peru: Disaster risk Management in Water and Sanitation ... · Peru: Disaster Risk Management in Water and Sanitation Utilities. Volume II Foreword The seismic risk in Peru is the

Water and Sanitation Program: Technical paper

peru: Disaster risk Management in Water and Sanitation UtilitiesVolume ii: Policy Considerations and Financial Protection Strategies

October 2012

CanadianInternationalDevelopmentAgency

Agencecanadienne de

internationaldéveloppement

Peru: Disaster Risk Management in Water and Sanitation UtilitiesVolume II: Policy Considerations and Financial Protection Strategies

AuthorThis publication has been produced by Consorcio Evaluación de Riesgos Naturales – América Latina, ERN – AL, conformed by Centro Internacional de Métodos Numéricos en Ingeniería (CIMNE), Evaluación de Riesgos Naturales, Ingenieros Consultores S.C., ITEC Ltda. and INGENIAR Ltda.

Content Contributors

World BankFernando Ramírez, Senior Specialist in Disaster Risk Management (LCSDU)Oscar Ishizawa, Specialist in Disaster Risk Management (LCSDU)Diana Rubiano, Senior Specialist in Disaster Risk Management – ETC (LCSDU)

Water and Sanitation Program (WSP)Glenn Pearce Oroz, Regional Director for Latin America and the Caribbean Iris Marmanillo, Disaster Risk Management in Water and Sanitation Sector Project LeaderGustavo Perochena, Disaster Risk Management in Water and Sanitation Sector Project Coordinator

The production of this study was made possible by the financial support from the Canadian International Development Agency (CIDA).

Graphic DesignShinny Montes

First Edition: October, 2012Press Run: 150 copiesPrinting: GMC Digital S.A.C.Lima, Peru

© 2012, World Bank’s Water and Sanitation ProgramAll rights reservedwww.wsp.org [email protected]

The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent.

The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries.

Rights and permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to the work is given.

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table of Contents

Foreword .......................................................................................................................

i inTrODUcTiOn ..........................................................................................................

ii inSTiTUTiOnal cOnTeXT FOr The WaTer SUpplY anD SaniTaTiOn SecTOr in perU .......................................................................................................

2.1 Sector service providers (SP) .................................................................................

2.1.1 Sector service provider description and general statistics ...........................

2.1.2 Sector service provider indicators and financial statistics ............................

2.1.3 management and financial indicator analysis ..............................................

2.2 institutional context for water supply and sanitation services in Peru ......................

2.2.1 overview ....................................................................................................

2.2.2 ministry of economics and Finance (meF) ...................................................

2.2.3 ministry of Housing, Construction, and Sanitation (mVCS) ..........................

2.2.4 Presidency of the Council of ministers (PCm) ..............................................

2.2.5 national Superintendence of Sanitation Services (SUnaSS) .......................

2.2.6 Banking and insurance Superintendence (SBS) ..........................................

2.2.7 association of municipalities .......................................................................

2.3 Legal framework ....................................................................................................

2.4 insurance sector in Peru ........................................................................................

2.4.1 general description ....................................................................................

2.4.2 general opinion on the insurance sector .....................................................

iii caTaSTrOphic riSK in The WaTer SUpplY anD SaniTaTiOn SecTOr in perU ............................................................................................................................

3.1 overview ................................................................................................................

3.2 risk assessment methodology ...............................................................................

3.3 Probabilistic risk analysis procedure .......................................................................

3.3.1 necessary basic information .......................................................................

3.3.2 Hazard assessment ...................................................................................

3.3.3 exposure assessment ................................................................................

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3.3.4 Component vulnerability ............................................................................

3.3.5 risk assessment .......................................................................................

3.4 general risk analysis for the sector ........................................................................

3.4.1 analyses made and assumptions ..............................................................

3.4.2 general diagnosis of the sector risk profile ................................................

3.5 general diagnosis of the sector risk ......................................................................

iV pOlicY eleMenTS FOr riSK ManaGeMenT anD Financial prOTecTiOn STraTeGY ..........................................................................................

4.1 overview ...............................................................................................................

4.2 elements for disaster risk management .................................................................

4.3 elements for specific policy ...................................................................................

4.3.1 overview ...................................................................................................

4.3.2 identifying the risk .....................................................................................

4.3.3 risk reduction ..........................................................................................

4.3.4 Comprehensive sector financial protection strategies ................................

4.3.5 Contingency plans, emergency attention, and reconstruction ....................

4.4 Financial protection strategy for the sector and for the SP ....................................

4.4.1 introduction ...............................................................................................

4.4.2 alternative 1: individual insurance scheme for the SP ................................

4.4.3 alternative 2: Sector SP group insurance ..................................................

4.5 implementation and interaction with sector SP .....................................................

4.5.1 implementation .........................................................................................

4.5.2 interaction with the agencies related to the sector .....................................

4.5.3 Budget reallocations .................................................................................

4.6 recommendations for strengthening disaster risk management and financing ......

4.7 recommendations for driving risk financial protection ...........................................

V anneX 1: prOBaBiliSTic riSK MODelinG MeThODOlOGY .............................

5.1 overview ...............................................................................................................

5.2 identification of the basic information required .......................................................

5.3 risk analysis .........................................................................................................

5.3.1 risk analysis procedure .............................................................................

5.3.2 Basic risk calculation equation ..................................................................

5.3.3 Hazard temporality ....................................................................................

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5.3.4 Uncertainties ............................................................................................

5.3.5 Specific risk estimators ............................................................................

5.3.6 Probability of Loss Value exceedance ......................................................

5.3.7 Sole scenario analysis ..............................................................................

5.4 Hazard and risk analysis ......................................................................................

Vi anneX 2: General DiaGnOSiS OF The caTaSTrOphic riSK FOr The SecTOr ...........................................................................................................

6.1 Financial risk management indicators ..................................................................

6.2 general diagnosis of the sector risk situation .......................................................

Vii anneX 3: riSK TranSFer anD reTenTiOn inSTrUMenTS .............................

7.1 transfer and retention instruments .......................................................................

7.1.1 Financial risk transfer ...............................................................................

7.1.2 transfer and financing on the capital market ............................................

7.1.3 Financial risk retention ..............................................................................

7.1.4 transfer and retention through a captive insurance company

7.2 Combining financial protection alternatives ..........................................................

7.2.1 retention and transfer structure design ...................................................

7.2.2 Financial optimization analysis ..................................................................

7.3 need to protect public assets ..............................................................................

Viii anneX 4: WaTer SUpplY anD SaniTaTiOn SecTOr inTernaTiOnal Financial prOTecTiOn eXperienceS ..............................................................

8.1 international cases ..............................................................................................

8.1.1 experiences in Colombia .........................................................................

8.1.2 the experience in Chile ............................................................................

8.1.3 the experience in mexico ........................................................................

8.1.4 the experience in Costa rica ..................................................................

8.1.5 Comments on other mass insurance mechanisms ...................................

8.2 Case analysis Conclusions ..................................................................................

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List of Figures

Figure 2‑1 Water supply coverage evolution 2005‑2009 ..................................................................17

Figure 2‑2 Sanitation coverage evolution 2005‑2009 .......................................................................17

Figure 2‑3 Unit volume of water produced 2005‑2009 .....................................................................18

Figure 2‑4 Percentage of waste water treated 2005‑2009 ...............................................................19

Figure 2‑5 Service continuity 2005‑2009 .........................................................................................20

Figure 2‑6 mean service fees 2005‑2009 .........................................................................................21

Figure 2‑7 Work ratio 2005‑2009 .....................................................................................................22

Figure 2‑8 operating margin 2005‑2009 ..........................................................................................23

Figure 2‑9 Percentage of unbilled water 2005‑2009 ........................................................................24

Figure 2‑10 roles, by different levels of government ..........................................................................28

Figure 2‑11 roles, by different government ministries .......................................................................29

Figure 3‑1 Seismic hazard in Peru ...................................................................................................40

Figure 3‑2 detail of the pipe line network in a sector of the city of Lima............................................42

Figure 3‑3 illustrative vulnerability functions ......................................................................................43

Figure 3‑4 Loss exceedance curve in terms of exceedance rate (left) and return period (right)..........44

Figure 4‑1 retention and transfer structure ......................................................................................62

Figure 4‑2 risk retention and transfer structure................................................................................66

Figure 5‑1 Probabilistic risk assessment methodology .....................................................................86

Figure 6‑1 Seismic Hazard in Peru, Pga, rP = 500 years ................................................................91

Figure 6‑2 general risk indicators for the SP in Peru ........................................................................94

Figure 6‑3 Probable maximum loss for the SP groups .....................................................................95

Figure 6‑4 Probable maximum loss as a percentage of the exposed value.......................................96

Figure 6‑5 average annual loss as a percentage of the operating income ........................................96

