the economic impact of natural disasters, affected countries can recover more quickly without experiencing severe economic shocks. The payment trigger can be tied to a severity index for objective and immediate determination. The liquidity and flexibility of these funds would enable relief organizations to quickly obtain supplies from local/regional sources in direct response to victims needs. Linking the indexes to early warning systems could allow for early payments that could be used to mitigate losses from an impending disaster.
Even though CAT bonds hedge against very low-probability events, pooling these risks globally would further reduce expected loss, increasing investor appeal. A pooled CAT bond would also expand the capital reserve available for disaster relief. CAT bonds which are tied to a parametric index can eliminate moral hazard and time delays in acquiring relief funding. Furthermore, when established in conjunction with ex ante rules of distribution, opportunities for misallocation of funds are reduced.
Transferring the risk of catastrophic natural disasters prevents undue economic shocks to the fragile economies of low-income countries. This in turn can facilitate the development of formal risk management mechanisms, including insurance and mitigation measures. Reliable financial markets can provide opportunities for income generation and economic development with increased access to financial markets. However, long-run solutions to disaster risk management are constrained by the abilities of the central government to provide regulations, legal frameworks and other services. Poorly defined property rights also will limit investments made in risk mitigation. Until the underlying problems of poverty and social inequality are addressed, marginalized sectors of society will remain vulnerable to the economic impact of natural disasters.
There are several other foreseeable constraints to the implementation of a charity catastrophe bond. First, investor interest in commercial CAT bonds remains relatively low. It may be some time before investors and donors feel comfortable with the new concepts contained in a charity CAT bond. In addition to the newness of the concept, there is uncertainty regarding donors’ willingness to give before a disaster strikes. Without expressed interest in this concept, the initial costs for research and development may be perceived as prohibitive. Development banks have a role to play in lowering these initial costs. Once structured, however, the political economy could distort the effectiveness of the bond. Competition for credit between relief organizations can interfere with cooperation between different donors and relief organizations. Obviously, creating a consortium of aid organizations cannot be achieved without cooperation and coordination at all levels. Nevertheless, the structure of a charity catastrophe bond could make risks more explicit by pricing the risk. When information on risk exposure is identified, better decisions can then be made regarding risk management.