Hedging Natural Catastrophe Risk in Developing Countries

Abstract

International financial institutions like the World Bank are caught in the grip of two financial forces: the increasing demand from developing countries for borrowing to cope with the costs of natural hazard losses, and stagnant budgets that have not increased with the demand on their resources. The squeeze creates interest on the part of these institutions in the possible use of catastrophe hedges as a tool to provide post-disaster reconstruction financing for developing countries. In particular, the use of capital markets as a mechanism to absorb risk traditionally handled by insurance markets has sparked interest in the possible use of capital market tools as an alternative to post-disaster financing. Over the past few years, with the co-operation of other international finance institutions, the World Bank has sponsored or supported several research initiatives to examine the role private markets may play in supplying post-disaster reconstruction financing (Pollner, 2000). In probing the role of hedges for catastrophe risks in developing countries, there emerge a series of novel policy and research questions. One central question is the value of a hedge to a government with limited resources and competing demands for those resources. What benefit might compel a government in a poor country to spend its limited resources to hedge risk of future events? While answering this question is well beyond the scope of this article, a starting point is to understand the government’s catastrophe risk and identify the existing strategies for coping with that risk. Those existing strategies have costs associated with them. If the cost of hedging provides greater value than the existing alternatives, then purchasing a hedge may make sense. If not, it is unlikely that these new initiatives will bear fruit in providing a market alternative to current practices. A key ingredient in dealing with risk from natural hazard losses in poorer countries is the critical role of the government. Since these countries often have nascent risk transfer markets, the responsibility for absorbing natural catastrophe risk ultimately lies with the government. The failure of the government to provide risk shifting opportunities means that the victims of disasters bear all the costs of disasters. The economic good of risk shifting is lost. To understand the role that risk hedging may play in assisting governments in providing post-disaster reconstruction resources, it is essential to link the proposed hedging to a measured risk. To measure government risk from natural hazards is not so simple. Government risk from natural hazards arises from a wide variety of government functions. Often, the source of the risk is not well defined. The experience of Mexico is a good