2018 - 2019 Edition of Citi Perspectives for the Public Sector

42 Figure: Comparison of Conventional Financial Tools Available to Governments for Natural Disaster Risk Mitigation Natural Disaster Risk Management: A Brief Overview of Tools Available to Governments Based on this framework, the World Bank’s generalized advice is for governments to dedicate the cheapest, most rapidly available funds for response to recurrent, less severe natural disasters. For example, government budgetary instruments or concessional funds available from multilateral partners might be used to recover from and protect against predictable, seasonal storms. By contrast, the most suitable risk mitigation solutions for low frequency, high intensity disasters might come from international insurance providers and securities markets. 3 Globally, several DRMFs are in operation. In 1996, Mexico established the Fund for Natural Disasters (FONDEN) with an original mandate to provide financial resources for federal and state emergency reconstruction efforts without compromising the government budget. FONDEN receives no less than 0.4% of the federal budget annually by law and, since its foundation, has evolved into a comprehensive disaster risk management institution that also finances disaster risk mitigation investments. Following the World Bank’s multi-layer approach, FONDEN’s annual budget allocation directly funds government response to high- frequency, low-intensity events. It also buys market-based risk transfer instruments such as catastrophe bonds and indemnity insurance to address high-intensity, low-frequency events. When cat bonds make sense At the top of the multi-layer approach, catastrophe (cat) bonds are risk transfer securities issued in the capital markets to help governments respond to low-frequency, high- intensity natural disasters. In a basic cat bond structure, a government sponsors the issue of catastrophe-linked notes by a special purpose reinsurer or a development bank, such as the World Bank’s IBRD, to international investors. The notes have a defined redemption date, analogous to a regular bond maturity date, and a defined catastrophe trigger. The sponsor makes payments on the bond in the form of a premium until the sooner of the occurrence of the trigger event or the redemption date. If the disaster trigger occurs prior to redemption, the sponsor government ceases premium payments and receives the bond principal value as a payout, while the investors lose their invested principal. If the redemption date arrives first, the issuer returns the principal to investors. Cat bond sponsors have significant flexibility to choose from different types of covered losses and triggers. Often, the payout to the sponsor government is automatic following the trigger event. This is called a “parametric” trigger and could be defined as, for example, an earthquake above a certain magnitude occurring within a defined distance from a city. 3 Clarke, D. et al. (2016) Evaluating Sovereign Disaster Risk Finance Strategies: A Framework . World Bank Policy Research Working Paper; Mahul, O. (2012) Sovereign Disaster Risk Financing. World Bank Disaster Risk Financing and Insurance Program. Overarching Considerations for Governments Cost of Solutions Capacity to Implement Data Availability Transparency Technology More Expensive Risk pools /i.e., Caribbean Catastrophe Risk Insurance Facility (CCRIF) Market Risk Transfer / i.e., Catastrophe (Cat) bonds Traditional Insurance Cost of Funds Non-Market Solutions Market Financing /i.e., post-disaster bonds, lines of credit Budgetary Instruments / i.e., Disaster Risk Management Funds (DRMF) Concessional Financing i.e., aid relief, IBRD CAT-DDO Time to Distribution of Funds Longer to Distribution The role of disaster risk management funds A disaster risk management fund (DRMF), in the bottom left of the above illustration, is a suitable tool to respond to recurrent, low- intensity events. A DRMF is funded prior to the occurrence of a natural disaster event and pays out in the aftermath. It is structured as a trust to receive contributions from government as well as corporate and individual donors. Best practice dictates that the DRMF should have clearly defined governance guidelines to facilitate the management, disbursement and monitoring of disaster relief funds. A technical committee should be appointed to provide overall management of the fund, authorize payouts and issue payment instructions. If designed properly, a DRMF provides transparent, timely, predictable and auditable distribution of relief funds so that they reliably reach the intended beneficiaries.