This paper proposes a framework for ex ante evaluation of sovereign disaster risk finance instruments available to governments for funding disaster losses. The framework can be used by governments to help choose between different financial instruments, or between different combinations of instruments, to achieve appropriate and financially efficient strategies to fund disaster losses, taking into account the risk of disasters, economic conditions, and political constraints.
The framework provides evidence to support the tiered approach to sovereign risk financing, and provides a methodology to allow governments to select a risk financing strategy based on their objectives (for example to minimise average costs or minimise the costs for a disaster of given magnitude). The proposed framework allows the government to consider the costs of funding their contingent liability to disasters using different combinations of financial instruments, and to minimise this cost based on their preferences towards risk.
INTRODUCTION
As the frequency and severity of climate extremes continues to rise, governments are having to consider new ways of meeting the growing financial consequences of natural disasters. In post‐disaster situations, the requirements for critical and rapid expenditures can lead to governments using slow or expensive instruments, such as budget reallocations or borrowing on unfavorable terms (Benson and Clay, 2004). In an attempt to be better financially prepared for when disasters occur, there is an increasing interest amongst governments in implementing comprehensive sovereign Disaster Risk Finance strategies, defined by World Bank Group (2014) as “the bringing together of pre‐ and post‐disaster financing instruments that address the evolving need of funds – from emergency response to long‐term reconstruction – and are appropriate to the relative probability of events”. As the knowledge and understanding of disaster risk increases there is a growing need for concrete evidence to inform investments made in financial protection against such events alongside increased spending on reducing disaster risks through mitigation measures. Ministries of Finance of disaster‐prone countries, along with donor partners who are also facing rising costs due to disasters, are increasingly asking questions such as:
Should we set aside funds in a reserve fund, and how large should this reserve fund be?
How much reliance should be placed on emergency reallocations of funds away from other parts of our budget to finance disaster losses?
Should we seek to establish a line of credit which can immediately be drawn upon if a disaster were to occur?
How can we evaluate proposals for risk transfer products such as disaster insurance or catastrophe bonds?