## _wp06199

## Source details

**Canonical URL:** [_wp06199](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06199.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06199.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06199.pdf.json)

---

### I. Introduction — key observations
- Natural disasters have become more frequent and severe in recent decades and this trend is expected to continue (Munich Re, 2006).
- Drivers cited:
  - Increasing concentration of population in vulnerable areas (Wisner and others, 2004).
  - Possible changes in weather patterns associated with rising global surface temperatures, increasing frequency and intensity of adverse weather events (IPCC, 2001; Swiss Re, 2002; Webster and others, 2005).
- Developing and smaller countries face heightened fiscal vulnerability:
  - Developing countries often cannot marshal substantial resources after major disasters.
  - Smaller countries lack geographic redistribution of risk available to larger countries (natural hedge), so disaster costs can quickly overwhelm public-sector response capacity.
  - Example comparisons:
    - Hurricane Katrina: damage of less than 2 percent of national GDP in the United States (2005).
    - Hurricane Ivan: damage to Grenada amounted to 200 percent of GDP in 2004, causing GDP to fall by 3 percent that year and forcing the government into default.
- Ex ante strategies to reduce disaster impacts include:
  - Mitigation (improved land-use policies and environmental standards).
  - Adaptation (restructuring activity away from disaster-prone sectors, upgrading infrastructure).
  - Provisioning through saving and earmarked resources (e.g., FONDEN contingency fund in Mexico) or reducing government debt to create fiscal room.
- Constraints:
  - Resource limitations and high indebtedness often preclude adequate buffering; contingent liabilities can exceed attainable buffers.
- Complementary strategy:
  - Transfer of disaster risk to outside parties (ex ante risk financing), moving from ex post donor financing toward insurance-based approaches.
- Paper scope:
  - Taxonomy of disaster-insurance modalities; stock-taking of recent initiatives in developing and emerging market countries; intended to raise awareness and prompt discussion of insurance-based fiscal tools.

### II. Fiscal pressures and insurance — overview
- Channels by which natural disasters pressure public finances:
  - Weakened revenue base as private sector losses reduce economic activity.
  - Disruption to tax administration and collection.
  - Increased government spending needs for short-term disaster relief, restoration of public infrastructure (roads, bridges, airports, harbors, public buildings).
  - Pressures to provide compensation or financial support to households and businesses; legal obligations to restore housing in some cases.
- Current reliance in vulnerable countries:
  - Predominantly ex post financing: grants and concessional loans from donors, IFI support, emigrant remittances.
  - Samaritan’s dilemma: anticipation of external assistance reduces incentives to insure ex ante.
- Disadvantages of ex post financing:
  - Large uncertainty about timing and availability of resources after disasters.
  - Potential competition among recipients for limited donor resources as disasters increase.
- Advantages of insurance (ex ante):
  - Predictability of post-disaster public finance conditions (predetermined resource amounts and timing).
  - Even if donor contributions are needed to subsidize premiums, shifting from ex post to ex ante financing benefits both recipient and donor.
- Benefits from donor perspective:
  - Reduces perverse incentives of recipients to underprovision for disasters.
  - Helps smooth donor cash flows by converting uncertain future outlays into predictable premia.
  - Gives donors leverage to condition subsidies on structural measures (e.g., building codes), fiscal provisioning, or governance-related measures to improve effectiveness of post-disaster assistance.
- Empirical note:
  - Yang (2005) finds that four years after a hurricane, international financial flows (remittances, official development assistance, foreign lending, foreign direct investment) tend to have covered about 85 percent of the costs of the natural disaster.

### III. Modalities of insurance — core decision dimensions
- Key government decisions:
  - To whom to transfer risk: other countries (pooling), commercial insurers, reinsurers, or capital markets.
  - Who should be the insurance taker and what should be insured: private-sector vs. public-sector coverage.
  - What insurance trigger to apply: indemnity-based vs. parametric triggers.
- Table 1: Two Types of Insurance Triggers
  - Indemnity-based triggers
    - Basis used: Actual and verified size of the losses incurred.
    - Used in: Most private and commercial property insurance.
    - Advantage: Precision—the insurance claim will be close to the actual loss incurred.
    - Disadvantage: Settling claims is time consuming and costly; Moral hazard.
  - Parametric triggers
    - Basis used: The occurrence of a pre-defined event.
    - Used in: Weather derivatives.
    - Advantage: Low transaction cost; High speed of payout; Allows for standard contracts, facilitating risk transfer to capital markets.
    - Disadvantage: Basis risk—insurance claim may either exceed or undershoot the actual loss.
- Box 1. Index Insurance — salient points
  - Index (parametric) insurance uses objective exogenous variables correlated with losses; payout is conditional on the variable reaching a preset threshold.
  - Examples: weather derivatives linking payouts to weather events (wind speeds, precipitation).
  - Incentive effects: Limited moral hazard because payout is not directly linked to actual damage; insured parties retain prevention and mitigation incentives.
  - Operational advantages:
    - Simplicity and transparency; reduced information asymmetries; eliminates need for ex post damage assessment; lower transaction costs.
    - Faster payouts (weeks or days after trigger) compared with indemnity-based insurance.
    - Potential for contract standardization enables transfer to international capital markets.
    - Technological advances (satellite imagery, monitoring systems) improve feasibility in developing countries and reduce basis risk through better loss modeling.
  - Main disadvantages:
    - Basis risk: payout may not match actual loss.
    - Market development: index insurance market is still in its infancy.

