimed at diminishing and reducing the risks associated with natural disasters. In order to achieve its goals, the FONDEN uses several instruments including CAT Bonds (catastrophe bonds). A Cat Bond (see the figure below) is a bond that pays periodic coupons to investors during the bond's life and that covers the sponsor against a number of natural disasters (earthquakes, hurricanes, etc.). If any of the events covered occurs during the life of the bond, the sponsor country retains the principal to finance payments for aid to the population and reconstruction work.

In 2006, the FONDEN issued CatMex bonds totalling 160 million dollars to transfer the risk of a possible earthquake to international financial markets. This was the first time an instrument of this nature had been issued by a government. In 2009, after the CatMex matured, Mexico decided to diversify its coverage further by issuing parametric bonds maturing in October 2012, along the lines of a programme designed by the World Bank. The amount place was 290 million dollars and demand by investors reached very high levels, with private entities of the stature of Swiss Re and Goldman Sachs taking part. With this issuance, the Mexican government has partly passed on the risk of a climate-related or geological disaster to the market, ensuring pluriannual coverage at a reasonable cost. The appeal for private agents acquiring the bond lies in the possibilities for diversification, as these are assets that do not depend on the economic or financial performance of a government or firm and are therefore uncorrelated with the rest of securities.

Malawi is other example of a country that has benefitted from disaster risk management strategies. This is a poor nation located in southern Africa, highly vulnerable to drought and where 38% of its GDP depends on agriculture. In 2005 the country had a severe drought that forced the government to allocate 200 million dollars to alleviate the hunger suffered by millions of farmers. Although the international community collaborated with a similar amount, the effects were considerable. As a result of this situation, the government of Malawi, advised by multilateral bodies, developed a strategy to pass on part of the risk to the capital markets and thereby mitigate the negative impact of another similar event on the economy and the government's budget. The main aim was to ensure fast access to funds to help reduce the country's dependence on international humanitarian aid. To this end, the Malawi government bought, in 2008-2009, 2009-2010 and 2010-2011, an index-based weather derivative contract (a six-month put option). This index associates rainfall with the production of corn so that, if this falls below a certain level (10% of the historical average), the contract offers protection for any crops that might be lost. In 2009-2010 the dreaded drought occurred but, thanks to this coverage, the Malawi government received a payment which it allocated to buying corn on the international futures market, thereby ensuring the cost of supply for the country.

These are simply two experiences of countries that, making use of novel instruments, have managed to partly and effectively pass on the risk of a natural disaster to the international financial and insurance markets. These strategies are clearly not a complete solution but they undoubtedly promote greater stability in public budgets and long-term growth.

(1) «Disaster Risk Management: Building a Safe and Resilient Future for All», The World Bank, September 2011.

(2) In 2006, the Global Facility for Disaster Reduction and Recovery (GFDRR) was set up. The main mandate of the GFDRR is to collaborate in developing strategic policies aimed at reducing the risk of disaster (DRR or Disaster Risk Reduction) and adaptation to climate change (CCA or Climate Change Adaptation).

This box was prepared by Eduardo Pedreira

Financial Markets Unit, Research Department, "la Caixa"

Eduardo Pedreira