Getting Ready for the Next Catastrophe

In the past week, the volatility in financial markets was not the only storm to hit the region: Hurricane Dean, a category 5 wind-storm (the strongest in the scale) wiped through the Caribbean region leaving a trail of human and economic losses across Haití, Dominica, Santa Lucía, República Dominicana, Jamaica and Mexico’s Yucatan peninsula. And a terrible earthquake (it had a magnitude of 7.9 on the Richter scale) devastated coastal areas of Peru.

Unfortunately, this is not the first time…and it won’t be last…Though these natural catastrophes are to a large extent unavoidable, the vulnerable countries in the region are by-and-large not well prepared to deal with the consequences. On the one hand few countries have well-thought and tested disaster preparedness policies: how to evacuate people before a storm, how to get medical supplies to the affected areas, how to deal with the casualties, etc. On the other hand, while the extent of the damage is directly proportional to the size of the population leaving in the most vulnerable areas, few countries have building codes or enforce zoning laws that could help mitigate the damage. Elevated risk exposure and lack of preparation are a serious threat to development and require urgent attention at the national level as well as in donor countries. Unfortunately, there is too much complacency.

At the same time, despite its vulnerability to natural disasters, insurance coverage in the Latin American and Caribbean region is the lowest in the world. Why are catastrophic insurance markets so underdeveloped in the region? Perhaps it is because internal markets don’t have the scale needed to develop such insurance mechanisms. Everyone assumes that when push comes to shove, the government will cover the costs. Why don’t governments buy insurance to minimize the fiscal impact of natural disasters? Perhaps the biggest obstacles are the lack of available instruments at reasonable prices and a resistance to spending money on something so intangible that might not even provide a future benefit. Politicians don’t have many incentives for investing today, when the benefits tomorrow may be enjoyed by another administration.

In a recent joint paper with Eduardo Borensztein and Patricio Valenzuela we discuss the potential benefits of catastrophic risk insurance in the context of the case of Belize, a particularly vulnerable country in the region that was devastated by two hurricanes in the early 2000’s and had to restructure its debt in 2006. But let us not be disingenuous: catastrophic risk insurance isn’t a panacea. Countries that adopt it have to ensure that their regulatory mechanisms allow the government to purchase the insurance without creating disincentives for private agents and sub-national entities. This is key, since the less private insurance that is available, the larger the state’s liabilities and the less effective any level of public insurance.

Quick development of capital markets in this region will create opportunities to diversify financial instruments, including insurance. Nevertheless, governments have to be proactive and understand that a hurricane or earthquake can wipe out decades of investments and push millions of people into poverty. Sitting to wait until the next storm, and hoping for aid to help pay for recovery and reconstruction won’t do any good.

6 Responses to "Getting Ready for the Next Catastrophe"

  1. Vitoria Saddi   August 29, 2007 at 8:38 am

    Eduardo, I read your paper and really like it. My question to you is if poor countries like Belize, have to wait for financial development in the country or whether international agencies can implement programs to grant insurance? If the World Bank implemented the MDG and the IMF created the Heavily Indebted Poor Countries (HIPC) Debt Initiative why can’t the IDB do something to grant insurance ‘against the next storm’?

  2. Adrian R.   August 29, 2007 at 8:40 am

    Don’t you think that these governments have too tight of a budget to allocate on insurance against storms?

  3. Guest   August 29, 2007 at 9:14 am

    Let’s say that there is an insurance for catostrophes. How do you handle with corruption beyond the economists’ idea to enforce ‘rule of law’ and so forth? Any examples of poor countries that set the grounds for a credible insurance market?

  4. Rogerio W.   August 29, 2007 at 9:18 am

    Why can’t economists write about something good? All I read in these postings is about inflation, poverty, corruption, inquality. Is there anything good that these Latin countries have done lately or all is yet to be implemented?

  5. Lellis   August 29, 2007 at 1:33 pm

    One of the reasons there is an extremely underdeveloped insurance market in most Latin American countries is that the markets are closed for foreign insurers, the size of each local economy dictating the cost of insurance. In this situation catastrophe insurance would be prohibitive. Would the markets be more opened there would be lower costs and the possibility of using more cost reducing instruments like cat bonds to reduce the cost of this type of insurance.

  6. Eduardo Cavallo   August 29, 2007 at 5:00 pm

    Thanks for all the comments.  Vitoria: I agree. The IDB is currently working on this. The World Bank has already created the CCRIF to grant some insurance to Caribbean countries and the IDB supports this initiative. Adrian R.: budgets set priorities. You don’t need to raise overall spending to accommodate insurance if you reduce other expenditures with lower social returns.  Guest: corruption is a problem even without insurance. Lellis: I agree, openness is certainly good in this sphere. Rogerio W.: Yes, of course there are some good things that Latin countries have done recently. For example: they produce very good economists!!!