### IV. Modalities of risk transfer — pooling, commercial insurance, reinsurance, capital markets
- Pooling:
  - Countries can share disaster risk with others to create cooperative insurance.
  - Effectiveness requires a large enough pool and low correlation of risks across participants.
  - Regional correlation of hazards (e.g., Caribbean hurricanes, European floods) can limit pooling effectiveness.
- Commercial insurance:
  - Commercial insurers maintain diversified portfolios and can absorb risk; transferring risk to international commercial insurance markets can be useful.
  - Market for catastrophe insurance has grown rapidly.
  - Primary insurers’ capacity to absorb very large losses depends on capitalization; second-tier insurance exists to pass on excess risks.
- Reinsurance:
  - Catastrophic risks differ from other insurable risks due to simultaneity and high year-to-year variance; the “law of large numbers” does not operate in the same way.
  - Insurers often transfer catastrophe exposure to reinsurers, who diversify risks across portfolios.
  - Consequences for pricing:
    - Disaster coverage tends to be expensive compared with other insurance.
    - Average premia for catastrophe coverage tend to lie well above the actuarially fair price to cover costs of maintaining capital reserves.
    - Reinsurance premia for disaster risks are very volatile because reinsurance capacity contracts sharply after major disasters, causing premia spikes.

- Box 2. The Rise of Catastrophe Insurance — key statistics
  - Natural Catastrophes and Estimated Losses, 1950–2005 (Billions of U.S. dollars; constant 2005 prices unless otherwise indicated)
  - Number of events by period:
    - 1950–59: 21
    - 1960–69: 27
    - 1970–79: 47
    - 1980–89: 63
    - 1990–99: 157
    - Last 10 Years: 212
  - Overall losses:
    - 1950–59: 48.1
    - 1960–69: 87.5
    - 1970–79: 151.7
    - 1980–89: 247.0
    - 1990–99: 728.8
    - Last 10 Years: 575.2
  - Insured losses:
    - 1950–59: 1.6
    - 1960–69: 7.1
    - 1970–79: 14.6
    - 1980–89: 29.9
    - 1990–99: 137.7
    - Last 10 Years: 176.0
  - Percentage insured:
    - 1950–59: 3.3
    - 1960–69: 8.1
    - 1970–79: 9.6
    - 1980–89: 12.1
    - 1990–99: 18.9
    - Last 10 Years: 30.6
  - Implication: While overall and insured losses have risen manifold over time, insurance penetration remains concentrated in advanced economies (North America, Japan, Western Europe).

### Box 3. Catastrophe Reinsurance Premium Volatility
- Insurer/reinsurer capital sensitivity and pricing dynamics
  - The insurance capacity of reinsurers is very sensitive to the incurrence of big insurance losses from (natural) disasters that reduce reinsurers’ capital base.
  - As a result, catastrophe insurance pricing tends to be quite volatile.
  - Insurance pricing is usually measured in the so called rate-on-line, defined as the premium paid over and above the expected annual loss.
    - The rate-on-line reflects operational and capital costs, profit margin, and a risk premium.
  - Between 1990 and 1993, reinsurance premia rose almost fourfold, mostly in response to the impact of Hurricane Andrew in 1992.
    - Hurricane Andrew caused an insurance loss of US$20 billion and bankrupting about 60 insurance firms.
  - Premia fell gradually in the years following Hurricane Andrew as the industry rebuilt capacity, and rose again following the September 11, 2001 terrorist attacks on the United States.
  - The figure in the source shows the average rate-on-line for catastrophe reinsurance since 1990 (Index, 1990=100).

