Risk Financing

Countries can reformulate financial risk management by conducting sophisticated probabilistic risk models to determine hazard exposure and potential economic and social losses and by estimating various risk metrics. Results from these studies could then be applied to a study of fiscal accounts to determine budgetary resilience to disasters. Once individual fiscal resilience is determined, each country can develop and implement a risk transfer strategy that includes a: i) national reserve fund; ii) contingent debt; iii) parametric insurance instrument; and iv) catastrophic insurance pools. A sound government strategy would also involve initiatives to promote private insurance, particularly homeowners insurance.

Modern funding approaches, by ensuring that sufficient liquidity exists in the aftermath of a disaster, can help speed recovery, ensure that the scare government funds are well used and reduce the risk-enhancing effects of moral hazard. Such strategy should also help stabilize the government's budget by allowing an integration of risk within its budget planning process. The proposed approach rests on the layering of risk with particular instruments covering each layer.

• National reserve fund. This fund would finance frequent and recurring events (e.g., return periods of 5 years or less) as well as small risk mitigation investments and emergency assistance. The government can help stabilize its development process and avoid permanent reallocations of the budget by appropriating these resources in advance.
  
  
• Contingent debt. Less frequent but more severe events (e.g., with return period between 5 and 20 years) could be financed with a contingent credit facility. It enables the user to access capital after the occurrence of contractually pre-defined events. It is designed to provide immediate capital when it is most needed (i.e. in the aftermath of a disaster) and most scare.
  
  
• Parametric instruments. These instruments pay claims based on the measurement of the intensity of a pre-defined natural event in a pre-defined area over a pre-defined period. This type of instrument is less expensive than indemnity-based instruments since it does not require evaluating losses on an indemnity basis. Catastrophe bonds are another example of insurance-linked securities that transfer catastrophic risk to the capital markets via the issue of a bond where repayment of principal is contingent upon occurrence of a predefined catastrophe.
  
  
• Catastrophe insurance pools. Loss potentials arising from natural disasters can be so large that the insurance markets are unable to provide sufficient capacity at acceptable prices. Catastrophe insurance pools can be developed, usually as a public-private partnership, to provide private assets with cost-effective coverage, thus limiting the government's commitments in the case of a disaster. Such facility could be used to (i) insulate the domestic insurance market from catastrophe losses; (ii) act as a center of technical excellence to support insurers; (iii) ensure efficient local retention by pooling non-retainable risks; (iv) facilitate access to international reinsurance at better terms by providing a more diversified portfolio; and to (v) limit the government's fiscal exposure to natural disasters.