There are at least two big problems inherent in the way that the world has become accustomed to dealing with natural disasters in low- and middle-income , including of weather-related, disease-related, and geologically-related varieties. One problem is that disaster aid from donor nations often arrives too little and too late. The other problem is that it often becomes apparent, in considering the aftermath of a disaster, that relatively inexpensive precautionary steps could have substantially reduced the effects of the disaster. \”Catastrophe bonds\” (to be explained in a moment, if you haven\’t heard of them) offer a possible method to ameliorate both problems. Theodore Talbot and Owen Barder. provide an overview in \”Payouts for Perils: Why Disaster Aid Is Broken, and How Catastrophe Insurance Can Help to Fix It\” (July 2016, Center for Global Development Policy Paper 087).
Here\’s a quick overview of the costs of natural disasters in recent decades. The green bars show estimates of deaths from natural disasters from the Centre for Research on the Epidemiology of Disasters (CRED), while the red bars show estimated deaths from the Munich Reinsurance Company. In especially bad years, deaths from natural disasters can reach into the hundreds of thousands.
Here are estimates from the same two sources for estimated damages from natural disasters. In especially bad years, the losses run into the hundreds of billions of dollars. The additional blue bars seek to estimate losses due to reduced human capital. You\’ll notice that the patterns of deaths and damages from natural disasters aren\’t perfectly correlated. One of the patterns in this data is that financial damages from natural disasters are typically higher in high-income countries, while deaths from natural disasters are often higher in low- and middle-income countries (for more on this point, see \”Natural Disasters: Insurance Costs vs. Deaths,\” April 16, 2015).
Disaster aid is falling short of addressing these costs along a number of dimensions. At the most basic level, it isn\’t coming close to covering the losses. The red area shows the costs of disasters. The blue area shows the size of disaster aid.
But insufficient funds are only part of the problem, as Talbot and Barder spell out in some detail. Aid is often too slow. Here is a sampling of their comments:
\”As Bailey (2012) has set out in a detailed study of the 2011 famine in Somalia, slow donor responses meant that what might have been a situation of deprivation descended into mass starvation. As he points out, this happened even though early-warning systems repeatedly notified the global public sector about the emergency … Mexican municipalities that receive payouts from Fonden, a natural disaster insurance programme, grow 2-4% faster than those that also experience a hazard but did not benefit from insurance cover, ultimately generating benefit to cost ratios in the range of 1.52 to 2.89.\”
\”For example, food aid is often the default mechanism donors use to address food shortages, even though it would often be cheaper, faster, and much more effective to provide cash to governments or directly to households, enabling markets to react …\”
\”Yet examining data on aid flows from 1973 to 2010 reported to the OECD by donors indicates that less than half a cent of the average dollar– just 0.43% – of disaster-related aid has been labelled as earmarked for reducing the costs future hazards (“prevention and preparedness”, which we refer to elsewhere using the standard label “disaster risk reduction”). Put differently, the vast majority of our funding is devoted to delivering assistance when hazards have struck, not reducing the losses from hazards or preventing them from evolving into disasters. … For humanitarian response, a study funded by DFID, the UK aid agency, evaluated $5.6 million-worth of preparedness investments in three countries– such as building an airstrip in Chad for $680,000 to save $5.2 million by not having to charter helicopters in the rainy season– and concluded that the overall portfolio of investments had an ROI of 2.1, with time savings in faster responses ranging from 2 to 50 days.\”
Instead of cobbling together disaster assistance on the fly each time a disaster happens, can global insurance markets be brought into play for low- and middle-income countries? After all, the global insurance industry covered catastrophe costs of $105 billion in 2012, mainly because of flooding in Thailand. But private insurance markets, even given their access to the reinsurance markets that currently end up covering 55%-65% of the costs of what private insurance pays in large natural disasters, don\’t seem to be large enough to handle the costs of natural disasters.