Figure 7‑1 Losses due to small events and large events during a prolonged period of time ............101

Figure 7‑2 retention and transfer structure ....................................................................................123

Figure 7‑3 Financing costs .............................................................................................................124

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List of tables

table 2‑1 total number of water connections in 2009 (Continued in table 2‑2) ...............................14

table 2‑2 total number of water connections in 2009 (Continuation of table 2‑1) ...........................15

table 2‑3 Summary of the number of water connections in 2009 ....................................................16

table 2‑4 Water supply and sanitation system coverage in 2009 ....................................................16

table 2‑5 Water supply coverage evolution 2005‑2009 ...................................................................16

table 2‑6 Sanitation coverage evolution 2005‑2009 .......................................................................17

table 2‑7 Unit volume of water produced 2005‑2009 .....................................................................18

table 2‑8 Percentage of waste water treated 2005‑2009 ................................................................19

table 2‑9 Service continuity 2005‑2009 ..........................................................................................20

table 2‑10 mean service fees 2005‑2009 .........................................................................................21

table 2‑11 Work ratio 2005‑2009 .....................................................................................................22

table 2‑12 operating margin 2005‑2009 ..........................................................................................23

table 2‑13 Percentage of unbilled water 2005‑2009 .........................................................................24

table 2‑14 Water supply and sanitation sector main functions and responsibilities ............................27

table 2‑15 net insurance premiums ‑ 2010 as compared to 2009 ....................................................33

table 2‑16 insurance claims ‑ September 2010 as compared to 2009 .............................................34

table 2‑17 insurance loss variation ...................................................................................................35

table 2‑18 net technical results, by type of insurance .......................................................................35

table 3‑1 Basic SP information required for risk analysis .................................................................39

table 3‑2 average annual loss ........................................................................................................45

table 4‑1 Probable maximum losses for the different SP groups .....................................................67

table 4‑2 range of probable commercial premium values ..............................................................67

table 5‑1 detailed seismic hazard information, requested from the Service Providers (SP) ..............82

table 5‑2 detailed basin flooding hazard information, requested from the SP..................................83

table 5‑3 detailed landslide hazard information, requested from the SP..........................................83

table 5‑4 detailed risk, exposure and vulnerability study information, requested from the SP ..........84

table 5‑5 Hazard temporality .........................................................................................................87

table 6‑1 risk indicator for the 50 SP in Peru (Continues on table 2‑15) ........................................92

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table 6‑2 risk indicator for the 50 SP in Peru (Continued from table 2‑14) .....................................93

table 6‑3 Probable maximum loss for the different SP groups ........................................................94

table 7‑1 Benefits for catastrophic risk sellers and buyers ............................................................107

table 7‑2 Catastrophe indexes .....................................................................................................109

table 7‑3 disaster risk coverage financial instruments ...................................................................122

table 8‑1 aguas de manizales insured amounts (at 2008) .............................................................132

table 8‑2 aguas de manizales combined material damages policy deductibles ............................132

table 8‑3 insured amounts during the installation process ............................................................134

table 8‑4 medium‑sized and large Chilean SP. market share ........................................................134

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Peru: Disaster Risk Management in Water and Sanitation Utilities. Volume II Foreword

The seismic risk in Peru is the highest catastrophic risk in the country. According to a World Bank study, Peru is located on the 20th spot of the world ranking of countries with highest economic1 risk due to threats caused by extreme events such as earthquakes, floods, frosts, among others. In August 2007, Peru’s south region was hit by an 8.0 Mw earthquake, affecting the population with infrastructure damage. This disaster put in evidence the weakness in disaster risk management politics, and holes especially in the reduction of vulnerability and emergency management2.

As part of the support that the World Bank offered the Peruvian government in facing reconstruction, infrastructure seismic risk evaluation was developed for SEDAPAL3 and EMAPICA4, two Peruvian companies that provide drinking water and sanitation services. The study looked to quantify the probable losses that these companies are exposed to for damages on their infrastructure due to the occurrence of future earthquakes. The results of this evaluation are constituted in a fundamental input for future analysis in the design and prioritization of disaster risk reduction measures of these companies. The study features some recommendations of risk management policies and emphasizes on the need to continue improving the knowledge of threats and risks.

Due to its reach and methodology (probabilistic risk modeling, using the CAPRA platform)5 it is the first to be developed in the water and sanitation sector in Peru. In this sense, the study also offers an excellent opportunity to review and learn the usefulness of the probabilistic approximation and to promote new studies in other regions of the country.

Foreword

The study had the decided support of Board Members and officers of SEDAPAL and EMAPICA companies for the collecting and arrangement of the baseline information and the technical studies.

We would like to express our acknowledgement to those who, with their invaluable contribution, made possible the development of this publication; Fernando Ramirez (Disaster Risk Management Senior Specialist, LCSDU), Oscar Ishizawa (Disaster Risk Management Specialist, LCSDU), Diana Rubiano (Disaster Risk Management Senior Specialist ETC, LCSDU), Iris Marmanillo (Water and Sanitation Senior Specialist, TWILC), Gustavo Perochena (Senior Economist, TWILC), Yehude Simon (Communications Officer, TWILC), Juan Chong (Consultant, TWILC) and Marisol Noriega (Program Assistant, TWILC). We also thank the Canadian International Development Agency (CIDA), for funding this study.

Anna WellesteinSector ManagerDisaster Risk Management and Urban Issues for Latin America and the Caribbean The World Bank

Glenn Pearce OrozRegional Director for Latin America and the CaribbeanWater and Sanitation ProgramThe World Bank

1 The World Bank. Natural Disaster Hotspots, 2005. Chart 7.2: Countries at Relatively High Economic Risk from Multiple Hazards. Page. 89.2 The World Bank. Strategic Alliance with the country for the Republic of Peru. Exercises 2012-2016. Page 28.3 Company located in the city of Lima (Central coast of Peru) with 9 millions of inhabitants.4 Company located in the city of Ica (South of Lima) with 500 thousand inhabitants.5 The study was advanced by Consorcio ERN LA

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Peru: Disaster Risk Management in Water and Sanitation Utilities. Volume II Introduction

The rigorous risk assessment made by water supply and sanitation service providers (SP) in Peru as well as an analysis of the institutional context (State agencies, service providers, insurance companies) are the fundamental bases for proposing a risk protection scheme and the requirements for its eventual implementation in each one of the service providers and in the sector at large through sector policy.

The catastrophic risk assessment of a water supply and sanitation system must give priority to the main natural hazard(s) to the system and to the vulnerability of its different components, that is to say, the predisposition of said elements suffering damage if an important event occurs. The analysis must be made for each one of the service providers and for the set of service providers simultaneously because catastrophic scenarios can affect one of more service providers at the same time.

In Peru natural events have historically produced significant economic losses. It is worth highlighting the August 2007 earthquake that caused damages worth US$ 2 billion; the 1997 flood that caused damages estimated at US$ 1.2 billion; the 1983 flood that caused damages of around US$ 988 million; the 1970 earthquake that caused damages estimated at US$ 530 million; the 2001 earthquake that generated losses of US$ 300 million; and the 1992 draught that originated damages estimated at US$ 250 million.

Considering the high impact that seismic events have in Peru, demonstrated by the above statistics and given the fact that this study aims to estimate catastrophic losses, the risk analysis has given the first priority to seismic events.

IntroductionI.

Volume I of this report presents a detailed seismic risk assessment for two service providers that are representative of the sector, SEDAPAL and EMAPICA. Based on the results, specific recommendations were made regarding vulnerability mitigation and reduction strategies, financial protection strategies, and an action plan for proper risk management at short, medium, and long terms for each one of the sector service providers. The main objective of this part of the study (Volume II) is to suggest policy elements for risk management for the service providers (SP) and to propose a financial protection strategy for the individual service providers and for the sector as a whole. To do so, the study presents a review of the institutional context of the Peruvian water supply and sanitation sector, including the service providers (SP), the institutional context, the legal framework, and the insurance sector. In addition, the study conducts a comprehensive catastrophic risk assessment for the sector, based on the specific case analyses of SEDAPAL and EMAPICA (presented in Volume I), but broadened to include the other sector service providers, and, finally, based on those results, it suggests policy elements for risk management and a sector strategy for the financial protection of the sector. Volume II is aimed at and directed to the public sector, that is, mainly regional and national governments, and to the persons in charge of establishing and supervising the policy for this sector. It also serves as a reference document for sector service providers that wish to implement a risk management system.

