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Financing Natural Disaster Risk Using Charity Contributions and Ex Ante Index Insurance - page 3 / 15





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Natural disasters disproportionately affect low and middle income countries (LMIC), which are limited in their capacity to absorb widespread damage brought about by catastrophic events. According to the World Bank, 94 percent of natural disasters and 97 percent of deaths related to natural disasters between 1990 and 1998 occurred in developing countries (World Bank, 2001). The average cost of a natural disaster as a proportion of GDP is 20 percent greater for LMIC than for high-income countries (Freeman, 2000).

In the wake of a natural disaster, LMIC must divert funds from limited budgets, take on additional loans and/or accept international aid to provide humanitarian aid and reconstruction. Though research on the long-term economic impact of natural disasters on LMIC is mixed, it is evident that natural disasters do negatively impact the poorest, marginalized sectors within an affected community. Frederick Cuny wrote, “A disaster makes it very evident that the poor are vulnerable because they are poor” (Cuny, 1983:54). Marginal groups may suffer extreme losses from a natural disaster while the economic impact may not be felt nationwide since these groups contribute only a small amount to GDP. The rest of the economy may experience positive growth post-disaster, while affected sub-groups remain marginalized and even excluded from the reconstruction efforts.

Market Failure

The insurance markets in most LMIC are underdeveloped. Risk exposure and weak infrastructure of many LMIC often limits the supply of insurance. Likewise, lack of information and high poverty rates translate into very little demand for formal insurance mechanisms. In these cases, informal insurance mechanisms provide limited hedging against certain independent risks. However, informal insurance can be more costly and may become “insolvent” when a catastrophe affects an entire community (World Bank, 2000/2001).

While insurance is designed to reduce the public burden of individual loss, it is less useful for managing the economic impact and correlated losses of a catastrophic event (Petak, 1998). Natural disasters cause highly correlated losses which are essentially uninsurable. Unlike independent events, such as fires or auto accidents, weather-related catastrophes typically affect a large proportion of people within a single area. Consequently, highly correlated losses translate to a larger than expected number of insurance claims. In the aftermath of a catastrophic event, indemnity obligations can overwhelm insurance companies, threatening them with insolvency. Without access to global markets, local insurers must spread correlated losses temporally rather than spatially, however retaining this risk drives up the cost of insurance. Large reinsurance companies can offer some protection from correlated losses by creating a pool of independent catastrophic risks across the globe.

Catastrophic risks fail to meet standard conditions of insurability. The six conditions of insurability are: 1) there must be a large number of exposure units; 2) the loss must be accidental and unintentional; 3) the loss must be determinable and measurable; 4) the loss should not be catastrophic; 5) the chance of loss must be calculable; and 6) the premium must be economically feasible (Rejda, 1995:23). Natural disasters violate the last three conditions. Whereas risk pooling reduces risk exposure for independent events, it increases an insurer’s catastrophic risk exposure by insuring a large group that may suffer simultaneous losses from a natural disaster. Though catastrophic events may be infrequent, ambiguity surrounding the frequency and severity of natural disasters is high. This uncertainty makes the pricing of catastrophe insurance difficult as losses are not independent nor are they completely correlated. Risk loading is a common

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