- Capital markets response: securitization and cat bonds
  - Prompted by Hurricane Andrew in 1992, reinsurers progressively sought to manage exposure by securitizing risks and selling them in international capital markets.
  - This gave rise to a steadily expanding market for insurance-linked securities, the most important of which are “cat bonds.”
  - Typical cat bond features:
    - Target layers of risk with very low annual loss probabilities (less than 1 percent per annum).
    - Usually have a maturity of around three years.
    - Function via a Special Purpose Vehicle (SPV) that issues the bond and invests capital in low-risk securities; investors receive coupon/principal unless a prespecified catastrophe occurs, in which case principal (part or all) is forfeited and paid out to the sponsor.
    - From the sponsor’s perspective these structures function as a pure insurance arrangement and are not debt creating.
    - From the investor’s perspective, cat bonds yield above-market rates (a premium over the low-risk/risk-free return) and offer portfolio diversification because catastrophe risks tend to be uncorrelated with stock or bond markets.

- Market growth, issues, and resilience
  - After the first cat bond issue in 1994, market activity picked up considerably from 1997 onward.
    - Since 1997, some 69 cat bonds have been issued.
    - By 2005, the total market size had grown to almost US$5 billion (Guy Carpenter, 2006).
    - Swiss-Re predicted that the market could well reach US$10 billion by 2010.
  - 2005 highlights:
    - 2005 saw a record US$2 billion cat bond issuance, which represented a 74 percent increase over the previous year.
    - 2005 also saw the first significant loss to a publicly disclosed cat bond, even as cat bond prices are reported to have come down.
  - Analysts expected 2006 to be another year of expansion for the cat bond market.
  - Despite unusually severe 2004 and 2005 Atlantic hurricane seasons, investor appetite remained robust and reinforcers’ urgency to involve capital markets increased, likely strengthening cat bond supply.

- Cat bond pricing and investor appetite
  - Pricing varies widely by insured risk, expected loss, and uncertainty; comparison across issues is difficult.
  - Evidence from developed markets suggests that for catastrophes with a probability of around 1 percent, over all issues to date, premiums have ranged from about 2½ to 8 times the expected annual loss (Guy Carpenter, 2005).
    - Example: for a policy covering a once-in-a-century event with maximum coverage of US$100 million, the typical annual premium (the spread paid over the risk-free yield) would be between US$2½ million and US$8 million a year.
  - Prices have reportedly come down in recent years, reflecting increasing investor acceptance and appetite for cat bonds (Guy Carpenter, 2005).
    - Example: Mexico’s 2006 US$160 million cat bond paid a spread of about 2½ percent over LIBOR and had a loss probability of 0.93 percent; this spread is among the very lowest for cat bonds with similar risk.

- Policy-relevant implications and uses for governments
  - Governments seeking to shield budgets from natural disasters face choices about who should be the insurance taker and what should be insured.
  - Two complementary government strategies:
    - Promote/facilitate/subsidize private-sector insurance (e.g., property insurance for homeowners, crop insurance for farmers) to limit government contingent liabilities.
    - Governments can insure themselves directly against prespecified disaster-related outlays or against budgetary pressures more broadly.
  - Recent initiatives in low- and middle-income countries demonstrate diverse approaches and instruments for disaster risk management, including:
    - Schemes aimed at limiting government contingent liabilities by targeting private-sector insurance (e.g., Turkish Catastrophe Insurance Pool; World Bank/IFC drought insurance project in southern India; Taiwan Province of China residential earthquake insurance pool).
    - Schemes to provide resources for disaster relief and reconstruction (e.g., World Food Program project in Ethiopia using a weather derivative; Mexico’s FONDEN fund complemented by a US$160 million cat bond in 2006).
    - Schemes to provide lump-sum support to government budgets conditional on a disaster (less common; World Bank planning a Caribbean scheme).
  - Example detail: Turkish Catastrophe Insurance Pool (TCIP)
    - Mandated in September 2000 the purchase of standard, indemnity-based property insurance and created the TCIP.
    - As of end-2004, approximately 16 percent of total dwellings within the compulsory scheme had obtained the required coverage.
    - Operational management contracted to a leading Turkish reinsurance company; a large amount of risk ceded to international reinsurance markets until TCIP accumulates sufficient financial resources.

### Box 10. Caribbean Catastrophe Risk Insurance Facility
- Purpose and design
  - Primary aim: allow for immediate budget support to participating Caribbean countries in the aftermath of a natural disaster, providing governments with (partial) coverage for associated operating and recovery expenses.
  - Objective: allow Caribbean countries to pool natural disaster risks and to facilitate the purchase of commercial insurance against adverse natural events (World Bank, 2006, 2005b).
  - Envisaged implementation: facility potentially implemented as envisaged in 2007.