Peru: Disaster Risk Management in Water and Sanitation Utilities. Volume II Institutional context for the water supply and sanitation sector in Peru

14

2.1 Sector service providers (SP)Currently in Peru water supply and sanitation service operations, maintenance, and administration are the responsibility of Service Providers (SP) comprised of Servicios de Agua Potable and Alcantarillado de Lima (SEDAPAL) and municipal service providers (jointly, they cover the needs of 62% of the population of Peru), community organizations (they cover 29% of the population, mainly in the rural areas), and small municipalities (they cover 9% of the total population). In the urban ambit, out of the 62% covered by the SP, 29% corresponds to SEDAPAL and the remaining 33% corresponds to 53 other service providers of different sizes with distinct degrees of complexity1.

2.1.1 Sector service provider description and general statisticsThe water supply and sanitation sector in Peru is made up of a total of 50 service providers of different sizes with different characteristics. A general classification was established according to the company size: large, medium, and small. Based on the information available at the National

Institutional context for the water supply and sanitation sector in Peru

II.

Superintendence of Sanitation Services (SUNASS), the service providers were given a general characterization.

The total population attended with water supply by the 50 service providers is approximately 15 million persons. Out of them, SEDAPAL alone serves over 7 million, representing near half of the total population attended whereas the other service providers classified as large SP serve another 5 million persons. The medium service providers attend approximately 2 million persons and the small service providers solely attend 300,000 persons. Along the same lines, the total number of water connections follows a similar pattern in which SEDAPAL has almost half of the total number of connections (1.3 million connections). Table 2-1 summarizes the number of service providers in each group and the total number of connections.

2.1.1.1 number of connections and classificationThe SP are classified into three groups according to their size: large (L), medium (M), and small (S). Tables 2-1 and 2-2 show the list of the 50 SP classified and the number of total water connections for the year 2009.

Table 2.1: TOTal nUMBer OF WaTer cOnnecTiOnS in 2009 (cOnTinUeD in TaBle 2-2)

name Type population attended with water supply

no. of water connections 2009

AGUAS DE TUMBES M 132,221 35,801

EMAPA CAÑETE S.A. M 138,779 28,444

EMAPA HUACHO S.A. M 94,670 21,818

EMAPA HUANCAVELICA S.A.C P 26,896 6,881

EMAPA HUARAL S.A. M 65,727 13,654

EMAPA MOYOBAMBA S.R.LTDA. M 46,617 13,165

EMAPA PASCO S.A. M 61,835 11,216

EMAPA San Martín S.A. M 155,231 35,128

EMAPA Y P 10,625 4,166

EMAPAB S.R.LTDA. P 15,996 4,710

1 National Sanitation Plan 2006-2015


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Table 2.2: TOTal nUMBer OF WaTer cOnnecTiOnS in 2009 (cOnTinUaTiOn OF TaBle 2-1)

name Type population attended withwater supply

no. of water connections 2009

EMAPACOP S.A. M 125,214 22,944

EMAPAT S.R.LTDA. M 52,771 11,253

EMAPAVIGSSA P 26,683 7,089

EMAPICA S.A. G 166,763 43,359

EMAPISCO S.A. M 80,988 19,284

EMAQ S.R.LTDA. P 18,629 5,361

EMPSSAPAL S.A. M 52,344 11,722

EMSA PUNO S.A. M 160,085 36,156

EMSAP CHANKA P 15,473 3,746

EMSAPA YAULI P 11,703 2,695

EMUSAP ABANCAY M 51,607 10,862

EMUSAP AMAZONAS P 21,404 5,852

EPS - SEDACUSCO S.A. G 362,322 61,218

EPS AGUAS DEL ALTIPLANO P 17,176 5,191

EPS CALCA P 11,689 2,544

EPS CHAVIN S.A. M 92,759 22,496

EPS GRAU S.A. G 862,796 173,156

EPS ILO S.R.LTDA. M 71,791 21,790

EPS MANTARO S.A. M 56,928 14,848

EPS MARAÑON P 37,756 9,272

EPS MOQUEGUA S.R.LTDA. M 41,555 17,984

EPS SEDALORETO S.A. G 387,872 67,847

EPS SELVA CENTRAL S.A. M 96,497 18,993

EPS SIERRA CENTRAL S.A. P 31,667 9,124

EPS TACNA S.A. G 257,422 67,533

EPSASA G 179,716 44,567

EPSEL S.A. G 707,640 142,712

EPSSMU S.R.LTDA P 23,108 6,232

NOR PUNO S.A. P 21,156 7,329

SEDA Huánuco S.A. M 176,878 35,860

SEDACAJ S.A. M 151,155 32,426

SEDACHIMBOTE S.A. G 348,187 74,395

SEDAJULIACA S.A. G 201,827 41,373

SEDALIB S.A. G 788,200 148,583

SEDAM HUANCAYO S.A.C G 310,145 62,404

SEDAPAL S.A. S 7,235,363 1,285,348

SEDAPAR S.A. G 776,698 218,825

SEDAPAR S.R.L. (Rioja) P 18,627 5,089

SEMAPA BARRANCA S.A. M 59,744 16,507

SEMAPACH S.A. M 159,675 37,526


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Table 2-3 summarizes the number of service providers in each group and the total number of connections.

2.1.1.2 CoverageWater supply and sanitation coverage is measured as the percentage of the population who live in the zones under the administration of each SP with access to said services. For water supply, domiciliary connections as well as public basins are taken into consideration. Tables 2-4 through 2-6 show the percentage of coverage for large, medium, and small SP and for the service provider SEDAPAL (SE) separately.

Table 2.3: SUMMarY OF The nUMBer OF WaTer cOnnecTiOnS in 2009

Service providers no. of companies population attended Total number of water connections

SEDAPAL 1 7,235,363 1,285,348

Large 12 5,349,598 1,145,972

Medium 22 2,125,071 489,877

Small 15 308,586 85,281

Total 50 15,018,619 3,006,478

Table 2.4: WaTer SUpplY anD SaniTaTiOn SYSTeM cOVeraGe in 2009

Service providers

Type Urban population

2009 water supply coverage 2009 sanitation coverage

population attended [%] population attended [%]

SEDAPAL SE 8,979,056 7,235,363 80.6 6,873,595 76.6

Large L 6,114,346 5,349,598 87.5 4,630,893 75.7

Medium M 2,591,978 2,125,071 81.6 1,813,040 69.9

Small S 434,567 308,586 70.9 260,907 60.0

Total 18,119,947 15,018,619 82.8 13,578,435 74.9

Table 2.5: WaTer SUpplY cOVeraGe eVOlUTiOn 2005-2009

Service providers


Water supply coverage [%]

2009 2008 2007 2006 2005

SEDAPAL SE 8,979,056 80.6 87 84.6 85.6 87.3

Large L 6,114,346 87.5 86.1 82.3 82.8 82.1

Medium M 2,591,978 81.6 80.5 79.1 79.7 78.7

Small S 434,567 70.9 85.4 83.5 80.9 82.4

Total T 18,119,947 82.8 85.7 83 83.6 84.1


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Figure 2-1 presents the evolution of the water supply coverage through time for the different service provider groups.

As can be seen in Figure 2-1, solely the large and medium service providers have had water supply coverage growth whereas SEDAPAL and the small service providers have shown a clear drop in coverage for the year 2009.

Figure 2-2 shows that the sanitation coverage behavior has a tendency similar to the water supply coverage evolution. Here, only the large and medium service providers present growth in sanitation coverage whereas SEDAPAL and the small service providers present a relative drop in the coverage for this service for the year 2009.

Table 2.6: SaniTaTiOn cOVeraGe eVOlUTiOn 2005-2009

Service providers


Sanitation coverage [%]

2009 2008 2007 2006 2005

SEDAPAL SE 8,979,056 76.6 82.7 83.7 81.3 82.9

Large L 6,114,346 75.7 74 72.4 72.7 72.4

Medium M 2,591,978 69.9 67.8 68.1 64.8 64.8

Small S 434,567 60 73.4 71.2 66.4 59.7

Total T 18,119,947 74.9 77.5 77.2 75.4 75.8

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90

2005 2006 2007 2008 2009

Wat

er s

upp

ly c

over

age

(in

%)

Year

Sedapal Large SP Medium SP Small SP

FIgURe 2.1: WaTer SUpplY cOVeraGe eVOlUTiOn 2005-2009

FIgURe 2.2: SaniTaTiOn cOVeraGe eVOlUTiOn 2005-2009

Sew

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2005 2006 2007 2008 2009

Year


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FIgURe 2.3: UniT VOlUMe OF WaTer prODUceD 2005-2009

Table 2.7: UniT VOlUMe OF WaTer prODUceD 2005-2009

Service providers

Type population attended 2009

Volume produced 2009 Unit volume produced [l/inhabitant]

[l] 2009 2008 2007 2006 2005

SEDAPAL SE 6,669,933 671,604,144 275.87 258.95 269.59 283.02 287.56

Large L 4,631,300 405,678,707 239.99 250.19 258.16 251.68 254.13

Medium M 1,728,045 190,921,277 302.7 323.47 299.35 316.95 326.37

Small S 262,410 36,050,889 376.39 446.4 368.48 359.39 300.26

Total T 13,291,688 1,304,255,018 268.84 267.44 272.31 280.51 283.41

0

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2005 2006 2007 2008 2009Uni

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f w

ater

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duc

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3/in

hab

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Year


2.1.1.3 Water supply production and wastewater treatment volumes Table 2-7 and Figure 2-3 present statistics for the water supply volume produced for the population, by service provider

group. It also presents the unit volume produced (volume per inhabitant) as an indicator of business efficiency.


