practice used to raise premium rates to account for the uncertainty of loss. As a result, the people who are most vulnerable to natural disasters are the least able to afford risk mitigation and management.
Yet even where catastrophe coverage is available, it has been observed that there is low demand for catastrophe insurance, even in high-income countries. Kunreuther (1979) examined the psychology behind peoples’ decision to purchase insurance—particularly the lack of coverage against cataclysmic events-- and found that most people are unwilling to pay for low probability events, even when the potential damage incurred can be great. This behavior is used to rationalize government response. Even when insurance coverage is mandated, as with the U.S. National Flood Insurance Acts (1973, 1994), the government still assumes responsibility for providing aid to those who declined to purchase insurance and suffered losses (Barnett, 1999).
While the affected governments bear the brunt of the costs of major catastrophes, the over-burdened budgets of LMIC will be highly inadequate to meet these needs following certain disasters. External disaster financing from bilateral and multilateral emergency aid provides an additional source of financial assistance. However, limitations of international assistance prevent the most efficient provisioning of disaster relief. Two major concerns regarding international aid are delay in the disbursement of funds and unreliable funding (Fowler, 1997; IFRC, 2001). Money coming from international relief organizations must be raised; while bilateral aid must travel through the political pipeline where it is may be tied to conditions for its use. Reliance on damage assessments, fundraising, and administrative approval also creates delays in the disbursement of relief aid. Additionally, this type of humanitarian response reinforces risk-taking behavior, meaning that more damages will result from subsequent disasters.
Charity Catastrophe Bonds
Current applications of catastrophe (“CAT”) bonds are limited to providing liquid capital for commercial uses (and high-yield bonds for investors). CAT bonds emerged in response to Hurricane Andrew in 1992 as an instrument for reinsurance companies to hedge their own risk of insolvency resulting from catastrophic events. Reinsurance companies provide access to contingent capital for primary insurers when indemnities exceed a specific level. Just as reinsurers serve to reduce the credit risk of the primary insurer, catastrophe bonds reduce the credit risk of the reinsurer by providing a source of back-up capital. Primary providers of insurance can also use catastrophe bonds to reinsure some of their own exposure.
Like reinsurance, CAT bonds are intended to hedge against the upper limits of catastrophic loss. Figure 1 illustrates the distribution of losses for a covariant event. Variance from the mean is abnormal, making it difficult to insure against the “tail risk” due to the large losses associated with infrequent but catastrophic natural disasters. A catastrophe bond segments out the tail risk to a third party. For countries with developed insurance sectors, insurers and reinsurers can manage lower layers of loss, incorporating a catastrophe bond to manage only the most extreme losses.