Disaster triggered financial instruments for vulnerable communities

Natural disasters have broad range of impacts that encompass human, social, financial, economic, and environmental dimensions, often resulting in long-lasting effects that can span generations. Recent years have seen an alarming increase in the frequency and intensity of natural disasters, with the number of climate related disasters tripling over the last 30 years. The economic toll of such disasters is staggering, with the World Meteorological Organisation estimating daily losses of approximately US $202 million globally over the past 50 years, stemming from lost wages, utility disruptions, and property damage. Furthermore, most often, those affected, lack the resources necessary for recovery due to limited adaptive capacity, facing financial constraints that hinder their ability to rebuild or invest in resilience measures.

Natural disasters generate significant fiscal risk and create major budget volatility. According to a report by Swiss Re, the total economic damage from natural disasters globally amounted to approximately US $380 billion in 2023. However, insurance covered only 31% losses, posing a financial strain on governments, particularly in poorer countries. Thus, managing the financial repercussions of disasters poses a significant challenge for individuals and governments.

Disaster-triggered financial instruments are, therefore, essential tools for providing financial protection and support to communities vulnerable to natural disasters. Addressing the grave challenges posed by natural disasters necessitates targeted investments in education, infrastructure, and inclusive governance to enhance resilience among vulnerable populations. This requires a comprehensive approach to disaster risk management that includes robust financial instruments. These financial instruments help mitigate the economic and fiscal impacts of disasters, enabling quicker recovery and resilience building.

Financial resource needs for disaster management can be categorized based on the timing of their utilization into:

Ex-ante financing needs: Resources allocated before a disaster occurs, focusing on prevention and preparedness
Ex-post financing needs: Resources utilized after a disaster strikes, aimed at response

Types of ex-ante financing instruments

Reserves or calamity funds

Reserve funds are disaster risk financing instruments that cover small and recurring losses caused due to natural disasters. Typically funded through annual budget allocations from governments or organizations, specifically for disaster response and recovery, these funds act as immediate resources when a disaster strikes. A notable example is Mexico’s National Disaster Fund, known as FONDEN. FONDEN functions as a budgetary tool that allocates funds annually through three distinct accounts: an infrastructure fund dedicated to repairing uninsured public infrastructure, an agriculture fund dedicated to low-income farmers affected by disasters, and an assistance fund for providing relief to disaster victims.

Budget contingencies

Allocated within government budgets, these contingencies allow for the reallocation of funds to address unforeseen disaster-related expenses without needing extensive legislative approval. The only difference between reserves and budget contingencies is that any funds not used at the end of the fiscal year may lapse and be returned to the treasury. For instance, Japan’s national government allocates funds in its budget for disaster mitigation, preparedness, response, and recovery activities, including those related to volcanic events. From 1995 to 2004, the government averaged approximately JPY 4.5 trillion (about US $49.9 billion) annually for disaster management, which represented around 5% of the total national budget.

Contingent credit lines

These are pre-approved loans that can be accessed quickly when a disaster strikes. An example is the US $300 million Catastrophe Deferred Drawdown Option (CAT-DDO) approved by World Bank for Colombia in 2021 aimed at reducing the country’s fiscal vulnerability to adverse climate events, including disease outbreaks.

Risk transfer mechanisms

According to the United Nations Office for Disaster Risk Reduction (UNDRR), risk transfer mechanisms are essential tools in disaster risk management, allowing individuals, organizations, and governments to shift the financial burden of potential losses to third parties. The key sources and types of risk transfer mechanisms are:

Traditional insurance: These are the most common forms of risk transfer which involve individuals or entities purchasing insurance policies that cover specific natural disaster risks. Government-backed initiatives like the Turkish Catastrophe Insurance Pool (TCIP) demonstrate how public-private partnerships can provide compulsory earthquake insurance for residential buildings in Turkey, safeguarding public infrastructure against natural disasters.
Parametric insurance or index-based solutions: Instead of paying for the actual losses brought on by an event, such as an earthquake, this kind of insurance focuses on covering the probability or possibility that the event will occur. Rather than the extent of the actual damage incurred, payouts are initiated based on predetermined factors, such as wind speed or earthquake magnitude.
Catastrophe bonds (CAT bonds)

Catastrophe bonds or “CAT bonds” are financial instruments that allow insurance and reinsurance companies to transfer risks related to natural disasters to capital market investors. These are high-yield bonds that pay out to investors if a specified disaster occurs, such as a hurricane or earthquake. They allow governments and organisations to transfer disaster risk to the capital markets, providing immediate liquidity when needed. According to a report on the insurance lined securities (ILS) market from Aon, US $12.2 billion in CAT bonds were issued in the second quarter of 2023.

Disaster risk financing programs

These are specific programs designed to enhance financial resilience of countries against the impacts of natural disasters. Programs such as the World Bank’s Disaster Risk Financing and Insurance Program (DRFIP) help countries develop tailored financial strategies that enhance their resilience against natural disasters. The program also includes the integration of public-private partnerships to improve financial protection for vulnerable populations.

Types of ex-post financing instruments

Donor support

Humanitarian relief: These financial assistances are provided by international donors for immediate relief efforts. For example, The UN Central Emergency Response Fund (CERF), managed by the Office for Coordination of Humanitarian Affairs (OCHA), is recognized as one of the fastest and most effective mechanisms for supporting rapid humanitarian responses for individuals affected by natural disasters and armed conflicts.
Recovery and reconstruction: These are fundings aimed at rebuilding and recovery efforts. For Example, ADB offers emergency assistance loans to support rapid recovery after disasters. These loans feature extended grace periods, lower interest rates, and fast-tracked processing to ensure timely financial support for early recovery phases.

Domestic credit and external credit

This includes issuing bonds or seeking loans from local and international financial institutions or foreign governments for emergency funding.

Tax increases

Governments may implement temporary tax increases to generate additional revenue for disaster response and recovery efforts. For instance, following the 2016 earthquake, Ecuador raised its value added tax (VAT) from 12% to 14% for a year. Additionally, individuals with wealth above US $1 million were subject to a 0.9% one-time tax, and corporate profits were subject to a 3% one-time tax. This was on top of a contingency credit line of over US $600 million from multilateral lenders and emergency assistance of US $300 million from the Ministry of Finance

As a result, both categories of financial instruments play essential roles in comprehensive disaster risk management strategies. These instruments complement risk reduction efforts by enabling governments to manage climate-related vulnerabilities and financial shocks that affect both public budgets and diverse societal groups. Thus, by incorporating financial protection into comprehensive disaster risk management strategies, governments can strengthen their resilience to the economic impacts of natural disasters while also promoting long-term sustainable development.

Sources

auctusESG Copyright © 2024, All Rights Reserved.