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Another indicator that enables measuring business efficiency in service provision is waste water treatment that measures the percentage of collected waste water that is treated before

Table 2.8: percenTaGe OF WaSTe WaTer TreaTeD 2005-2009

Service providers

Type Volume sent through network

Volume of waste water treated

% of waste water treated

[l] [l] 2009 2008 2007 2006 2005

SEDAPAL SE 412,039,298 86,681,487 21 19.5 13.3 12.4 12.2

Large L 245,045,122 144,607,435 59 58.1 57.3 51 54.3

Medium M 105,047,877 33,256,179 31.7 33.7 28.7 40.8 48.2

Small S 24,247,302 10,507,647 43.3 47.7 30.3 38.3 41.5

Total T 786,379,599 275,052,749 35 34.2 29.1 28.1 29.7

FIgURe 2.4: percenTaGe OF WaSTe WaTer TreaTeD 2005-2009

0

10

20

30

40

50

60

70

2005 2006 2007 2008 2009

Was

te w

ater

tre

ated

(%)

Year


being sent to the receiver. That information is summarized in Table 2-8 and in Figure 2-4.


20

Table 2.9: SerVice cOnTinUiTY 2005-2009

Service providers

Type active connections

continuity [hours/day]

2009 2008 2007 2006 2005

SEDAPAL SE 1,151,092 21.6 21.6 21.3 21 21.4

Large L 963,429 15.1 14.8 14.9 14.8 15.4

Medium M 379,287 16.3 16 15 15.1 15

Small* S 58,631 14.5 14.9 15.0 14.7 14.1

Total T 2,552,439 18.2 18 17.8 17.7 18.1

* Not all of the small SP have available information.

FIgURe 2.5: SerVice cOnTinUiTY 2005-2009


10

12

14

16

18

20

22

24

2005 2006 2007 2008 2009

Co

ntin

uity

(Ho

urs/

day

)

Year

2.1.1.4 Service continuity Water supply service continuity is the weighted average of the number of hours per day that the service provider renders the service to the users. The available statistics are presented in Table 2-9 and in Figure 2-5.


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2.1.2 Sector service provider indicators and financial statisticsThe proposal of possible risk management strategies (mitigation programs, financial protection, and contingency plans, among others) for the sector service providers requires reviewing and assessing SP indicators and financial statistics. Some general indicators are presented below according to the information

FIgURe 2.6: Mean SerVice FeeS 2005-2009

Table 2.10: Mean SerVice FeeS 2005-2009

Service providers

Type Billed volume

amount billed

Mean service fee [in US$/m3]]

[m3] [in US$] 2009 2008 2007 2006 2005

SEDAPAL SE 412,709,798 324,413,982 0.79 0.70 0.65 0.59 0.51

Large L 230,059,762 125,155,359 0.54 0.50 0.47 0.47 0.48

Medium M 96,617,437 41,641,916 0.43 0.41 0.38 0.37 0.36

Small S 16,927,749 5,231,934 0.31 0.27 0.31 0.31 0.33

Total T 756,314,746 496,443,192 0.66 0.59 0.56 0.52 0.48


0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

2005 2006 2007 2008 2009

Mea

n se

rvic

e fe

e (in

US

$/m

3)

Year

furnished by the National Superintendence of Sanitation Services (SUNASS).

2.1.2.1 Service fees Among the financial indicators, the mean service fee was considered. It is the average value billed per water supply unit of volume.


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Table 2.11: WOrK raTiO 2005-2009

Service providers

Type Operating income

Operating costs without depreciation or bad debt allowance

[%]

[in US$] [in US$] 2009 2008 2007 2006 2005

SEDAPAL SE 403,457,570 230,998,159 57.3 57.2 54 57.2 63.4

Large L 147,512,479 107,771,220 73.1 74.8 76.6 76.7 76.8

Medium M 46,470,681 38,503,313 82.9 86.9 84.5 87.6 85.4

Small S 5,762,107 5,153,562 89.4 88.9 83.4 86.1 90.9

Total T 603,202,838 382,426,254 63.4 64.1 62.1 65 69

FIgURe 2.7: WOrK raTiO 2005-2009


95

90

85

80

75

70

65

60

55

50

452005 2006 2007 2008 2009

(Wo

rk r

atio

(%)

Year

2.1.2.2 Work ratio The work ratio was used to measure service sustainability. This is the ratio that represents total operating costs (without

including depreciation and bad debt allowance) over total operating income.


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2.1.2.3 operational margin The operating margin is another useful indicator because it measures the percentage that represents the operating profit (operating income minus operating costs) over operating income. Table 2.12: OperaTinG MarGin 2005-2009

Service provider

Type Operating income [in US$]

Total operating costs [in US$]

[%]

2009 2008 2007 2006 2005

SEDAPAL SE 403,457,570 312,610,191 22.5 21.7 20.2 14.3 5.6

Large L 147,512,479 135,502,125 8.1 4.6 -3.3 -3.4 -2.7

Medium M 46,470,681 47,831,037 -2.9 -6.4 -11.1 -13.4 -6.9

Small S 5,762,107 6,197,376 -7.6 -5.8 -2.7 -5.8 -10.8

Total T 603,202,838 502,140,728 16.8 15.1 11.9 7.3 2.2

FIgURe 2.8: OperaTinG MarGin 2005-2009


-20

-15

-10

-5

0

5

10

15

20

25

2005 2006 2007 2008 2009

Op

erat

ing

Mar

gin

(%)

Year


24


0

10

20

30

40

50

60

70

2005 2006 2007 2008 2009

Unb

illed

Wat

er (%

)

Year

2.1.2.4 Unbilled waterThis indicator measures business efficiency because it represents the percentage of the water supply produced by each SP, which it does not bill, either due to system losses or to not having been measured.

Table 2.13: percenTaGe OF UnBilleD WaTer 2005-2009

Service providers

Type Volume produced Volume billed [%]

[m3] [m3] 2009 2008 2007 2006 2005

SEDAPAL SE 671,604,144 412,709,798 38.5 37.5 37.5 39.1 41.1

Large L 405,678,707 230,059,826 43.3 44.7 46 46.3 46.4

Medium M 190,921,277 95,960,665 49.7 49.6 49.4 49.6 48.2

Small S 36,050,889 16,929,302 53 57.6 54 53.6 50.5

Total T 1,304,255,018 755,659,591 42.1 42 42.4 43.3 43.9

FIgURe 2.9: percenTaGe OF UnBilleD WaTer 2005-2009


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2.1.3 Management and financial indicator analysis In general terms sector service providers present management and financial indicators that are not very encouraging. First of all, the SP show a level of coverage of water supply to the population from 80% to 87%, but only the medium and large SP have had an increase in coverage through time. Sanitation coverage shows a level from 65% to 85%, but SEDAPAL and the small SP show some coverage difficulty. Treated waste water percentages range from 10% to 60% in some cases and SEDAPAL and several medium SP show the most critical situations. Most of these SP have a service continuity of around 15 hours per day whereas SEDAPAL shows an average of 22 hours per day.

The financial indicator situation is not very positive either. On one hand, the sector service fees have increased through time, especially those of SEDAPAL, whereas the small SP service fees have remained practically constant over the past five years. The ratio total operating costs over operating income is around 55% for SEDAPAL, 80% for the large SP, and over 85% for the other SP. Operating margins are negative for most of the medium and small SP, barely positive after several years of negative values for the large SP, and only SEDAPAL presents operating margins of over 20%. Unbilled water percentages are more than 40% in all cases and some service providers show more than 50%.

In general, the statistics for the sector evidence important problems such as low levels of water supply and sanitation coverage, low levels of waste water treatment, low levels of service continuity, and financial problems in most of the medium and small SP, aggravated by minimum increases in service fees in recent years, and very high percentages of unbilled water. Those aspects generate a series of priorities for the service providers at the same time as the need for risk management. There is also an evident need to improve business operations aspects, through actions such as optimizing operations, reducing unbilled water, and increasing coverage, among others. If all of the above can

be achieved in a sustainable manner through time, that would generate sounder financial conditions for the service providers, which would naturally lead to more resources, in particular for risk management in the service providers.

