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Prepared by Paul Cashin and Pawel Dyczewski.
A disaster is the realization of risk (the potential for significant loss), requiring the presence of a hazard, and the vulnerability of physical and human capital to that hazard. While the Caribbean region is the most disaster-prone in the world, there are significant differences in disaster (typically hurricane) exposure within the region (see Rasmussen, 2004). Traditionally, the Leeward Islands (St. Kitts and Nevis, Anguilla, Montserrat, and Antigua and Barbuda) are more exposed to hurricanes than the northern Windward Islands (St. Lucia, Dominica) and Barbados, which in turn are more exposed than the southern Windward Islands (Grenada, St. Vincent and the Grenadines) and Trinidad and Tobago.
Cashin (2004) finds that Caribbean output volatility is about twice that of the United States, while Auffret (2003) attributes much of this excessive Caribbean volatility to exogenous natural disaster shocks.
Economic diversification and restructuring economies away from disaster-prone activities, while being a traditional means of risk mitigation, is a much more difficult challenge in geographically-small island economies with economic agents subject to covariant disaster risk.
However, contingency funds maintained in liquid accounts offer a lower rate of return than that typically earned on alternative investment of such funds, and there may be political difficulties in maintaining annual commitments and protecting accumulated funds (Benson and Clay, 2003).
Reconstruction financed by borrowing does increase national public debt, but typically does not increase a country’s ability to service its debt. In addition, the majority of the six Fund members of the ECCU have public debt stocks which are extremely high. Reliance on debt-financed disaster reconstruction is not an optimal policy for highly-indebted, disaster-prone countries.
In 1996 Mexico established the Fund for Natural Disasters (FONDEN), which is an annual budgetary allocation designed to meet post-disaster expenditures. The fund is designed to finance the repair of uninsured infrastructure, restore the productivity of affected low-income farmers, and for disaster relief activities (particularly in rural areas). However, FONDEN was insufficiently capitalized to accomplish its multiple obligations, and was recapitalized with the assistance of the World Bank in 2002. In addition, it is important to bear in mind that public commitment to extend disaster coverage to private assets reduces the incentive for economic agents to purchase risk transfer instruments.
Evidence from econometric analysis using panel data from 1980–2002 for 13 Caribbean countries indicates that while there is weak support for a contemporaneous insurance motive, the insurance effect does occur with a lag of two years. A 1 percent decrease in real GDP is associated with an increase in remittances of about 3 percent, following a two-year lag. There is also evidence that countries with higher remittances have lower volatility of real private consumption, a result that is consistent with the insurance motive (Mishra, 2005).
Typically, only certain public assets are insured in most Caribbean countries: key public buildings, as well as some hospitals and airports. Catastrophe insurance is more common in insuring hotels and private tourism infrastructure. While there is no compulsory insurance coverage in the eastern Caribbean, catastrophe cover (involving all natural hazards) is typically required in securing a mortgage.
Auffret (2003) confirms that Caribbean catastrophe insurance premiums represented about 1.5 percent of GDP over the period 1970–99, while average (insured and uninsured) losses were only about 0.5 percent of GDP. Both would be equal under actuarially-fair pricing, and confirm that the price of catastrophe insurance in the Caribbean is ‘high.’
Worldwide, the World Bank has funded post-disaster reconstruction projects in the 1980s and 1990s totaling over US$14 billion, concentrating on repairs to transportation infrastructure, energy systems, and essential social services.
As of April 30, 2005, four countries—Grenada, Malawi, Maldives and Sri Lanka—have outstanding purchases under the Fund’s ENDA policy. Both Grenada and Malawi have accessed ENDA at subsidized rates of interest.
A study of Dominica in the year following the 1995 hurricane season (during which it was hit with two hurricanes and a tropical storm) revealed that grants and loans pledged constituted about 40 percent of storm damage. Similarly, pledges received following Hurricane Ivan’s devastation of Grenada in 2004 amounted to about 20 percent of storm damage.
In capturing the financial risk of catastrophic events and transferring them to capital markets, catastrophe bonds pay out if a defined event (such as a category four hurricane on the Saffir-Simpson scale) occurs. Catastrophe bonds have traditionally been issued by an insurance or reinsurance company, to assist in transferring underwriting risk. However, while of potential relevance to governments in developing countries, as yet no developing country (including those in the Caribbean) has used such bonds to transfer catastrophe risk.
Weather-indexed securities have not been as successful as originally envisaged, even in developed countries. A major stumbling block appears to be that of ‘basis risk’—indexes such as the Saffir-Simpson scale or quantity of rainfall are often poorly correlated with the extent of individual losses.
Catastrophe insurance is expensive, with premia several times larger than the actuarially-determined expected loss, chiefly due to a large risk premium arising from the variance of catastrophic losses (Froot, 1999). Over the past two decades, less than 1 percent of losses from catastrophes were insured in poor countries (Rasmussen, 2004).
Crop insurance is not typically available in the Caribbean, which makes poor farmers especially vulnerable to natural disasters. An exception exists for banana growers, whereby growers’ cooperatives have banded together to provide crop insurance to farmers in Dominica, St. Lucia, Grenada and St. Vincent and the Grenadines affected by windstorm damage, through the Windward Islands Crop Insurance (WINCROP) scheme. About one-fifth of losses (including those arising from disasters) are covered. The size of the fund has been hampered by limited reserves, traditional adverse selection and moral hazard constraints, costly monitoring of small farmers, and large covariant risk in insuring crop yields.
From the perspective of Caribbean governments, the opportunity costs of risk transfer mechanisms include: creation of a catastrophic risk insurance program will limit discretion to provide disaster relief subsidies, and will undermine the ability of countries to access post-disaster external assistance; accumulating funds in national disaster funds will divert scarce national savings from other productive uses; and creation of a regional disaster insurance pool may result in the loss of reinsurance commissions to local insurers which have a relationship with international reinsurers.