Preparing for Disasters: Financing Earthquake Reconstructions in El Salvador

Due to its geographic location, El Salvador is highly exposed to the risk of natural disasters. Although tropical storms and droughts frequently hit the country, earthquakes are the most important source of risk. These events not only disrupt the lives of thousands of people and produce millionaire losses, but also dislocate government’ budgetary resources and generate pressure on the fiscal accounts.

Like in most developing countries, the government of El Salvador lacks the funding required for post-earthquake reconstruction, and traditionally has relied on multilateral credit facilities to meet its emergency needs. The absence of an ex ante financing strategy has important shortcomings. On the one hand, negotiating emergency funds generates delays that hinder the provision of post-earthquake aid. On the other hand, fiscal accounts worsen as a consequence of the use of debt to finance earthquake-expenses, putting in risk the macroeconomic stability of the country.

This work proposes shifting from an ex post financing of earthquake expenses to an ex ante strategy. Earthquakes are recurrent events in the lives of Salvadorans and they need to be incorporated in the development strategy of the government.

In 2001, two devastating earthquakes hit El Salvador. The economic losses were documented by the ECLAC and they became the base for estimating a proxy for the fiscal costs that these catastrophes impose on the government of El Salvador.

Once the costs for the government were estimated, the next step was the analysis of four alternatives for financing those expenditures: setting a special saving account, issuing catastrophic bonds, financing through loans, and insuring public infrastructure.

Regarding the possibility of insuring public assets, we conclude that it is feasible for the government to insure those buildings that satisfy standard construction codes. Public assets built before the 1986 earthquake and some municipal infrastructure (e.g. schools) may be uninsurable due to lack of guarantee that they satisfy adequate construction techniques.

Catastrophic bonds are an attractive mechanism for financing at least part of the earthquake expenses. While these catastrophe-related securities have been successfully used by insurers and reinsurers to avoid the risk of insolvency from catastrophic losses, there is lack of experience with them in developing countries. This and the existence of a “catastrophic risk premium” are the reasons why this strategy could be expensive for the government. Nonetheless, the costs of using this option could be reduced if the government can get the support of the World Bank to act as an intermediary.

After analyzing the pros and cons of the four strategies we conclude this document recommending the use of a mix of these alternatives. The weight of every mechanism in the final strategy will depend on the perceived priorities of the government and its ability to reallocate resources toward the ex-ante financing strategies.

The private sector accounted for a large fraction of the economic losses of the 2001 earthquakes. In particular, housing was one of the sectors most affected by these disasters. We devote a section of the document to analyze the factors affecting the demand and supply of catastrophic insurance in El Salvador.