2.2 Institutional context for water supply and sanitation services in Peru

2.2.1 Overview A general description of the institutional context for the water supply and sanitation sector in Peru is presented below. (The information is based on the report “Regional plan for the region of Cajamarca”, prepared for the World Bank in 2010).

During the 1970s, the General Directorate of Sanitation Works (DGOS) ascribed under the Ministry of Housing was the agency in charge of the sanitation sector; its sole purpose was the construction of sanitation works at a national level. Then, in 1981, the National Water Supply and Sanitation Service (SENAPA) was created; it consisted of 15 Affiliates and 12 Operating Units.

When SENAPA was liquidated in 1990, the services were transferred to the provincial municipalities that had to constitute municipal public utility companies devoted to sanitation service provision (SP). However, in many cases, the municipalities themselves directly took over the service provision.

Through 1992 Law No. 25965, the National Superintendence of Sanitation Services (SUNASS) was created. It is an agency in charge of promoting development and laws and regulations for sanitation service provision and in charge of settling user claims. It is the first time in Peru that a regulation mechanism exists for the sector. Indeed, before there was no legal framework to regulate operating conditions, rights and obligations for the service providers and for the users, nor for regulating service fees.


26

The General Sanitation Service Law was signed in 1994 and was later regulated through Supreme Decree No. 09-95-PRES, thus establishing the institutional context for the sector and three main protagonists, as follows:

• ThenationallevelGoverningBody,whosefunctionswere initially performed by the Ministry of the Presidency and afterwards by the Ministry of Housing, Construction, and Sanitation through the Vice-Ministry of Construction and Sanitation. Its main functions are to formulate, approve, execute, and supervise national policy for service provision, as well as to formulate national development plans for the sector and allocate State resources.

• The Regulating Body comprised of the National Superintendence of Sanitation Services (SUNASS) that is currently ascribed under the Presidency of the Council of Ministers. Its main objective is to create laws and norms, to regulate, supervise, and control sanitation service provision in an impartial and objective manner to the best interest of the State, of the investors, and of the users. It is in charge of approving the water supply and sanitation service fees that the service providers in the urban areas charge (SEDAPAL in Lima and municipal companies (SP) in the Provinces), except for Tumbes that has a private sector service provider. It does not regulate or supervise other service providers (municipalities and community organizations). It is important to highlight that, in August 2006, the approval of Law No. 28870 granted the National Superintendence of Sanitation Services the power to set the SP service fees, a function that until then had corresponded to the General Shareholders Assembly or Partners of those

companies. Furthermore, the Unique Ordered Text (TUO) in the Regulation of the General Sanitation Services Law approved through Supreme Decree No. 023-2005-VIVIENDA of November 2005 set forth that the SP were obliged to formulate Optimized Master Plans (PMO) that would serve as a basis for setting the service fees.

• TheserviceprovidersinPeruare:a)ServiciodeAguaPotable and Alcantarillado de Lima (SEDAPAL) and Municipal Sanitation Service Providers (SP) that jointly cover 62% of the total population; (b) the Community Organizations that are responsible for 29% of the population, which mainly cover the rural areas, and (c) Small Municipalities (490) that attend to 9% of the total population. Pursuant to the law, the provincial municipalities are responsible for sanitation service provision; so, consequently, they have the power to grant the right of exploitation to the service providers. It is further set forth that, in the event that the municipalities directly provide this service, they must constitute a Management Unit for such services.

In addition to the above-mentioned entities, there are other participants in the water supply and sanitation sector who act and are involved according to their particular competence, mainly the Ministry of Health and the Ministry of Economics and Finance (the General Directorate of Multi-annual Scheduling, the National Directorate of Public Debt, and the National Directorate Of Public Budgeting), the Ministry for Women and Social Development (FONCODES), and the Ministry of the Environment.

Table 2-14 below summarizes the main sector functions, by institution.


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Also, Figures 2-10 and 2-11 (taken from Jorge Villacorta - Jornada Latinoamericana de Políticas e Inversiones de Agua and Alcantarillado) present a schema that summarizes the roles according to the different levels of government.

Table 2.14: WaTer SUpplY anD SaniTaTiOn SecTOr Main FUncTiOnS anD reSpOnSiBiliTieS

areas Urban zone rural zone

Policy definition Ministry of Housing, Construction, and Sanitation (MVCS)Vice-Ministry of Construction and Sanitation (VMCS)National Sanitation Directorate (DNS)MVCS-VMCS: DNS, OGPP – OPI HousingMEF: General Directorate of Multi-annual SchedulingDRVCS: Regional Directorates of Public Budgeting

Investment prioritization

Resource allocation VMCS: DNS – Urban Sanitation Directorate VMCS: DNS – Rural Sanitation Directorate

MEF: National Directorate of Public DebtNational Directorate of State Company Activity Financing (FONAFE)

Regulation National Superintendence of Sanitation Services (SUNASS)

Service fee and quota setting and approval

Service Provider Shareholders Boards Municipalities

Community Organizations

Norms and codes

Studies and work performance

MVCS – VMCS: DNSMINSA: National Directorate of Environmental Health (DIGESA)

Regional GovernmentsMunicipalitiesWater for Everyone ProgramINADEService Providers

Regional GovernmentsMVCS – PROSANARPROMUDEH – FONCODESMINSA – DIGESANGOsInternational Cooperation Agencies

Service provision Service Providers (Public, Private or Dual Economy) Municipalities

Community Organizations


28

FIgURe 2.10: rOleS, BY DiFFerenT leVelS OF GOVernMenT

Source: Jorge Villacorta - Jornada Latinoamericana de Políticas e Inversiones de Agua and Alcantarillado

Local Government

Regional Government

National Government

Provincial Municipalities

SP – Municipalities– JASS*

Region

Ministry of Housing, Construction, and Sanitation

SUNASS

Responsible for service provision

In charge of service provision. Investments.

Offers technical and �nancial assistance.

Governing body. De�nes policy, prioritizes investments and �nancing.

Regulating body. Regulates and supervises service provision.


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FIgURe 2.11: rOleS, BY DiFFerenT GOVernMenT MiniSTrieS

Source: Jorge Villacorta, Jornada Latinoamericana de políticas e inversiones de agua and alcantarillado

EnvironmentOffice

Supportspolicies for

sector environmental

issues

National Directorate

of Public Credit

Approves and channels

funds for investment

Municipalities That own sanitation

service provision companies outside of Lima

Central Government (FONAFE)

Owner of SEDAPAL stock

Ministry ofProduction

Ministry forWomen

Ministry of Health

Ministry of Agriculture

FONCODESCarries out social and economic

infrastructure projects

INRENAGrants

licenses for the use of surface,

underground, and waste

water

OTHER SERVICE PROVIDERS OUTSIDE OF LIMA SEDAPAL

Ministry of Economics

Presidency Counsel Ministers

CONAMGoverning body for

the national environmental

policy

SUNASSRegulates

and supervises

urban service providers’

service quality,

service fees, and

investments

ProgramAgua para

todos(Water foreveryone)Finances

and carries out urban area and rural area projects

National Sanitation DirectorateDetermines policy and promotes

development Regulates

water supply and sanitation

system design standards

and technical speci�cations

Ministry of Housing, Construction

and Sanitation

Directorate of the

Environment,Industry

Regulates the quality of industrial

discharges in drainage

systems

Executive Directorate

of Basic Sanitation (DIGESA))Regulates the quality

of the water supply and sanitation

National Directorate

of Public BudgetingApproves

SP budgets and

management


30

2.2.2 Ministry of economics and Finance (MeF)The Vice-Ministry of Treasury ascribed under the Ministry of Economics and Finance ate (MEF) is responsible for the General Directorate of Indebtedness and Public Treasury that works in compliance with the General Law of Internal and External Public Indebtedness. That directorate is in charge of signing for contingent loans.

The agency also manages the external debt in all sectors of the Peruvian economy as well as public investment and sustainable debt.

The same Vice-Ministry is in charge of the General Directorate of Public Budgeting (DGPP) that is among the agencies that has the most interaction with the different water supply and annotation service providers including SEDAPAL S.A2. The directorate is in charge of approving the operating budgets of each one of the SP, a labor that it performs on an annual basis and it is further in charge of generating the possibility of assessing credit lines for insurance policy payments.

The Directorate of Territorial Budgeting Articulation is the agency in the DGPP that studies the possibility of the Municipal Governments participating in financing the public expenses related to mitigation works that lead to increasing the feasibility of the different SP acquiring insurance policies. It also studies different mechanisms for motivating the intervention of the pipe line network systems and somehow taking risk mitigation measures. To do so would require a series of conditions imposed by the MEF on the municipalities thus complying with water supply and sanitation sector risk management schemes. Currently, there are mechanisms established by the Directorate for Local and Regional Investment for encouraging studies and projects to reduce risk in sectors that are key to the population, and there are programs underway such as Vulnerability reduction and Emergency Disaster Attention along the same lines.

