97453 Sovereign Disaster Risk Financing Background At a glance There has been increasing interest in recent years in using financial instruments to help developing  Natural disasters slow long-term development and lead countries cope with financial needs resulting from to increased poverty in developing countries. natural disasters. Experience suggests that  Sovereign disaster risk financing increases the financial governmental policies of risk neutrality do not hold for response capacity of governments of developing most developing countries: small islands are too small countries in the aftermath of natural disasters, while to diversify their risks; high levels of indebtedness of protecting their long-term fiscal balances. some countries does not allow them to access post- disaster credit, thus limiting their ability to distribute  Governments are usually better served by retaining most losses between generations; and budget processes in of their natural disaster risk while using risk transfer many countries do not allow governments to reallocate mechanisms to manage the excess volatility of their budgets post-disaster, creating liquidity crunches. budgets or to access immediate liquidity after a disaster. Various new instruments have become available that works can take several months or even years. The allow governments to more easily access the design of an efficient financial protection strategy must international financial markets, enabling them to take this time dimension into account to ensure that transfer their risk in order to better manage budget funding requirements are matched with capacity to volatility resulting from natural disasters. A key lesson disburse funds when required. from the experience of the last decade, however, is that there is no magic bullet. Governments interested Sources of Post-Disaster Financing in strengthening their response capacity will generally have to combine a number of complementary financial Governments generally have access to various sources instruments and policies. of financing following a disaster. These sources can be categorized as ex-post and ex-ante financing Disasters have a much more disruptive impact on less instruments. Ex-post instruments are sources that do advanced economies. Although major disasters catch not require advance planning. These instruments the attention of the public, they rarely impact the include budget reallocation, domestic credit, external economy (and budget) of advanced economies. In credit, tax increase, and donor assistance. Ex-ante risk absolute terms, the costliest disasters primarily occur financing instruments require proactive advance in developed countries, where the concentration of planning and include reserves or calamity funds, assets, and thus potential losses, is highest. In such budget contingencies, contingent debt facility, and risk economies, however, the damage as a proportion of transfer mechanisms. Risk transfer instruments are GDP is limited to a few percentage points. For example, instruments through which risk is ceded to a third Hurricane Katrina’s economic impact in the US in 2005 party, such as traditional insurance and reinsurance, caused direct losses of 1.1% of GDP. Conversely, parametric insurance (where insurance payouts are Hurricane Ivan’s hitting Grenada caused direct losses of triggered by pre-defined parameters such as the wind- greater than 300% of GDP. speed of a hurricane), and Alternative Risk Transfer (ART) instruments such as catastrophe (cat) bonds. A government facing a natural catastrophe will not require funding for its entire recovery and Figure 1 lists the instruments that can be used by reconstruction program immediately following the governments to mobilize funding after a disaster. It event. While immediate resources will be necessary to provides an assessment of the time necessary to support relief operations, the bulk of needed funds will mobilize funds through these instruments. The main only be required several months later, when the actual advantage of ex-ante instruments is that they are reconstruction program starts. Indeed, the planning of secured before a disaster and thus allow for quick reconstruction programs, the designing of disbursement post disaster. On the contrary, ex-post infrastructure to be rebuilt, and the tender of major instruments can take some time to mobilize. Figure 1: Sources of Post-Disaster Financing Optimal Mix of DRF Instruments Catastrophe risk layering can be used to design a risk financing strategy (see Figure 2). Budget contingencies together with reserves are the least expensive ex-ante risk financing source and generally cover recurrent losses (low risk layer). Other financing sources, such as contingent credit, emergency loans, and possibly insurance should be used only once reserves and budget contingencies are exhausted or cannot be quickly accessed (medium risk layer). Finally, major disasters can be financed through risk transfer instruments, such as catastrophe risk insurance or cat bonds (high risk layer). A “bottom-up” approach is recommended: the government first secures funds for recurrent disaster events and then increases its post-disaster financial capacity to finance less frequent but more severe events. The level of fiscal resilience to natural disasters, which drives the optimal financial strategy, is a decision based on economic and social considerations. Figure 2: Three Tier Risk Layering and Optimal Sovereign Disaster Risk Financing Further Reading Cummins, J.D. and O. Mahul (2009). Catastrophe Risk Financing in Developing Countries: Principles for Public Intervention. The World Bank, Washington, D.C. ISBN 978-0-8213-7736-9 Ghesquiere F., and O. Mahul (2010). Financial Protection of the State Against Natural Disasters: A Prime. World Bank Policy Research Working Papers #5429 Contact Olivier Mahul, Program Coordinator, Disaster Risk Financing and Insurance, Capital Markets Practice (NBFI), and GFDRR, The World Bank, omahul@worldbank.org, +1(202) 458-8955 Updated March 2012 www.worldbank.org/fpd/drfip www.gfdrr.org