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FEATURE STORY

21st Century Finance: A Buffer to Nature’s Disasters or A Premium on Its Destruction?

September 21, 2016


Image

Rebuilding a road after eruption of Mount Merapi. Yogyakarta, Indonesia.
Photo: Nugroho Nurdikiawan Sunjoyo/World Bank


Natural disasters do not discriminate, affecting coastlines and mountain villages, prairies and plateaus, major and minor cities—in corridors largely populated by the poor. Committing financial resources before potential disasters, recent research at The World Bank Group indicates, is smart. An impact evaluation of FONDEN, Mexico’s fund for natural disasters, found that it increased post-disaster gross domestic product by 2–4 percent, a big benefit.

Ex-ante approaches to finance potential disasters require three things:

  1. A sound, coordinated plan for post-disaster action agreed in advance
  2. A fast, evidence-based process to make decisions
  3. Financing on standby to ensure implementation of the plan

Ex-ante approaches provide the foundation for fast, reliable, cost-effective response, as well as for reducing and adapting to changing risks. These solutions minimize the cost and optimize the timing of meeting post-disaster funding needs without compromising development goals, fiscal stability, or well-being. And, they are an integral part of disaster and climate risk management.

Developing these solutions also requires input from scientists, public officials, front-line implementers, and financial specialists:

  • Technological advances allow scientists to better understand and model the probability of disasters; this helps reduce cognitive bias and balance disaster planning.
  • Public officials help to make difficult tradeoffs over who or what to protect, and explain it to the public; a good plan comes from a well-communicated political choice.
  • Front-line implementers bring knowledge and experience to draw up a practical plan, prepare for potential implementation, and ultimately carry the plan out on the ground.
  • Financial specialists put a cost on potential disasters while making sure promises are credible and kept; financial planning is the glue the holds a disaster risk plan together.

Implementing ex-ante solutions requires strong leadership by a country’s ministry of finance, partners in the private sector, and comprehensive systems to collect, process, and disseminate data.

Where financing is committed before potential disasters, governments are showing how a better system is possible. In 1985, an earthquake in Mexico City caused over 10,000 deaths, cost over US$11 billion, and triggered a national dialogue followed by government action on disaster preparedness. By 1999, FONDEN served to insure timely reconstruction of the federal and part of the subnational infrastructure and recovery from disaster losses. In 2012, a 7.4 magnitude earthquake in Mexico City resulted in no human casualties (early warning systems and public safety awareness) and negligible damage to buildings (more stringent building codes).

The Disaster Risk Financing and Insurance Program, a partnership of the World Bank and the Global Facility for Disaster Reduction and Recovery, is working with over 60 countries around the world to develop, implement, and learn from ex-ante financial protection solutions against disasters. And, these solutions work.

NOTES:

1. A Plan—But Not Just Any Plan (back to top)

  • Planning for natural disasters is a political choice, not just a technical exercise.
  • Good planning for natural disasters is based on an iterative dialogue among scientists, bureaucrats, implementers, and financiers about what or who is to be protected, how it or they are to be protected, and what the cost will be. Bad planning happens when at least one of these parties is missing from the dialogue.
  • Useful political statements focus on target outcomes and leave the details on the “how” to be worked out by the implementing agencies and financiers.
  • Benefactors who want to maximize the development impact of their support should think through different natural disaster scenarios, assess what support they would provide in each scenario, and own up to this contingent liability when in discussions with other partners.
  • Behavioral biases against good planning are strongest for the kinds of disasters that did not occur in the recent past—that is, for nearly all future disasters.

-    To combat these biases, investing in science-based risk information and in clear communication of this information ensures that everyone knows what contingencies they need protection for.

2. Sound Decision Making—But Based on Good Rules, Good Data (back to top)

  • Rules can promote decisive, timely action by minimizing decisions when disaster strikes.
  • The data driving decisions need to resist manipulation and to balance cost, speed, and accuracy.
  • Investing in a data collection system, including an audit function, and in the human and technological capacity for timely inputs is critical.
  • Options for data to trigger post-disaster action include:

-    Ground data on damage to/loss of people and buildings
-    Area average index data on damage and loss
-    Parametric indices

  • No rule is perfect; a discretionary backup system should deal with situations when the rules fail.

3. Standby Financing—But Based on Smart Choices of Instruments and Triggers (back to top)

  • Disaster Risk Finance is the glue that holds credible plans together—deflecting the whirlwind of highly charged post-disaster politics.

-    When designing and implementing disaster risk finance strategies, details matter.
-    Financial experts add value; paying for financial advice and building in-house expertise is important.
-    The triggers in the financial strategy and in the plan should ideally match.
-    Traditional reinsurance can be useful to lock in plans for reconstruction.
-    Indexed reinsurance can be useful to lock in plans to finance indexed early actions.
-    Partially subsidized financial instruments can be used to encourage others to contribute toward the cost of well-defined plans.

  • Leaders should focus on providing protection, not relief, and on using financial incentives to encourage others to own up to and finance their share up-front.
  • Ad-hoc, post-disaster support should not be the first line of defense for droughts, floods, earthquakes, tropical cyclones, or pandemics. It is still needed, but it should act as a last resort.

Financial and Budgetary Instruments

Goal                

Ex ante instrument
(arranged before a disaster)

Ex post instrument
(arranged after a disaster)

Risk retention
(changing how or when one pays)

Contingency fund or budget allocation
Line of contingent credit

Budget reallocation
Tax increase
Post-disaster credit

Risk transfer
(removing risk from the balance sheet)

Traditional insurance or reinsurance
Indexed insurance, reinsurance, or derivatives
Capital market instruments

Discretionary post-disaster relief

Source: Clarke and Dercon (2016)


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