IPCC_Managing Risks of Extreme Events.pdf - Climate Access

Managing the Risks: International Level and Integration across ScalesChapter 7events. A discussion of these instruments goes beyond the scope of thischapter, but it is worth drawing attention to the most prominent risklinkedsecurity, the CAT bond, which is a fully collateralized instrumentwhereby the investor receives an above-market return when a specificnatural hazard event does not occur (e.g., a Category 4 hurricane orgreater), but shares the insurer’s or government’s losses by sacrificinginterest or principal following the event if it does occur.Over 90% of CAT bonds are issued by insurers and reinsurers in developedcountries. Although it is still an experimental market, CAT bondplacements more than doubled between 2005 and 2006, with a peak atUS$ 4.7 billion in 2006 (Cummins and Mahul, 2009), but declining toUS$ 3.4 billion in 2009 (Munich Re, 2010).In 2006 and 2009, the first government-issued disaster relief CAT bondplacements were executed by Swiss Re and Deutsche Bank Securities toprovide funds to Mexico to insure its catastrophe fund FONDEN againstearthquake and (in 2009) hurricane risk, and thus to defray costs ofdisaster recovery and relief (Cardenas et al., 2007). The World Bankprovided technical assistance for these transactions. Although thetransaction costs of the Mexican CAT bond were large, and basis risk(the risk that the bond trigger will not be highly correlated with losses)is a further impediment to their success, it is expected that this form ofrisk transfer will become increasingly attractive especially to highlyexposed developing country governments (Lane, 2004). As discussed inChapter 6, a large number of government treasuries are vulnerable tocatastrophic risks, and post-disaster financing strategies generally havehigh opportunity costs for developing countries.International and donor organizations have played an important role inanother case of sovereign risk transfer (discussed in Section 9.2.13). In2006, the World Food Programme purchased an index-based insuranceinstrument to support the Ethiopian government-sponsored ProductiveSafety Net Programme, which provides immediate cash payments in thecase of food emergencies. While this transaction relied on traditionalreinsurance instruments, there is current interest in issuing a CAT bondfor this same purpose. Tomasini and Van Wassenhove (2009) note theimportant role that securitized instruments can play in providing backupfor humanitarian aid when disasters strike.7.4.4.2.5. Regional risk poolsRegional catastrophe insurance pools are a promising innovation thatcan enable highly vulnerable countries, and especially small states, tomore affordably transfer their risks internationally. By amalgamatingrisks across individual countries or regions and accumulating reservesover time, catastrophe insurance pools generate diversification benefitsthat can eventually reduce insurance premiums. There is also growingempirical evidence that catastrophe insurance pools have been able todiversify intertemporally and thus dampen the volatility of the reinsurancepricing cycle and offer secure premiums to the insured governments(Cummins and Mahul, 2009).As a recent example (discussed in Section 6.3.3 and Case Study 9.2.13),the Caribbean Catastrophe Risk Insurance Facility (CCRIF) was establishedin 2007 to provide Caribbean Community governments with an insuranceinstrument at a significantly lower cost (about 50% reduction) than ifthey were to purchase insurance separately in the financial markets.Governments of 16 island states contributed resources commensuratewith their exposure to earthquakes and hurricanes, and claims will bepaid depending on an index for hurricanes (wind speed) and earthquakes(ground shaking). Early cash payments received after an event will helpto mitigate the typical post-disaster liquidity crunch (Ghesquiere et al.,2006; World Bank, 2007a,b).7.4.4.3. Value Added by International InterventionsInternational financial institutions, donors, and other international actorshave played a strongly catalytic role in the development of catastrophicrisk-financing solutions in vulnerable countries, most notably by:• Exercising convening power, for example, the World Bank coordinatedthe development of the CCRIF (Cummins and Mahul, 2009)• Supporting public goods for development of risk market infrastructure,for example, donors might consider funding the weather stationsnecessary for index-based weather derivatives• Providing technical assistance, for example, the World FoodProgramme carried out risk assessments and provided otherassistance to support the Ethiopian sovereign risk transfer (Hess,2007), and the World Bank provided technical assistance for theMexican CAT bond (Cardenas et al., 2007)• Enabling markets, for example, DFID is active in creating the legaland regulatory environment to facilitate access to banking services,which, in turn, greatly expedite remittances (DFID, 2005; Pickens etal., 2009)• Financing risk transfer, as examples, the Bill Gates Foundationsubsidizes micro-insurance in Ethiopia (Suarez and Linnerooth-Bayer, 2010); the World Bank provides low-cost capital backing forthe Mongolian micro-insurance program (Skees et al., 2008); theSwiss SECO and the IADB provide low-interest credit to the ELF(UNFCCC, 2008); and many countries have contributed to theCCRIF reserve fund (Cummins and Mahul, 2009).Though only a few of many examples of involvement by the internationalcommunity in risk-sharing and transfer projects, they show thatinternational financial institutions and development/donor organizationscan assist and enable risk-sharing and transfer initiatives in diverseways, which raises the question of their value added. Largely uncontestedis the value of creating the institutional conditions necessary forcommunity-based risk sharing and market-based risk transfer, yet, directfinancing, especially of insurance, is controversial. Critics point to the‘economic efficiency principle’ discussed in Section 7.2.2, and arguethat public and international support, especially in the form of premiumsubsidies, can distort the price signal and weaken incentives for takingpreventive measures, thus perpetuating vulnerability. Supporters pointto the ‘solidarity principle’ discussed in Section 7.2.3 and the important420