Catastrophe Risk Financing in Developing Countries PRINCIPLES FOR PUBLIC INTERVENTION J. DAVID CUMMINS OLIVIER MAHUL Catastrophe Risk Financing in Developing Countries Catastrophe Risk Financing in Developing Countries Principles for Public Intervention J. David Cummins and Olivier Mahul ©2009 The International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org E-mail: [email protected] All rights reserved 1 2 3 4 12 11 10 09 This volume is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: [email protected]. Cover photo: © Getty Images ISBN: 978-0-8213-7736-9 e-ISBN: 978-0-8213-7737-6 DOI: 10.1596/978-0-8213-7736-9 Library of Congress Cataloging-in-Publication data has been applied for. Contents Foreword . .xi Acknowledgments . .xv Abbreviations . .xvii Glossary . .xxi Overview . .1 Toward a Country Catastrophe Risk Financing Framework . .2 Why Should Donors Intervene in Catastrophe Risk Markets? . .4 How Should Donors Intervene in Catastrophe Risk Markets? . .8 What Roles for the Donor Community? . .11 1. Introduction . .13 Cost of Natural Disasters in Developing Countries . .13 Proactive Country Disaster Risk Management . .17 Toward a Country Catastrophe Risk Financing Framework . .20 Objectives . .25 2. Market Imperfections and Catastrophe Insurance . .27 Basic Features of Catastrophe Insurance Markets . .27 Demand-Driven Market Imperfections . .39 Supply-Driven Market Imperfections . .48 Are Prices of Catastrophe Risk Transfer Instruments Excessive? . .64 Summary: Insurance Markets and Market Imperfections . .69 Notes . .73 vi Contents 3. Principles for Public Intervention in the Catastrophe Insurance Markets . .75 Risks of Public Intervention in Catastrophe Insurance Markets . .76 Guiding Principles for Market Intervention . .84 Notes . .90 4. Roles for the Donor Community . .91 Convening Power . .92 Promoter of Public Goods . .93 Provider of Technical Assistance for Innovative Catastrophe Risk Financing Solutions . .99 Financier . .104 References . .108 Appendixes 1. World Bank List of Economies . .115 2. Reference Catastrophe Losses . .123 3. Catastrophe Risk Modeling . .127 Introduction: Using Modeling to Manage Risk . .127 Methodology . .128 Risk Metrics . .130 4. Catastrophe Risk Financing Projects Supported by the World Bank and Donors . .133 5. Some Recent Catastrophe Risk Financing Initiatives Supported by the World Bank and Donors . .147 Property Catastrophe Insurance Programs for Homeowners . .147 Agricultural Insurance Programs . .155 Sovereign Risk Financing . .162 Notes . .176 References . .176 6. Prototype Weather-Based Crop Insurance Policy . .177 7. Commercial Catastrophe Risk Models . .179 8. Review of the Catastrophe Reinsurance Market . .185 Introduction . .185 The Role of Reinsurance . .188 Contents vii The Global Market for Reinsurance . .189 Insurance and Reinsurance Market Response to Mega-Catastrophes . .194 Conclusion . .206 Notes . .207 References . .207 9. CAT Bonds and Other Risk-Linked Securities: State of the Market and Recent Developments . .211 Introduction . .211 The Structure of Risk-Linked Securities . .212 The Risk-Linked Securities Market . .222 Conclusion . .232 Notes . .233 References . .233 10. Catastrophe Reinsurance Pricing . .237 Introduction . .237 The Mean-Variance Model . .238 A More Realistic Actuarial Model . .241 Reinsurer’s Target Economic Return . .244 Numerical Illustration . .252 Notes . .255 References . .255 Index . .257 Boxes 1.1 GFDRR Financial and Technical Assistance . .18 1.2 World Bank Group’s Catastrophe Risk Products and Services . .22 2.1 Portfolio Cost of Capital . .38 2.2 World Bank Project Reallocations After a Natural Disaster . .46 2.3 Catastrophe (CAT) Bonds . .53 2.4 Information Prerequisites for Reinsurers to Provide Weather Reinsurance . .63 3.1 Basic Principles for Efficient Catastrophe Insurance . .77 3.2 Theories of Market Intervention . .84 viii Contents 4.1 Caribbean Catastrophe Risk Insurance Facility . .93 4.2 Data Quality Issues in Middle- and Low-Income Countries . .94 4.3 Drought Risk Assessment Model in India . .97 4.4 Central America Probability Risk Assessment . .98 4.5 Parametric Insurance in Middle- and Low-Income Countries . .100 4.6 Turkish Catastrophe Insurance Pool . .103 4.7 Livestock Indemnity Insurance Pool in Mongolia . .104 4.8 Innovative Sovereign Risk Transfer Mechanisms . .105 4.9 World Bank Contingent Loan . .107 A5.1 Catastrophe Insurance Pools . .149 A5.2 Index-Based Agricultural Insurance . .157 A5.3 Main features of CCRIF . .167 Figures 1.1 Direct Losses from Natural Disasters, Worldwide . .15 1.2 Average Annual Direct Losses from Natural Disasters Compared to GDP . .16 2.1 Developed Insurance Market Structure . .28 2.2 Technical Catastrophe Insurance Premium Decomposition . .35 2.3 Non-life Insurance Penetration . .42 2.4 Direct Losses From Natural Disasters Covered by Insurance (Percentage) . .43 2.5 Economic Losses from Natural Disasters Covered by Donor Assistance (Percentage) . .47 2.6 Global Reinsurance Capital . .50 2.7 Global Property Catastrophe Excess of Loss Reinsurance Coverage, By Region . .51 2.8 Catastrophe Bonds: Annual Number of Transactions and Issue Volume . .53 2.9 Catastrophe Reinsurance: World on Line . ..