- Capital structure and instruments
  - Reserve pool of risk capital to consist of donor contributions and paid-in premia from participating countries.
  - Additional risk capital to be purchased through multi-year reinsurance or issuance of financial coverage instruments (e.g., cat bonds).
  - Underlying insurance contract to pay claims depending on parametric triggers based on objective measurement of the intensity of a predefined natural event in an agreed area over a certain period, up to a preset limit per year.
  - Intensity of actual events to be determined by an independent agency (example given: National Hurricane Center of the U.S. National Oceanic and Atmospheric Agency).

- Advantages of pooling and capital markets
  - Pooling of risk and economies of scale (a larger and better diversified portfolio) expected to help secure competitive insurance coverage.
  - Transferring risks to international capital markets would greatly expand the pool of insurance capital available to developing countries, increasing the insurability of large disaster risks.
  - Pooling by reinsurance companies before transfer to capital markets may under certain circumstances be more efficient and cost effective.
  - Example motivation: Taiwan Province of China paid a slightly higher price for its cat bond than for reinsurance but opted for the bond because it provided a fixed price over its three-year maturity, shielding the pool from volatility of annual reinsurance premia.
  - Existing precedents: Mexico and Taiwan Province of China have directly tapped the international capital market with cat bond issues; the WFP scheme in Ethiopia packaged risks in an instrument potentially tradable in international capital markets (though sold wholesale to a traditional reinsurer).

- Key challenges and uncertainties
  - Climate-related uncertainty:
    - Global warming and its possible effect on the frequency and intensity of natural disasters is a major source of uncertainty for catastrophe insurance markets.
    - Recent record insurance losses highlighted: US$45 billion losses from Hurricane Katrina referenced; insured losses amounted to US$49 billion in 2004 and US$94 billion in 2005, about half of which were associated with Hurricane Katrina.
    - Rating agencies and insurers have warned of the possibility of events with losses past the US$100 billion mark.
    - Consequence: insurers may reassess risk models and adopt a more cautious stance, with an upward effect on catastrophe insurance premia; some U.S. insurers (including Allstate and State Farm) reported withdrawing from selected coastal regions.
  - Capital market appetite:
    - Appetite for catastrophe risk in international capital markets is uncertain.
    - Success of cat bonds coincided with favorable global liquidity conditions and a quest for yield that led to a decline in risk premia; investor withdrawal could occur as liquidity conditions tighten.
  - Affordability:
    - Even under favorable scenarios, catastrophe insurance may remain costly for developing countries; high volatility in insurance premia can undermine viability.
    - Viability in many instances may crucially depend on the contribution of donors.

- Donor and IFI roles
  - Mobilizing donors to contribute to disaster insurance schemes is a key challenge.
  - Example: WFP scheme in Ethiopia as a promising example of donor involvement.
  - Donor incentives: donors may prefer post-disaster relief for public recognition and immediate visibility, which could limit engagement in structural ex ante support.
  - Role for IFIs:
    - IFIs may help design and facilitate structures of donor and recipient collaboration (examples cited: World Bank, IFC, WFP projects).
    - IFIs may act as intermediaries or provide technical assistance to overcome lack of acquaintance with risk markets.
    - Short-run value in overcoming initial coordination problems to demonstrate viability; longer-term sustainability of projects may require continued IFI intervention.

- Concluding observations and policy implications
  - Natural disasters can put severe strain on public finances of developing and small countries; insurance and capital markets offer opportunities to transfer parts of this risk.
  - Recent initiatives—often aided by IFIs and sometimes with donor assistance—deserve to be followed to alleviate periodic fiscal disruptions.
  - Sustainability concerns:
    - Variable investor risk appetite could introduce cyclicality to catastrophe risk markets, in addition to volatility in reinsurance capacity.
    - Effects of climate change may fundamentally impact the catastrophe insurance industry.
    - Insurers must keep risk models up to date with changing weather and disaster patterns to keep uncertainty and risk premia within manageable boundaries.
  - Policy objective for IFIs and donors: work toward a sustainable model for collaboration that facilitates a shift from ad hoc after-the-event relief toward more reliable and predictable ex ante provisioning based on commercial insurance, thereby reducing fiscal second-round effects and facilitating faster recovery.

*Source: _wp06199 - References (excerpts).*

### References..............................................................................................................

