Hedging Natural Catastrophe Risk in Developing Countries: Comment

Abstract

Paul Freeman offers an important contribution to understanding the specific needs of developing countries in mitigating the effects of natural catastrophes. Freeman succinctly recaps the potentially dramatic and disastrous impacts of these events, but the real contribution is in making explicit the roles and interests of international financial institutions like the World Bank and in articulating a taxonomy for understanding risks faced by governments in developing countries. He then applies standard economic analysis to these risks considering the particular role of new risk-hedging instruments that have developed over the past several years. While no specific solutions or recommendations are offered, the paper does offer insights into how risk-transfer mechanisms might provide efficient solutions for some categories of developing-country risks, and how they may not be appropriate for all risk types. The application of a traditional risk management framework is helpful for delineating issues, constituents, and incentives. Freeman uses the simple framework of risk identification, risk ownership, techniques for risk mitigation, and mechanisms for risk transfer and risk financing, including an analysis of the costs, as opposed to the benefits, of risk transfer. As is usual in this framework, issues of information quality and asymmetry, moral hazard, adverse selection, and degree of risk aversion are critical. One particular argument advanced by Freeman (drawing on the work of Arrow) is that governments are typically thought of as risk-neutral. If that is the case, then the government itself will be the most efficient at managing the risk and there is "no theoretical justification for them to engage is risk-shifting transactions like hedging". Freeman's proposition is that while this may hold for developed countries, this need not be the case for developing countries, where the size of a natural catastrophe, relative to the size and wealth of the economy, could swamp the ability of a government to self-finance the event through internal sources (i.e. taxation). Hurricane Mitch is used as an example. The storm caused damage in Honduras equivalent to one year's gross domestic product. For countries vulnerable to such events, having risk-averse preferences may be desirable. Thus, risk-shifting may be appropriate. Freeman's proposition is practical and reflects the economic and risk realities facing the developing world. Freeman identifies three classes of risks faced by governments: (1) risks created by governmental investment decisions, especially those related to physical infrastructure; (2) risks assumed for other economic agents in the economy particularly where there are market failures; and (3) risks associated with the governmental role as protector of the poor. Presuming that governments from developing countries ought to be risk-averse, Freeman