Furthermore, the National Environmental Action Plan and the Bicentennial Plan include natural disaster risk reduction as one of the activities to be carried out in their strategic lines of action. Using all of the above, it will be necessary to shape specific risk mitigation and vulnerability reduction projects in water supply and sanitation service provision companies.

The General Directorate of Multi-annual Scheduling of the Public Sector is in charge of orienting and integrating public investment plans, which represents an MEF technical filter. Therefore, any risk prevention and mitigation program must pass through this agency and some rules can be set here for accepting retrofitting programs as well as credit line generation for the intervention of the most vulnerable system elements. The retrofitting strategy must be coordinated with the importance of the quality of the information, to enable knowing with a high degree of reliability what the systems comprise and thus be able to establish which components should be worked on3.

2.2.3 Ministry of housing, construction, and Sanitation (MVcS)The National Sanitation Directorate (DNS) is the governing body for the sector; it is ascribed under the Vice-Ministry of Construction and Sanitation of the Ministry of Housing, Construction, and Sanitation. The Directorate is responsible for including risk management in the sector and is bound to do so, either based on international experiences or on specific studies to enable defining how it should be handled and, even more importantly, how such policy would be implemented in the sector.

DNS boasts three directorates that are related to the technical laws and regulations for the systems (here considerable changes can be achieved for mitigating risk and guaranteeing minimum safety conditions when new systems are designed), plans and programs, and technical assistance. Moreover,

2 SEDAPAL S.A. is a company adscribed to the State Business Activity Financing Fund (FONAFE). In that sense, SEDAPAL is a particular case because it depends directly on the central government, not on any municipal government. Currently, the Metropolitan Municipality of Lima has requested to be in charge of the administration and management of SEDAPAL.

3 In that sense, MEF has published a document named “Guidelines for the identification, formulation, and social assessment of public investment projects at a profile level”.


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MVCS oversees the Territorial Management Program ascribed under its Vice-Ministry of Housing and Urbanism; one of the action lines of that program is disaster risk reduction in urban areas.

Currently, the National Sanitation Plan is being updated; it will be in effect until the year 2021; disaster risk management must be incorporated into the plan guidelines and it is desirable to include aspects related to risk retention and risk transfer. That should also occur in the regional plans and in the Optimized Master Plans as it would enable giving financial visibility to risk-management related activities.

2.2.4 presidency of the council of Ministers (pcM)The Presidency of the Council of Ministers is the governing body of the National Risk Management System (SINAGERD) and of the National Disaster Prevention Center (CENEPRED).

This agency promoted Law 29664 through which the National Disaster Risk Management System was created and disaster risk management was defined as “a social process whose ultimate end is to prevent, reduce, and permanently control disaster risk factors in the society, as well as to properly prepare for and respond to disaster situations, taking into consideration national policies with a special emphasis on those related to economic, environmental, safety, security, national defense, and territorial issues in a sustainable manner.”

Currently the regulation of that law is being prepared; it will allow more precisely determining PCM functions in SINAGERD.

2.2.5 national Superintendence of Sanitation Services (SUnaSS)The National Superintendence of Sanitation Services is a public decentralized agency ascribed under the Presidency of the Council of Ministers, whose function is to regulate water supply and sanitation service provider operations in Peru. Among others, its functions are to set service fees, supervise,

oversee, and audit the different SP that provide their services in the Peruvian territory.

Given its nature of regulator, it has an Optimized Master Plan for the SP, to be updated once every five years; that makes it difficult for them to update service fees or to finance risk mitigation measures using their own funds. When acquiring insurance policies to properly cover the various exposed elements, it is possible that the current costs of the different SP increase. Therefore, that procedure must be taken into account when determining whether the service fees should be modified or not to cover such eventuality.

The goal of risk management must be incorporated into the Optimized Master Plan to enable controlling the degree of progress and periodical follow-up could be done directly by SUNASS.

Depending on the studies conducted, if the Superintendence determines that the impact of the service fees is high, a mechanism must be sought with the municipalities to enable external financing other than through the service fees or the budget approved by MEF must include a supplemental portion to allow additions solely aimed at risk reduction actions and interventions. Ideally that should be integrated into an ample risk reduction program that would enable, for example, negotiating the insurance premiums acquired according to the expected decrease in risk.

After additional resources are allocated for system intervention, as the regulating body for the sector, it is desirable for SUNASS, to carry out supervision activities to be able to guarantee that the works are being performed and also that the resources delivered are being entirely used for the purpose for which they were allocated.

Regarding contingency plans, the agency has a regulation related to service provision quality; Annex 5 of that regulation states that it is possible to make some modifications to establish some guidelines relating to how contingency plans must be carried out.


32

2.2.6 Banking and insurance Superintendence (SBS)This agency regulated the insurance market; its role in the water supply and sanitation sector financial protection strategy process implies a careful review of the possibilities of including all of the above-mentioned strategies in the insurance policies, as of the study stage, the quantity of required reserves, and the modifications that would be required for new proposed schemes to operate.

Currently, SBS demands that insurance companies that cover catastrophic events such as earthquakes, tsunamis or inundations keep a monetary reserve to guarantee compliance with their obligations in the event of a claim, without that implying placing the viability of the business at risk. Some of the insurance companies are issuing policies to water supply and sanitation service providers and they are integrating them into their catastrophic risk accounts receivable, so it is not clear how risk is being assessed.

2.2.7 association of MunicipalitiesIn most cases the municipalities are the owners of the SP; therefore, they are involved in the decision making regarding the comprehensive risk management plan for the sector. Nonetheless, all of the SP together guarantee water supply service to less than half of the Peruvian population. The rest of the population is attended by direct municipal management or by Water Supply and Sanitation Service Administration Boards. Future proposals must adapt to the reality of the Peruvian water supply and sanitation sector.

2.3 legal FrameworkThe general policies for the sanitation sector are traced by the Vice-Ministry of construction and sanitation that, among its functions, “promotes the vulnerability analysis and risk mitigation programs after natural disasters that can affect the sanitation infrastructure”.

The relevant laws and regulations that regulate the water supply and sanitation sector in Peru are listed below.

• GeneralSanitationServicesLaw,LawNo.26338

• RegulationoftheGeneralSanitationServicesLawwithits amendments, Supreme Decree No. 09-95-PRES

• SoleOrderedText(TUOisthePeruvianacronym)of the Regulations of the General Sanitation Services Law

• TheOrganizationandFunctionsRegulation(ROFisthe Peruvian acronym) of the Ministry of Housing, Construction, and Sanitation, Supreme Decree No. 002-2002-VIVIENDA

• OrganicLawforMunicipalities,LawNo.27972• FrameworkLawfortheRegulatingBodiesofPrivate

Investment in Public Utilities • Law forOptimizing Sanitation Service Provider

Management, Law No. 28870• RegulationofLawNo.28870Article2forOptimizing

Sanitation Service Provider Management, Supreme Decree No. 043-2006-VIVIENDA

• Amendment to the Regulation of the GeneralSanitation Services Law, Supreme Decree No. 010-2007-VIVIENDA.

2006 Law 007 “National Sanitation Plan 2006-2015” sets forth that risk prevention, vulnerability reduction, and attention optimization programs must be promoted in cases of emergency in the sector environment. The actions to be carried out are classified according to the environment in which the sanitation systems are located, that is to say, urban or rural environment. For the purpose of this study, what occurs in the urban environment is important because the topic of disaster prevention and attention is essential to of the water supply and sanitation system sustainability. Disaster risk management must promote measures to prevent the disaster risks and to mitigate vulnerability, by allocating the necessary economic resources to achieve that end.

Through 2005 Resolution No. 1305, the Banking and Insurance Superintendence (SBS) decreed the regulation for constituting a reserve for catastrophic risk and loss uncertainty. The regulation is applicable to all insurance and reinsurance companies established in Peru. It is well known that it is important for insurance companies to


www.wsp.org 33

know the probable maximum loss (PML) of the various sectors. Using that information, the different insurance and reinsurance companies can calculate their catastrophic risk reserve, up to 100% of which they can apply to cover a catastrophic event.

A Technical Note accompanies the resolution; it sets forth the PML calculation mechanism. The calculation methodology corresponds to the one used for processing and calculating the risk for the representative SP selected in this study (see Volume 1 of this report for risk calculation in the sector SP) or the detailed calculation methodology in Chapter 2.

2.4 Insurance sector in Peru

2.4.1 General DescriptionPeru has 14 insurance companies, five of which are devoted to life insurance, five to general insurance, and the remaining

four to a mix of both. The information presented below was taken from the Peruvian Association of Insurance Companies (APESEG) information system.

2.4.1.1 Production At September 2010, net insurance premiums rose to S/. 4.616 billion, which in nominal terms represented an increase of 18.8% as compared to the same period the year before.