### References

### I. Introduction — key observations
- Natural disasters have become more frequent and severe in recent decades and this trend is expected to continue (Munich Re, 2006).
- Drivers cited:
  - Increasing concentration of population in vulnerable areas (Wisner and others, 2004).
  - Possible changes in weather patterns associated with rising global surface temperatures, increasing frequency and intensity of adverse weather events (IPCC, 2001; Swiss Re, 2002; Webster and others, 2005).
- Developing and smaller countries face heightened fiscal vulnerability:
  - Developing countries often cannot marshal substantial resources after major disasters.
  - Smaller countries lack geographic redistribution of risk available to larger countries (natural hedge), so disaster costs can quickly overwhelm public-sector response capacity.
  - Example comparisons:
    - Hurricane Katrina: damage of less than 2 percent of national GDP in the United States (2005).
    - Hurricane Ivan: damage to Grenada amounted to 200 percent of GDP in 2004, causing GDP to fall by 3 percent that year and forcing the government into default.
- Ex ante strategies to reduce disaster impacts include:
  - Mitigation (improved land-use policies and environmental standards).
  - Adaptation (restructuring activity away from disaster-prone sectors, upgrading infrastructure).
  - Provisioning through saving and earmarked resources (e.g., FONDEN contingency fund in Mexico) or reducing government debt to create fiscal room.
- Constraints: resource limitations and high indebtedness often preclude adequate buffering; contingent liabilities can exceed attainable buffers.
- Complementary strategy: transfer of disaster risk to outside parties (ex ante risk financing), moving from ex post donor financing toward insurance-based approaches.
- Paper scope: taxonomy of disaster-insurance modalities; stock-taking of recent initiatives in developing and emerging market countries; intended to raise awareness and prompt discussion of insurance-based fiscal tools.

### II. Fiscal pressures and insurance — overview
- Channels by which natural disasters pressure public finances:
  - Weakened revenue base as private sector losses reduce economic activity.
  - Disruption to tax administration and collection.
  - Increased government spending needs for short-term disaster relief, restoration of public infrastructure (roads, bridges, airports, harbors, public buildings).
  - Pressures to provide compensation or financial support to households and businesses; legal obligations to restore housing in some cases.
- Current reliance in vulnerable countries:
  - Predominantly ex post financing: grants and concessional loans from donors, IFI support, emigrant remittances.
  - Samaritan’s dilemma: anticipation of external assistance reduces incentives to insure ex ante.
- Disadvantages of ex post financing:
  - Large uncertainty about timing and availability of resources after disasters.
  - Potential competition among recipients for limited donor resources as disasters increase.
- Advantages of insurance (ex ante):
  - Predictability of post-disaster public finance conditions (predetermined resource amounts and timing).
  - Even if donor contributions are needed to subsidize premiums, shifting from ex post to ex ante financing benefits both recipient and donor.
- Benefits from donor perspective:
  - Reduces perverse incentives of recipients to underprovision for disasters.
  - Helps smooth donor cash flows by converting uncertain future outlays into predictable premia.
  - Gives donors leverage to condition subsidies on structural measures (e.g., building codes), fiscal provisioning, or governance-related measures to improve effectiveness of post-disaster assistance.
- Empirical note:
  - Yang (2005) finds that four years after a hurricane, international financial flows (remittances, official development assistance, foreign lending, foreign direct investment) tend to have covered about 85 percent of the costs of the natural disaster.

### III. Modalities of insurance — core decision dimensions
- Governments choosing insurance must decide:
  - To whom to transfer risk: other countries (pooling), commercial insurers, reinsurers, or capital markets.
  - Who should be the insurance taker and what should be insured: private-sector vs. public-sector coverage.
  - What insurance trigger to apply: indemnity-based vs. parametric triggers (see Table 1, Box 1).
- Table 1: Two Types of Insurance Triggers (preserved terminology and attributes)
  - Indemnity-based triggers
    - Basis used: Actual and verified size of the losses incurred.
    - Used in: Most private and commercial property insurance.
    - Advantage: Precision—the insurance claim will be close to the actual loss incurred.
    - Disadvantage: Settling claims is time consuming and costly; Moral hazard.
  - Parametric triggers
    - Basis used: The occurrence of a pre-defined event.
    - Used in: Weather derivatives.
    - Advantage: Low transaction cost; High speed of payout; Allows for standard contracts, facilitating risk transfer to capital markets.
    - Disadvantage: Basis risk—insurance claim may either exceed or undershoot the actual loss.

Box 1. Index Insurance — salient points
- Index (parametric) insurance uses objective exogenous variables correlated with losses; payout is conditional on the variable reaching a preset threshold.
- Examples: weather derivatives linking payouts to weather events (wind speeds, precipitation).
- Incentive effects:
  - Limited moral hazard because payout is not directly linked to actual damage; insured parties retain prevention and mitigation incentives.
- Operational advantages:
  - Simplicity and transparency; reduced information asymmetries; eliminates need for ex post damage assessment; lower transaction costs.
  - Faster payouts (weeks or days after trigger) compared with indemnity-based insurance.
  - Potential for contract standardization enables transfer to international capital markets.
  - Technological advances (satellite imagery, monitoring systems) improve feasibility in developing countries and reduce basis risk through better loss modeling.
- Main disadvantages:
  - Basis risk: payout may not match actual loss.
  - Market development: index insurance market is still in its infancy.
- Reference: World Bank (2005a) for detailed discussion.

