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Financing Natural Disaster Risk Using Charity Contributions and Ex Ante Index Insurance - page 11 / 15

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high rainfall in the eastern Pacific increases with the expectation of reduced rainfall in Indonesia and Malaysia (NOAA Climate Prediction Center).

Figure 3: Effect of Risk-pooling on Variance of Returns

Variance

6.00%

5.00%

4.00%

transaction costs

3.00%

2.00%

1.00%

0.00%

  • 0

    5 10 15

Number of Regions

20

E(R)=7.90% E(R)=2.95%

The bond could also be structured to provide regular coupon payments to the investor; however, rolling over the interest and principal into consecutive years allows for leveraging of the initial investment and generates growth of potential relief payments. The main objective of implementing a market-based instrument for catastrophe financing is to provide an alternative and reliable source of emergency capital that can be provided in an efficient and equitable manner. Therefore, the role of the CAT bond as an investment tool is secondary.

Summary & Conclusions

A charity CAT bond eliminates or reduces the premium for catastrophe coverage for low- income countries, yet requires ex ante measures for disaster coping in coordinated effort with government agencies and aid organizations. Potential long-run benefits of supplying disaster aid in this form include improved disaster preparedness, cooperation between aid organizations, and emergence of domestic insurance and other financial markets.

More immediate benefits can be realized through more efficient use of disaster relief funds. The proposed charity CAT bond could be structured in a way to address the limitations of traditional aid, allowing for objective, reliable and accessible emergency capital. Access to capital is often more effective than the provisioning of material items as it allows funds to be spent locally, encouraging local disaster management capacity and supporting the local/regional economy (IFRC, 2001; Smillie, 2001). Monetary resources also ensure that only needed supplies will be purchased, eliminating the burden often placed on disaster-stricken communities by the flood of unnecessary items.

Additionally, the supplemental aid provided by a charity CAT bond could prevent budgetary diversions by the government and multilateral development institutions. By smoothing

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