This line of thought leads Talbot and Barder to a discussion of catastrophe bonds, which they describe like this:
\”[T]he principle is simple: rather than transferring risk to a re-insurer, an insurance firm creates a single company (a “special purpose vehicle”, or SPV) whose sole purpose is to hold this risk. The SPV sells bonds to investors. The investors lose the face value of those bonds if the hazard specified in the bond contracts hits, but earn a stream of payments (the insurance premiums) until it does, or the bond’s term expires. This gives any actor – insurer, re-insurer, or sovereign risk pool like schemes in the Pacific, Caribbean and Sub-Saharan Africa, which we discuss below – a way to transfer risks from their balance sheets to investors.
\”Bermuda has been the centre of the index-linked securities market because it has laws that enable insurance firms to create easily independent “cells” housing the SPVs that underlie index-linked securities transactions (In 2014, 60% of outstanding index-linked contracts globally were domiciled there.) The combination of low yields in traditional assets like stocks and bonds (due to historically low interest rates) and the insurance features of index-linked securities have contributed to fast growth in the instrument. According to deal tracking of the catastrophe bond and index-linked security markets, demand is healthy, and global issuance has grown quickly. … London is another leading centre. … The UK is considering developing enabling legislation to boost the number of underlying holding companies or SPVs that are domiciled there, taking advantage a capacious insurance and reinsurance sector …\”
Again, those who buy a catastrophe bond hand over money, and receive an interest rate in return. If a catastrophe occurs, then the money is released. Investors like the idea because the interest rates on catastrophe bonds (which work a lot like insurance premiums) are often higher than what\’s currently out there in the market, and also that the timing of the risk of natural disasters occurring is not much correlated with other economic risks (which makes cat bonds a useful choice in building a diversified portfolio). Countries like having definite access to a pool of financial capital. Those who would be donating to disaster relief can instead help by subsidizing the purchase of these bonds.
There are obvious practical questions with catastrophe bonds, which are being slowly worked out over time. One issue is how to define in advance what counts as a catastrophe where money will be released. Talbot and Barder expain the choices this way:
Tying contracts to external, observable phenomena such as Richter-scale readings for the extent of earthquakes or median surface temperature for droughts means that risk transfer can be specifically tailored to the situation. There are three varieties of triggers: parametric, modelled-loss, and indemnity. Parametric triggers are the easiest to calculate based on natural science data– satellite data reporting a hurricane’s wind speed is transparent, publicly available, and cannot be affected by the actions of the insured or the insurer. When a variable exceeds an agreed threshold, the contract’s clauses to payout are invoked. Because neither the insured nor the insurer can affect the parameter, there is no cost of moral hazard, since the risks– the probabilities of bad events happening– cannot be changed. Modelled losses provide estimates of damage based on economic models. Indemnity coverage is based on the insurance claims and loss adjustment and are the most expensive to operate and take the most time to pay out (or not).
Several organizations are now operating to provide insurance against catastrophes different ways. There\’s the Pacific Catastrophe Risk Assessment and Financing Initiative, which covers Vanuatu, Tonga, Marshall Islands, the Cook Islands, and Samoa, and where what the countries pay is subsidized by World Bank and Japan. There\’s the Caribbean Catastrophe Risk Insurance Facility, covering 16 countries in the Carribbean. There\’s the African Risk Capacity, which is just starting out and has provided natural disaster coverage to only handful of countries, so far, including Niger, Senegal, Mauritania and Kenya.
Catastrophe bonds have their practical problems and limits. But they can play a useful role in planning ahead for natural disasters, which has a lot of advantages over reacting after they occur. For those interested in the economics of natural disasters, here are a couple of earlier posts on the subject:
- \”Economics and Natural Disasters\” (November 2, 2012), written in the aftermath of Hurricane Sandy, and
- \”Why More Humanitarian Aid Should be Given in Cash\” (November 17, 2015)
- \”The Economics of Pandemic Preparedness\” (March 29, 2016).