The Hindu Business Line : Let not financing be a disaster after rapid onset of natural disasters

DISASTER, donations, distribution, and delay, form only a predictable combination that plays out whenever a major blow strikes. There can be a better alternative, argue Eugene Gurenko and Rodney Lester in a recent World Bank Policy Research working paper titled, "Rapid onset natural disasters: the role of financing in effective risk management."

Hazards destroy capital, and can come from `natural perils, epidemic and terrorism', and the rapid ones do their damage faster.

It is not as if natural disasters strike only the developing countries. The paper informs that there were 15 natural disasters in the US over the last 15 years, and these resulted in $43 billion losses. While the most massive economic losses from natural disasters occur in developed countries, because "the value of exposed capital is higher in absolute terms", developing countries suffer `greater and more disruptive' impact of natural disasters owing to several reasons.

For instance, "infrastructure is less resilient, building standards are lower, incentives for mitigation are absent, private markets do not provide catastrophe insurance for homeowners and small businesses, and there are greater constraints on government resources available to cope with disasters."

As a result, the first loss to happen in the developing world is usually of human lives, as in the recent tsunami, but there are extensive `fiscal and economic consequences' that follow.

A telling statistic in the paper is that of the 40 worst catastrophes in terms of the number of victims in 1970-2001, 39 occurred in developing countries. Also given are numbers showing the dent that GDP and government revenues took.

Thus, the 1999 earthquake in Turkey caused damages close to 5 per cent of GDP, or 21 per cent of government revenues, while losses due to the 1998 floods in Bangladesh sliced off 17 per cent of the country's GDP, or 152 per cent of government revenues.

The impact of the Gujarat quake was "$2.1 billion in damage, equivalent to only 1 per cent of GDP but a substantial 7 per cent of State government annual revenues." But wait, over the last 35 years, India has experienced 360 natural disasters "with reported direct losses on public and private economic infrastructure of approximately $30 billion (nominal values at then applying exchange rates)" and the authors note that, on average, the direct cumulative costs of these disasters add up to 12 per cent of government revenues.

There are two significant observations: One, frequency of weather related calamities are on the rise; and two, developing countries too suffer increasing economic damage due to urban development in disaster-prone areas. An analysis by the authors shows that the `reported frequency of natural disasters' has been increasing over time: From 121 events or eight per year, 1965-80, to 181 events or 15 per year during 1981-95, and 75 events in 1996-2001.

There is also a pattern of "more frequent hydro-meteorological hazards."

Financing disaster

More than the damage that disasters cause, what can be more of a problem is the absence of financial strategy to recover from the attack. Fiscal resources are limited, and insurance penetration is low, so governments get into action only after the event. "Typically this means relying on domestic budgets, including diversion of resources from other projects, and on extensive financing from international donors," state the authors.

It is not as if `ex post disaster funding' is not relevant when managing risks. However, there is a tendency to excessively rely on such a strategy, because of s-o-s calls from developing countries and "willingness of donors to provide emergency grants and loans". This is not sustainable, declare the authors, because of the possibility of `growing losses' in developing countries that accumulate more assets "in limited geographic spaces."

It is also understandable that "the capacity and willingness of donors to fund disaster relief and reconstruction is ultimately constrained." In short, `funding gaps' are likely.

Ex post disaster funding, or raising money after the happening of the event, is sub-optimal, aver the authors. One, release of funds can be slow. There is disturbing evidence that in many cases loans have not been disbursed owing to lack of "local human and institutional capacity to deploy the available funds". Two, there can be `ineffective use' of money. There are `political agendas' that come to the fore and dictate ad hoc allocations in great hurry, and `extreme urgency' gives a go-by to all scrutiny. And three, funds may not be sufficient.

A risk management framework

The solution lies in a proactive approach, advise the authors. A successful strategy to manage risk arising from rapid onset natural disasters would reduce risk exposures to reduce losses, hone response planning and relief targeting, and ensure sufficient liquidity. The paper discusses four steps in this regard.

First, collect data on "probable occurrence of natural disasters" and then calculate likely resultant damage, and this would help in risk measurement. Second, try fitting in risk reduction techniques to reduce `identified loss exposures'; "the most beneficial mitigation programs are those that are done before or at the time of new construction." Third, "determine the most effective risk funding and risk transfer mechanisms", after balancing the ex post and ex ante components. And fourth, put in place legal and institutional machinery for quick response.

Risk measurement

This is an appropriate area for accountants to pitch in, but know that there are four stages or modules in `loss risk assessment', which I'm sure they'd teach in the ICAI's post-qualification course on insurance. Hazard module is the first, and this uses simulation `to generate stochastic events' and study the `intensity'.

Next is the exposure module; for this cull out property data and also `population distribution' stats; use a simple equation to compute value exposed as the product of building stock and average building replacement cost. Third is vulnerability module, "to calculate the damage to each type of building from a given intensity event at a specific site." Classify buildings according to material used, usage, number of floors, and age. Compute `damage ratio' to relate repair cost to replacement cost, "for each peril at various intensities and locations". Fourth comes loss analysis module, where you multiply the damage ratio by the value exposed to arrive at estimated loss.

The above four modules can help derive `five key measures of loss risk', guide the authors. One, `average annual loss' is what governments should ideally budget for, as disaster response. Two, `probable maximum loss' finds application in insurance "as an estimate of loss severity in determining reserves and other forms of claims paying capacity needed to finance a catastrophic loss." Three, `loss exceedance curves' help in calculating probabilistic estimate of average annual loss, "a basic input into deriving insurance premiums". Four, `pure risk premium', that is "generally expressed as the average annual loss per 1,000 dollars of exposed value". And five, `market value premium' or the cost of transferring risk to reinsurance market; this is "typically a 3-6 multiple of the pure risk premium", after factoring in "expenses, underwriting and loss adjustment costs, profit, cost of capital reserves, and inflation to the pure risk premium".

Catastrophe insurance pool

Insurance talk is okay, but it may be unaffordable for many. Will the government bail them out? Will private insurance companies build up `special catastrophic reserves for severe but unlikely events', when faced with no tax incentives on the one side, and shareholder expectation on the other? We have calamity relief funds to achieve `inter-temporal smoothing' but what do we do if the insurance market is not effective? Turn to catastrophe insurance pools, counsels the paper. These may fare better than reserve funds, especially if we are worried about events that occur once in a few centuries. In this, the authors foresee a major role for multinational insurance companies `with global risk portfolios'.

There is an elaborate discussion of TCIP, the Turkish Catastrophe Insurance Pool, "probably the best known of the more recent efforts in developing countries." This was developed in association with the World Bank, and is supported by "innovative funding mechanisms developed within the Bank."

Advantages of the pool, as the authors list, include affordability of premia and good governance, apart from "effective risk management and incentives for the private insurance industry to distribute the insurance product efficiently and effectively."

A paper that's worth a close study.

AccountSpeak@TheHindu.co.in

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