Paper Presented atWorld Bank Conference on

Financing the Risks of Natural Disasters:A New Perspective on Country Risk Management

June 2-3, 2003Washington, DC

Integrating Mitigation with Risk Transfer Instruments

Howard Kunreuther Wharton SchoolUniversity of PennsylvaniaE-mail: kunreuther@wharton.upenn.edu

George DeodatisDept. of Civil EngineeringColumbia UniversityE-mail: deodatis@civil.columbia.edu Andrew SmythDept. of Civil EngineeringColumbia UniversityE-mail: smyth@civil.columbia.edu

Objectives of PaperMotivating Question

What are the financial benefits to national governments by encouraging or requiring property owners to invest in cost-effective mitigation measures?

Why is this Interesting?

Previous studies have focused on benefits of mitigation to individual property owner.

World Bank has a stake in promoting cost-effective mitigation measures to avoid large expenditures after a major catastrophe.

Outline of Paper

• Defining cost-effective mitigation• Role of risk-transfer instruments• Combining mitigation with risk transfer

instruments to governments• Case study of Turkey• How World Bank can promote mitigation

using risk transfer instruments • Future Research

Defining Cost-Effective Mitigation

Cost of Mitigation (C) (e.g. $65,000)

Discounted Expected Benefits from Mitigation (B*)Reduction in direct losses Reducing indirect losses

Avoiding relocation of residentsAvoiding business interruption risk

Reducing losses to neighboring structures Reducing financial costs from catastrophic losses

Decision Rule:   If B* > C then mitigation is cost-effective

If B* < C then mitigation is not cost-effective

Building Collapse

“Nearly all the fatalities and injuries can be attributed to building collapse.” EERI Report (Oct. 99)

Photo by Nano Seeber

From BBC News

Role of Risk Transfer Instruments

Individual: Purchasing insurance  Reward policyholder with lower premiums for adopting mitigation measure Other factors influencing protective decisions

• Underestimation of risk

• Myopia (short time horizons)

• It will not happen to me

• Budget constraints

Government Insurer Provide funds to compensate disaster victims following a catastrophic event. Increase capacity for providing more coverage to individuals at risk

Using Exceedance Probability Curve to Show Benefits of Mitigation

possible EP curve with mitigation

measure

right - hand tail mid - range

Loss, L (in Dollars)

Exc

eed

ance

pro

bab

ilit

y, p

low - end

original EP curve

Questions government can address using EP curve

What types of mitigation measures are most appropriate for dealing with the hazard(s) that the country faces?

What types of risk transfer mechanisms are appropriate for reducing the magnitude of

claim payments following a major disaster?

Case Study: Protection Against Earthquake in Istanbul

Chances Istanbul will have strong earthquake in next 30 years = 62%

Possible losses to apartment buildings in Istanbul from severe earthquake

        5,000 complete structural failure

        40,000 significant structural damage

Turkish Insurance ProgramTurkish Catastrophe Insurance Pool (TCIP) created in

September 2000.

 Current status of insured private property (May 14,

2003)       1.9 million insurance policies in Turkey        776,755 purchased by Istanbul residents

TCIP has purchased excess of loss reinsurance through a consortium of 60 different companies

       $840 million in place

Pilot Study

Located in Caddebostan

Built in 1968, seismic code of 1967

Z-3 soil (relatively stiff)

Moment resisting reinforced concrete frame with no shear walls

Existing concrete’s yield limit of 16MPa

Retrofitting concrete’s yield limit of 25MPa

Nonlinear (Bilinear model)

Highly representative of residential buildings in and around Istanbul

Retrofitting Solution 1 (Braced)

Fragility Curves (Braced)

EP Curves for 30 Apartment Buildings

Reinsurance Cost to Turkish Government With and Without Mitigation

30 Buildings (Based on Actuarial Risk)

Without mitigation: $16,179

 With mitigation $3,507

 

30,000 Buildings (Based on Administrative Cost of 1.5 x Actuarial Risk)

 Without mitigation: $24.3 million

 With mitigation $5.3 million

Savings to Turkish Government: $19 million.

Role of World Bank in Encouraging Mitigation

Premium Reductions Linked with Government Mitigation Loans  

Provide funds for mitigation through some type of long-term loan. Insurance premiums are lowered to reflect benefits of mitigationMay have to subsidize low-income residents  

Issuing Catastrophe Bonds to Governments  

Can one require cost-effective mitigation as a condition for a cat bond?What are the prices of these new financial instruments likely to be?How can one combine reinsurance with capital market instruments?

Future Research Questions• What role can land-use planning play in supplementing mitigation

measures for reducing future disaster losses?

• What role can government institutions play in aiding low income families?

• What role can microcredit institutions (e.g Grameen Bank) play at individual and community level?

• What is the role of informal mechanisms (e.g. group-based insurance systems) in spreading coverage over a large area to diversify risk?

• How can other mechanisms (e.g. social investment funds and safety nets) help in managing disaster risk?

Conclusions and SummaryMitigation measures have many benefits to individuals and countries          Reducing direct physical damage         Indirect benefits to residents and businesses         Financial benefits to country

 

Risk transfer instruments can aid country in disaster planning

 

Mitigation measures can reduce country’s cost of risk transfer mechanisms

 

World Bank can encourage mitigation and provide risk transfer instruments

 

Need to combine many policy instruments for an effective risk management strategy:          cost-effective mitigation measures         land-use planning         risk transfer instruments         reconstruction programs