During the analyzed period, it was seen that all of the types of insurance had an upward trend. For example, General Insurance rose 2%, Accidents and Critical Illnesses rose 7%, Life Insurance 13% and Retirement Pension Insurance rose 72%.

Net insurance premiums at September 2010 and September 2009 are shown below (in Peruvian Nuevo Sol thousand).

Table 2.15: neT inSUrance preMiUMS - 2010 aS cOMpareD TO 2009

Type periods Variation Structure

September 2010

September 2009

S/. % September 2010

September 2009

General Risks Insurance 1,783,624 1,740,432 43,192 2.48% 39% 45%

Accidents and Critical Illnesses 656,447 614,666 41,781 6.80% 14% 16%

2,440,071 2,355,098 84,973 3.61% 53% 61%

Life Insurance 865,657 769,343 96,314 12.52% 19% 20%

Retirement Pension Insurance 1,310,487 760,639 549,848 72.29% 28% 20%

2,176,144 1,529,982 646,162 42.23% 47% 39%

4,616,215 3,885,080 731,135 18.82% 100% 100%


34

For General Insurance is important to highlight the increase in Auto Insurance (S/.52.1 million, 10%), Fire and Related Damage Insurance (S/.20.3 million, 4%), Transportation Insurance (S/.9.7 million, 10%), Technical Area Insurance (S/. 8.6 million, 4%), 3D Insurance (Disappearance, Destruction, and Dishonesty) and 3B Insurance (Bankers, Blanket, Bond) (S/.8.3 million, 15%). The types of insurance that showed a drop were Maritime-Hull (S/.- 11.9 million, 16%), and Miscellaneous Insurance (S/.- 30.5 million, 17%).

Catastrophe Insurance is normally associated with Fire and Related Damage Insurance; so, in general the analysis of Catastrophe Insurance cannot be isolated from others such as Fire Insurance.

An aspect to highlight is that, considering total insurance industry production, Auto Insurance holds first place for relative importance with 13%, moving Fire and Related Damage Insurance to second place with a relative share of 10%.

Table 2.16: inSUrance claiMS - SepTeMBer 2010 aS cOMpareD TO 2009

Types of insurance periods Variation Structure

September 2010

September 2009

S/. % September 2010

September 2009

General Risks Insurance 567,141 691,088 -123,947 -17.94% 31% 37%

Accidents and Critical Illnesses Insurance

332,737 340,976 -8,239 -2.42% 18% 18%

899,878 1,032,064 -132,186 -12.81% 49% 56%

Life Insurance 249,183 239,261 9,922 4.15% 14% 13%

Retirement Pension Insurance 682,171 573,002 109,169 19.05% 37% 31%

931,354 812,263 119,091 14.66% 51% 44%

1,831,232 1,844,327 -13,095 -0.71% 100% 100%

The increases seen in 2010 can be attributed to the following:

• RecoveryofthePeruvianeconomydynamics• Increasedmortgageloansandautoloans• InitiationoftheeffectivetermoftheEarlyRetirement

Policy (REJA) (Law No. 29426) – the a temporary policy effective until December 31, 2012

• Growthintheinsurancesupplyintheprovinces.

2.4.1.2 insurance Losses At September 2010, net insurance premium claims rose to S/. 1,831 million (S/. 1,844 million at September 2009), which in nominal terms represented a decrease of 0.7% as compared to the same period the year before.

Insurance claims at September 2010 and 2009 are shown in Table 2-16 (in Peruvian Nuevo Sol thousand).


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2.4.1.3 direct insurance losses Direct insurance losses saw a decrease in all of the types of insurance dropping from 47% at September 2009 to 40% at September 2010.

Table 2.17: inSUrance lOSS VariaTiOn

Types of insurance periods

September 2010

September 2009

General Risks Insurance 32% 40%

Accidents and Critical Illnesses 51% 55%

37% 44%

Life Insurance 29% 31%

Retirement Pension Insurance 52% 75%

43% 53%

40% 47%

2.4.1.4 technical resultsFor the net technical result, a significant improvement was seen from S/. 299.7 million at September 2009 to S/. 361.7

Table 2.18: neT Technical reSUlTS, BY TYpe OF inSUrance

neT Technical reSUlTS FOr September 2010

September 2009

Variation %

General risks insurance companies 286 944 217 334 69 610 32.0%

Life insurance companies (78 643) (34 469) 44 174) 128.2%

Mixed insurance companies 153 477 116 895 36 582 31.3%

TOTal 361 778 299 760 62 018 20.7%

million at September 2010, representing an improvement of S/. 62.0 million (21%).

Net commissions represented 9% of net insurance premiums, in both analyzed periods, showing an increase of S/ 43.0 million (12% as compared to the same period the year before). Diverse technical expenses represented 8% of net insurance premiums, in both periods analyzed and present an increase of S/. 67.3 million (22% as compared to the same period the year before).

In general, technical results are positive as a consequence of the insurance companies’ change in focus to the basic foundations of insurance business considering a good balance among price, subscription, and profitability. Also, operations were more efficiently managed and the quality of the services provided to the insured improved.

2.4.1.5 administration expensesTotal administration expenses net of revenues from services rose to S/ 616.8 million at September 2010 (S/. 519.2 million at September 2009), meaning an increase of S/.97.5 million (19%).


36

Administration expenses, without considering revenues from services, represented 14% of net insurance premiums, in both periods analyzed.

2.4.1.6 investment resultsInvestment results rose to S/ 874.4 million at September 2010 (S/. 620.9 million at September 2009), meaning an increase of S/. 253.5 million (41%).

2.4.1.7 net profit In the analyzed period, the sector obtained a net profit of S/. 528.4 million (S/.327.2 million at September 2009), meaning a growth of S/. 201.2 million (62%) as compared to the same period the year before. That result is net of the workers’ share of holdings and of income tax that jointly rose to S/. 91.0 million (S/. 68.7 million in 2009), representing an increase of S/. 22.2 million (32%).

2.4.2 General opinion on the insurance sector In general terms, the Peruvian insurance sector can be considered a sound sector with good growth indicators, with administration expenses that represent around 14% of the value of issued premiums, with positive technical results as a consequence of the insurance companies’ change of approach to basic business foundations considering a balance among price, subscription, and profitability, with more efficient operations management and improved quality in the services provided to the insured, and with direct losses of around 40%. That favorable overall situation can be attributed to the following main factors:

• RecoveryofthePeruvianeconomydynamics• Increasedmortgageloansandautoloans

• InitiationoftheeffectivetermoftheEarlyRetirementPolicy (REJA) (Law No. 29426), a temporary policy effective until December 31, 2012

• Insurance companies’ designing new products forspecific coverage with easy access and at a low cost, among which mass insurance and micro-insurance merit highlighting. It is important to underpin the momentum of the insurance supply through distribution channels complementary to financial system institutions, such as department stores and public utility companies

• Growthintheinsurancesupplyintheprovinces.

Considering this favorable panorama for insurance sector companies, it is easy to presume an interest on their part to protect the infrastructure, further considering the eventual implications that disasters can have on water supply and sanitation service provider operations. It is clear that the eventual interest, partly confirmed by some consulted companies, must be strengthened by the SP adopting risk management programs that include plans for careful maintenance, physical vulnerability intervention plans, and contingency and emergency attention plans. Without a doubt, that would give rise to the possibility of negotiating more attractive catastrophe insurance premiums.

To complement the interest of the insurance companies per se, it is essential to generate interest and trust among the reinsurance companies. That can partly be achieved if the SP have appropriate knowledge of the risk and if they adopt risk management plans. At any rate, it is possible that the SP may not agree to pay premiums that would be high in certain cases under current conditions or that the insurance and reinsurance companies consider that they are not interested in granting protection to determined service providers with very unfavorable risk situations.

Peru: Disaster Risk Management in Water and Sanitation Utilities. Volume II Catastrophic risk in the water supply and sanitation sector in Peru

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3.1 OverviewPeru is located in a high seismic risk area due to its proximity to the Nazca Plate’s subduction area on the South American Plate and it is subject to intense hydro-meteorological events mainly associated with the Niño and the Niña phenomena that are recurrent in the region. This particular situation generates the possibility of catastrophic events occurring in most of the areas of great population concentration in the country, such as Lima, Tacna, Arequipa, and Ica, among others. The most probable events are intense seismic movement, tsunamis, floods and avalanches, landslides caused by intense rainfall and earthquakes and events related to volcanic activity.

