Time to Insure Developing Countries Against Natural Disasters

Hurricanes, droughts, floods, landslides, earthquakes. They have always happened. But their frequency and their intensity are rising. You can blame climate change for much of that. Each time the death toll, the destruction, and the trauma seem worse than before. On average, natural disasters are estimated to cost a third of a trillion dollars a year. That would be more than twice the size of all official development assistance—the money developed countries set aside to help developing ones. And needless to say, the poor suffer disproportionately when a disaster strikes—they are more exposed, more vulnerable, and less able to recover. Think about it: when a cyclone comes, who is more likely to have informally settled on a flood plain, built a house with shoddy materials, lose a larger share of their assets, and have less savings to rebuild? A rich family or a poor one? The same storm may be an inconvenience for the former, and a calamity for the latter. Research shows that, every year, natural disasters trap some 26 million people in extreme poverty—that is, in living with $1.90 per day or less.

So, if natural disasters are becoming more frequent and more devastating, how should governments in the developing world manage the risk? Optimally, they should invest in resilience—things like early warning systems, sturdier infrastructure, tougher building codes, smarter urban planning, and wider social safety nets. They should also do their part to slow down global warming. The problem is that these governments typically lack the resources, the capacity and, at times, the incentive to put and keep all that in place. Many are forced to choose between disaster prevention and, say, nutrition programs.

There is, however, one source of disaster risk management that remains under-exploited: insurance. Over the past decade, several governments in emerging economies have managed to buy policies against weather and geological risk, either individually or joining forces with other countries. Take India, Mexico, Philippines, Uruguay, and the island-states of the Caribbean and the Pacific. They bought coverage against events like hurricanes, tsunamis, droughts, and earthquakes from private insurance companies. It proved to be a wise move, because those who were later hit by a disaster received a pay-out, in most cases within a couple of weeks. The money could not have come in handier, as tax revenues shrink, public expenditures balloon, and lenders flee following a catastrophe.

If the benefits are so obvious, why has natural-disaster insurance not been adopted by more developing countries? Two words: know-how and trust. It is not easy—or cheap—to calculate the probabilities that insurance companies need to price a policy against something that depends on the weather or on Earth’s crust, and which may affect different countries differently. How do you define the event, and choose a magnitude on a scale? Who certifies that it took place? These are highly technical matters for which governments in developing countries are rarely equipped.

And then there is trust. Many of these insurance policies take the form of catastrophic bonds—“CAT-bonds” in the jargon. It means that countries take on debt which they don’t have to repay if a natural disaster occurs. In fact, the proceeds of the bond are kept in an account and can only be withdrawn if a pre-defined disaster takes place. This, of course, assumes that investors trust the country to service its debt in normal times; otherwise, they may charge sky-high interests rates. This puts CAT-bonds beyond the reach of many poor countries.

At times, the trust problem flows the other way. A minister may fear that private insurers will not come through and pay up when a crisis comes—after all, those insurers know the technicalities and small print of the contracts better than anyone. If they refuse to pay, the political embarrassment that follows can sap the government’s credibility, right when citizens most need leadership they can count on.

With those obstacles in mind, is there a way to help governments in developing countries buy insurance against natural disasters? Enter multilateral institutions like the World Bank. They have—or can mobilize—the technical expertise necessary to define and negotiate the “parameters” that underpin insurance policies—such as the likelihood of an earthquake or a typhoon. They can serve as a forum for several countries, or several provinces within a country, to buy a policy together—thereby “pooling” their risk. They can broker the dialogue between a government and private insurers. They can even sell the insurance themselves, and then buy an identical policy in their own favor—in effect intermediating between a country and the market.

Whether serving as advisers, brokers, or intermediaries, multilateral institutions can—and should—play a critical role in helping governments hedge against disaster risk. They are perfect for the job, as they are owned by those governments and are active in international financial markets. Some progress has already been made: most of the disaster-risk insurance policies that have been issued to developing countries, were put together with support from the World Bank. [Disclaimer: the World Bank department which this writer heads was part of those transactions.] Donor countries—like Germany and the UK—are rightly directing part of their foreign aid to fund research and training in this area. Soon, they may even bear some of cost of the insurance premiums for the poorest nations. This is encouraging. But much more remains to be done to make coverage the norm, rather than the exception. There is no reason why a natural hazard should become a natural disaster.

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