### IV. Modalities of risk transfer — pooling, commercial insurance, reinsurance, capital markets
- Pooling:
  - Countries can share disaster risk with others to create cooperative insurance.
  - Effectiveness requires a large enough pool and low correlation of risks across participants.
  - Regional correlation of hazards (e.g., Caribbean hurricanes, European floods) can limit pooling effectiveness.
- Commercial insurance:
  - Commercial insurers maintain diversified portfolios and can absorb risk; transferring risk to international commercial insurance markets can be useful.
  - Market for catastrophe insurance has grown rapidly (see Box 2).
  - Primary insurers’ capacity to absorb very large losses depends on capitalization; second-tier insurance exists to pass on excess risks.
- Reinsurance:
  - Catastrophic risks differ from other insurable risks due to simultaneity and high year-to-year variance; the “law of large numbers” does not operate in the same way.
  - Insurers often transfer catastrophe exposure to reinsurers, who diversify risks across portfolios.
  - Consequences for pricing:
    - Disaster coverage tends to be expensive compared with other insurance.
    - Average premia for catastrophe coverage tend to lie well above the actuarially fair price to cover costs of maintaining capital reserves.
    - Reinsurance premia for disaster risks are very volatile because reinsurance capacity contracts sharply after major disasters, causing premia spikes.
- Box 2. The Rise of Catastrophe Insurance — key statistics (preserved exactly)
  - Natural Catastrophes and Estimated Losses, 1950–2005 (Billions of U.S. dollars; constant 2005 prices unless otherwise indicated)
  - Number of events by period:
    - 1950–59: 21
    - 1960–69: 27
    - 1970–79: 47
    - 1980–89: 63
    - 1990–99: 157
    - Last 10 Years: 212
  - Overall losses:
    - 1950–59: 48.1
    - 1960–69: 87.5
    - 1970–79: 151.7
    - 1980–89: 247.0
    - 1990–99: 728.8
    - Last 10 Years: 575.2
  - Insured losses:
    - 1950–59: 1.6
    - 1960–69: 7.1
    - 1970–79: 14.6
    - 1980–89: 29.9
    - 1990–99: 137.7
    - Last 10 Years: 176.0
  - Percentage insured:
    - 1950–59: 3.3
    - 1960–69: 8.1
    - 1970–79: 9.6
    - 1980–89: 12.1
    - 1990–99: 18.9
    - Last 10 Years: 30.6
  - Source: Munich Re (2005), and IMF staff calculations.
- Implication: While overall and insured losses have risen manifold over time, insurance penetration remains concentrated in advanced economies (North America, Japan, Western Europe).

### V. Structure of the paper (organization)
- Section II: discusses why natural disasters can lead to fiscal pressures and how insurance can help manage such pressures.
- Section III: outlines insurance modalities with respect to risk transfer and coverage scope; reviews existing disaster insurance schemes in low- and middle-income countries.
- Section IV: identifies key challenges to further progress on insurance application in this context.
- Section V: offers concluding remarks.

*Source: _wp06199 - References (excerpts).*

### Box 3. Catastrophe Reinsurance Premium Volatility

### Box 3. Catastrophe Reinsurance Premium Volatility

### Insurer/reinsurer capital sensitivity and pricing dynamics
- The insurance capacity of reinsurers is very sensitive to the incurrence of big insurance losses from (natural) disasters that reduce reinsurers’ capital base.
- As a result, catastrophe insurance pricing tends to be quite volatile.
- Insurance pricing is usually measured in the so called rate-on-line, defined as the premium paid over and above the expected annual loss.
  - The rate-on-line reflects operational and capital costs, profit margin, and a risk premium.
- Between 1990 and 1993, reinsurance premia rose almost fourfold, mostly in response to the impact of Hurricane Andrew in 1992.
  - Hurricane Andrew caused an insurance loss of US$20 billion and bankrupting about 60 insurance firms.
- Premia fell gradually in the years following Hurricane Andrew as the industry rebuilt capacity, and rose again following the September 11, 2001 terrorist attacks on the United States.
- The figure in the source shows the average rate-on-line for catastrophe reinsurance since 1990 (Index, 1990=100).

