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Financing Natural Disaster Risk Using Charity Contributions and Ex Ante Index Insurance - page 7 / 15





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Weather information is valuable to the agricultural sector, civil engineering and city planning, etc. This information can also help support the development of weather derivative markets as substitute for traditional insurance in LMIC for lower layers of risk (Skees, et al. 2002). Creation of a weather index requires a thorough risk analysis to determine the appropriate trigger levels. This assessment of exposure can identify a country’s vulnerabilities and aid in disaster planning and mitigation (Varangis, Skees, and Barnett, 2001). Because of the many benefits that can be derived from compiling this information, the World Bank and similar institutions should have a vested interest in supporting the infrastructure for weather stations, data analysis, etc.

The framework required to develop a parametric weather index would also serve to support multiple instruments for managing weather risk at several layers: 1) individual insurance against weather events; 2) insurance sold to collective groups that could become mutual insurance providers; 3) private/government reinsurance; and 4) indexed securities for disaster assistance. Skees, et al. emphasize the importance of effective financial markets to the growth and resilience of the rural sector. Creation of charity catastrophe bonds would facilitate the transition towards accessible markets for risk management, savings and investment.

The goal of a charity catastrophe bond is to provide an alternative source of disaster relief funds for infrequent, extreme events that are essentially uninsurable due to the widespread damage they cause. Other market-based mechanisms could be encouraged for hedging against more frequent, less severe risks, as reliance on free aid for all but the most extreme natural disasters provides no incentive for individuals and communities to reduce their exposure to regularly occurring events. Low-income countries are least able to absorb catastrophe risk and would benefit the most from a catastrophe bond that is pure charity. Countries with higher per capita incomes would be able to bear a portion of the cost of this risk transfer, while high income countries can internalize a fully commercial product.

Whereas the premiums paid to purchase reinsurance transfer the insurers’ catastrophe risk to a third party, charity bond premiums would pay to transfer the catastrophe risk to the capital markets (Kunreuther and Linnerooth-Bayer, 2002). The principal and interest would be held in escrow or placed in risk-free securities until occurrence of a triggering event, in which case the funds would then be disbursed as disaster relief. In the absence of a triggering event, investors would regain their principal and accumulated interest upon the bond’s maturity. Figure 2 illustrates the proposed structure of a charity CAT bond.

Investors who have both a desire to diversify their portfolios and a philanthropic heart would purchase these bonds from a managing financial institution (e.g. an investment bank). Investors purchase the bonds and in the event of a natural disaster, all or most of their principal will go towards disaster relief. Otherwise, they receive a premium above the risk-free rate.

The role of donors would be to contribute to the premium on the bonds, supplementing the contingent relief funds while simultaneously encouraging investment in CAT bonds. From one aspect, donations to the charity bond funds are essentially an investment in the development of market-based securities for managing catastrophic risk. Philanthropists who might typically donate to relief efforts after an event has occurred can leverage their money and good intentions via ex ante donations so that their contributions can be used more efficiently if needed. One constraint concerning the use of donations to generate the bond premiums is that a substantial amount of donations would need to be secured in advance of investments so that a minimum rate of return could be identified for investors.

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