### Capital markets response: securitization and cat bonds
- Prompted by Hurricane Andrew in 1992, reinsurers progressively sought to manage exposure by securitizing risks and selling them in international capital markets.
- This gave rise to a steadily expanding market for insurance-linked securities, the most important of which are “cat bonds.”
- Catastrophe bonds (cat bonds) were originally developed in the mid-1990s to help reinsurance companies cope with peak risks—i.e., risks too large to be absorbed by a single (re)insurance provider.
- Typical cat bond features:
  - Target layers of risk with very low annual loss probabilities (less than 1 percent per annum).
  - Usually have a maturity of around three years.
  - Function via a Special Purpose Vehicle (SPV) that issues the bond and invests capital in low-risk securities; investors receive coupon/principal unless a prespecified catastrophe occurs, in which case principal (part or all) is forfeited and paid out to the sponsor.
  - From the sponsor’s perspective these structures function as a pure insurance arrangement and are not debt creating.
  - From the investor’s perspective, cat bonds yield above-market rates (a premium over the low-risk/risk-free return) and offer portfolio diversification because catastrophe risks tend to be uncorrelated with stock or bond markets.

### Market growth, issues, and resilience
- After the first cat bond issue in 1994, market activity picked up considerably from 1997 onward.
  - Since 1997, some 69 cat bonds have been issued.
  - By 2005, the total market size had grown to almost US$5 billion (Guy Carpenter, 2006).
  - Swiss-Re predicted that the market could well reach US$10 billion by 2010.
- 2005 highlights:
  - 2005 saw a record US$2 billion cat bond issuance, which represented a 74 percent increase over the previous year.
  - 2005 also saw the first significant loss to a publicly disclosed cat bond, even as cat bond prices are reported to have come down.
- Analysts expected 2006 to be another year of expansion for the cat bond market.
- Despite unusually severe 2004 and 2005 Atlantic hurricane seasons, investor appetite remained robust and reinforcers’ urgency to involve capital markets increased, likely strengthening cat bond supply.

### Cat bond pricing and investor appetite
- Pricing varies widely by insured risk, expected loss, and uncertainty; comparison across issues is difficult.
- Evidence from developed markets suggests that for catastrophes with a probability of around 1 percent, over all issues to date, premiums have ranged from about 2½ to 8 times the expected annual loss (Guy Carpenter, 2005).
  - Example: for a policy covering a once-in-a-century event with maximum coverage of US$100 million, the typical annual premium (the spread paid over the risk-free yield) would be between US$2½ million and US$8 million a year.
- Prices have reportedly come down in recent years, reflecting increasing investor acceptance and appetite for cat bonds (Guy Carpenter, 2005).
  - Example: Mexico’s 2006 US$160 million cat bond paid a spread of about 2½ percent over LIBOR and had a loss probability of 0.93 percent; this spread is among the very lowest for cat bonds with similar risk.

### Policy-relevant implications and uses for governments
- Governments seeking to shield budgets from natural disasters face choices about who should be the insurance taker and what should be insured.
- Two complementary government strategies:
  - Promote/facilitate/subsidize private-sector insurance (e.g., property insurance for homeowners, crop insurance for farmers) to limit government contingent liabilities.
  - Governments can insure themselves directly against prespecified disaster-related outlays or against budgetary pressures more broadly.
- Recent initiatives in low- and middle-income countries demonstrate diverse approaches and instruments for disaster risk management, including:
  - Schemes aimed at limiting government contingent liabilities by targeting private-sector insurance (e.g., Turkish Catastrophe Insurance Pool; World Bank/IFC drought insurance project in southern India; Taiwan Province of China residential earthquake insurance pool).
  - Schemes to provide resources for disaster relief and reconstruction (e.g., World Food Program project in Ethiopia using a weather derivative; Mexico’s FONDEN fund complemented by a US$160 million cat bond in 2006).
  - Schemes to provide lump-sum support to government budgets conditional on a disaster (less common; World Bank planning a Caribbean scheme).
- Example detail: Turkish Catastrophe Insurance Pool (TCIP)
  - Mandated in September 2000 the purchase of standard, indemnity-based property insurance and created the TCIP.
  - As of end-2004, approximately 16 percent of total dwellings within the compulsory scheme had obtained the required coverage.
  - Operational management contracted to a leading Turkish reinsurance company; a large amount of risk ceded to international reinsurance markets until TCIP accumulates sufficient financial resources.

*Source: IMF Working Paper content (Box 3 and related boxes on catastrophe risk and cat bonds).*

### Box 10. Caribbean Catastrophe Risk Insurance Facility

### Box 10. Caribbean Catastrophe Risk Insurance Facility

### Purpose and design
- Primary aim: allow for immediate budget support to participating Caribbean countries in the aftermath of a natural disaster, providing governments with (partial) coverage for associated operating and recovery expenses.
- Objective: allow Caribbean countries to pool natural disaster risks and to facilitate the purchase of commercial insurance against adverse natural events (World Bank, 2006, 2005b).
- Envisaged implementation: facility potentially implemented as envisaged in 2007.

### Capital structure and instruments
- Reserve pool of risk capital to consist of donor contributions and paid-in premia from participating countries.
- Additional risk capital to be purchased through multi-year reinsurance or issuance of financial coverage instruments (e.g., cat bonds).
- Underlying insurance contract to pay claims depending on parametric triggers based on objective measurement of the intensity of a predefined natural event in an agreed area over a certain period, up to a preset limit per year.
- Intensity of actual events to be determined by an independent agency (example given: National Hurricane Center of the U.S. National Oceanic and Atmospheric Agency).

### Advantages of pooling and capital markets
- Pooling of risk and economies of scale (a larger and better diversified portfolio) expected to help secure competitive insurance coverage.
- Transferring risks to international capital markets would greatly expand the pool of insurance capital available to developing countries, increasing the insurability of large disaster risks.
- Pooling by reinsurance companies before transfer to capital markets may under certain circumstances be more efficient and cost effective.
- Example motivation: Taiwan Province of China paid a slightly higher price for its cat bond than for reinsurance but opted for the bond because it provided a fixed price over its three-year maturity, shielding the pool from volatility of annual reinsurance premia.
- Existing precedents: Mexico and Taiwan Province of China have directly tapped the international capital market with cat bond issues; the WFP scheme in Ethiopia packaged risks in an instrument potentially tradable in international capital markets (though sold wholesale to a traditional reinsurer).

### Key challenges and uncertainties
- Climate-related uncertainty:
  - Global warming and its possible effect on the frequency and intensity of natural disasters is a major source of uncertainty for catastrophe insurance markets.
  - Recent record insurance losses highlighted: US$45 billion losses from Hurricane Katrina referenced; insured losses amounted to US$49 billion in 2004 and US$94 billion in 2005, about half of which were associated with Hurricane Katrina.
  - Rating agencies and insurers have warned of the possibility of events with losses past the US$100 billion mark.
  - Consequence: insurers may reassess risk models and adopt a more cautious stance, with an upward effect on catastrophe insurance premia; some U.S. insurers (including Allstate and State Farm) reported withdrawing from selected coastal regions.
- Capital market appetite:
  - Appetite for catastrophe risk in international capital markets is uncertain.
  - Success of cat bonds coincided with favorable global liquidity conditions and a quest for yield that led to a decline in risk premia; investor withdrawal could occur as liquidity conditions tighten.
- Affordability:
  - Even under favorable scenarios, catastrophe insurance may remain costly for developing countries; high volatility in insurance premia can undermine viability.
  - Viability in many instances may crucially depend on the contribution of donors.

### Donor and IFI roles
- Mobilizing donors to contribute to disaster insurance schemes is a key challenge.
- Example: WFP scheme in Ethiopia as a promising example of donor involvement.
- Donor incentives: donors may prefer post-disaster relief for public recognition and immediate visibility, which could limit engagement in structural ex ante support.
- Role for IFIs:
  - IFIs may help design and facilitate structures of donor and recipient collaboration (examples cited: World Bank, IFC, WFP projects).
  - IFIs may act as intermediaries or provide technical assistance to overcome lack of acquaintance with risk markets.
  - Short-run value in overcoming initial coordination problems to demonstrate viability; longer-term sustainability of projects may require continued IFI intervention.

### Concluding observations and policy implications
- Natural disasters can put severe strain on public finances of developing and small countries; insurance and capital markets offer opportunities to transfer parts of this risk.
- Recent initiatives—often aided by IFIs and sometimes with donor assistance—deserve to be followed to alleviate periodic fiscal disruptions.
- Sustainability concerns:
  - Variable investor risk appetite could introduce cyclicality to catastrophe risk markets, in addition to volatility in reinsurance capacity.
  - Effects of climate change may fundamentally impact the catastrophe insurance industry.
  - Insurers must keep risk models up to date with changing weather and disaster patterns to keep uncertainty and risk premia within manageable boundaries.
- Policy objective for IFIs and donors: work toward a sustainable model for collaboration that facilitates a shift from ad hoc after-the-event relief toward more reliable and predictable ex ante provisioning based on commercial insurance, thereby reducing fiscal second-round effects and facilitating faster recovery.

*Source: Box 10. Caribbean Catastrophe Risk Insurance Facility, _wp06199.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06199.pdf_