On August 15, 2007 at 23.40.57 UTC (18:40:57 local time) a seismic event that lasted nearly 175 seconds (2 min 55 s) was recorded; its epicenter was on the coast at the level of central Peru, 40 km west of Chincha Alta, 150 km southwest of Lima and it was ground zero 39 km deep. It was one of the most violent earthquakes in Peru in recent years. The earthquake recorded a magnitude of 7.9 on the Seismic Moment Magnitude Scale and VI-IX on the Mercalli Scale; it left 513 dead, near 2,291 wounded, 76,000 homes completely destroyed and uninhabitable, and 431,000 persons affected. The areas that suffered most damage were the provinces of Pisco, Ica, Chincha, Cañete, Yauyos, Huaytará, and Castrovirreyna. The earthquake’s destructive magnitude also severely damaged the infrastructure that provides public utilities and basic services to the population, such as water supply and sanitation, education, health, and communications, which have not yet been rebuilt. The estimated economic losses due to the event were around USD 2,230,000,000.

In 1998 the town of Ica suffered flooding that had a high impact on the sector infrastructure, including severe damage

Catastrophic risk in the water supply and sanitation sector in Peru

III.

to drinking water pumping wells, water supply and sanitation pipe lines, tanks, and treatment plants.

The impact of this event and other similar events in Peru is not only physical losses and the need to replace or repair the damaged components of said infrastructure but also indirectly derived economic and social losses, meaning not being able to provide the services (which generates business interruption and a negative impact on the financial situation of the water supply and sanitation service providers (SP)).

Similar events may occur in the subduction area near Lima with devastating consequences not only to the drinking water and sanitation system but also to all of the infrastructure and population of that area. These types of events and their possible physical, economic, and social impact would have a high impact on State finances and on Peru’s social and economic development and they would probably change the direction and the pace of the country’s development for many years to come.

Therefore, It is clearly necessary to have a risk management strategy for the sector in place that will enable, among other things, better preparation for possible future events, reduced possible physical impacts on the system, a financial protection strategy, and contingency and emergency recovery plans that will allow re-establishing the service as soon as possible to minimize direct impacts on the population. More specifically, the sector must have a financial protection strategy to cover natural disaster risks that may affect the infrastructure, using risk retention and transfer instruments, thereby ensuring the sector’s financial sustainability.

To develop a risk policy and management strategy for the sector, it is essential to have information regarding possible events that may occur and the type of impact that can


38

be expected. Without such information it is impossible to develop the mechanisms that will enable avoiding and reducing damages or to gain access to economic resources that will permit a speedy recovery of the infrastructure and of the service.

This chapter presents a summary of the currently used methodologies for assessing water supply and sanitation system hazards, exposure, vulnerability, and risk, in order to have the necessary information for planning risk management strategies. Simultaneously, the resulting information will generate the elements for a sector risk management policy and, in particular, it will direct such strategies towards proper financial protection.

3.2 Risk assessment methodology Risk assessment mainly aims to determine physical impacts, economic losses, social impact, and direct and indirect environmental effects that a system, such as the water supply and sanitation system, may suffer during certain periods of time, as a consequence of the occurrence of natural disasters. In the particular case of the water supply and sanitation sector, risk assessment aims to estimate the direct physical impact on the main components of the infrastructure and the economic losses directly associated with the occurrence of events with the capability of destruction.

The main objective of the assessment is to determine maximum physical impacts and economic losses caused by catastrophic events. As the frequency of catastrophes is particularly low and there is probably no record of past catastrophes, especially no records that would reflect the

current degree of infrastructure development and exposure, it is necessary to resort to probabilistic risk modeling, which will enable estimating such future loss scenarios with a certain degree of confidence.

So, in summary, the probabilistic calculation procedure consists of assessing losses for the group of exposed assets during each one of the scenarios that collectively describe the hazard, and then do a probabilistic integration of the results obtained, using the frequencies of occurrence for each one of the seismic scenarios as weighting factors.

Probabilistic risk analysis entails uncertainties that must be taken into account and must be propagated along the calculation process. The next section describes the general calculation basis for achieving the above-mentioned objective.

3.3 Probabilistic risk analysis procedure The risk calculation procedure is presented in detail in Annex 1. This section presents the general basis for this type of analysis and illustrates some of the most important results.

3.3.1 necessary basic informationWater supply and sanitation sector risk analyses require information with a certain level of detail, to achieve reliable risk assessment results. Table 3-1 summarizes the type of information usually required for assessing the hazard, exposure, vulnerability, and risk. Annex 1 contains some tables with the specific information usually required from each one of the Service Providers (SP), in order to carry out the risk studies mentioned above.


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Table 3.1: BaSic Sp inFOrMaTiOn reqUireD FOr riSK analYSiS cOnTinUe

Pumping stations

Administrative buildings

Vulnerability information

Particular characteristics of each component:

Geometrical

Physical

Mechanical

Present condition

3.3.2 hazard assessment Characterizing hazards due to natural events is one of the key activities in conducting the risk assessment. In a probabilistic model, each one of the hazards associated with the natural events that may affect the area of interest must be characterized using parameters that will enable establishing a relation with the potential damage that the exposed elements may suffer. The hazard is characterized using a broad gamut of scenarios also known as stochastic events, each one with a mean frequency of occurrence (or associated probability of occurrence). Each scenario has an associated geographical distribution of the parameter of interest in the area under study.

Figure 3-1 illustrates a seismic hazard map of Peru, in terms of peak ground acceleration in Gal for a return period of 500 years.

Table 3.1: BaSic Sp inFOrMaTiOn reqUireD FOr riSK analYSiS

company information

Technical

Operating

Financial

hazard information

Seismic hazard:

Seismic hazard model for the entire country

Seismic microzonation of the town or area of influence

Flood hazard:

High resolution digital elevation model of the basin under analysis

Rainfall records in different seasons for minimum 30 years

Flow measurements

Soil characteristics in the basin

Landslide hazard:

Digital elevation model or high resolution topographic information

Geological information

Geotechnical information

exposure information

Tanks

Pipe lines

Treatment plants

Wells


40

FIgURe 3.1: SeiSMic hazarD in perU peaK GrOUnD acceleraTiOn in Gal, rp = 500 YearS

0

-2

-4

-6

-8

-10

-12

-14

-16

-18

AGUAS DE TUMBES

EPS GRAU S.A.EPSSMU S.R.LTDA

EMAPA HUARAL S.A.

EPS MARAÑÓNEMAPAB S.R.LTDA.

EPS SEDALORETO S.A.

EMAPA MOYOBAMBA S.R.LTDA.

EMAPA SAN MARTÍN S.A.

EMAPACOP S.A.

SEDACAJ S.A.

EPSEL S.A.

SEDALIB S.A.

EPS CHAVÍN S.A.SEDA HUÁNUCO S.A.

SEDACHIMBOTE S.A.

EMAPA PASCO S.A.

EPS SELVA CENTRAL S.A.

EPS SIERRA CENTRAL S.A.

SEMAPA BARRANCA S.A.

EPS TACNA S.A.

EPS ILO S.R.LTDA.

EPS MOQUEGUA S.R.LTDA.

SEDAPAR S.A.EMSA PUNO S.A.

SEDAJULIACA S.A.

NOR PUNO S.A.

EMAPAVIGSSA

EPSASAEMSAP CHANKA

EPS AGUAS DEL ALTIPLANOEMPSSAPAL S.A.

EPS - SEDACUSCO S.A.EMUSAP ABANCAY

EPS CALCA

EMAPAT S.R.LTDA.

EMAPA HUANCAVELÍCA S.A.C.EMAQ S.R.LTDA.

SEDAM HUANCAYO S.A.C.SEDAPAL S.A.EPS MANTARO S.A.EMSAPA YAULI

EMAPA CAÑETE S.A.

EMAPICA S.A.EMAPISCO S.A.SEMAPACH S.A.

EMAPA Y

EMUSAP AMAZONASSEDAPAR S.R.L. (Rioja)

-82 -80 -78 -76 -74 -72 -70 -68

750

720

690

660

630

600

570

540

510

480

450

420

390

360

330

300

270

240

210

180

150

120

90

60

30

0

EMAPA HUACHO S.A.


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3.3.3 exposure assessment To assess the risk and the direct socio-economic impact of a specific hazard in a determined area, besides the risk characterization presented above, a probabilistic risk model requires the following information: (i) a clear identification of the exposed elements in the area under study (e.g. the infrastructure, administrative buildings, etc.), (ii) a proper physical characterization of each element to enable determining its physical vulnerability to each hazard, and (iii) a functional characterization of the component and its socio-economic interaction with the system to which it belongs, in order to assess its social, environmental, and economic vulnerability.

The inventory of the exposed elements must be defined; it must specify the geographical location of the exposed asset plus the following parameters that qualify the element:

• Physicalvalueorreplacementcostoftheasset• Humanvalueorestimatednumberofoccupants• Structuraltypetowhichtheassetbelongs

Figure 3-2 shows a map of the pipe line system in a sector of the city of Lima, to illustrate the level of detail required for this type of information. In particular for the exposure database, the following information must be available: the stated geographical information, the identification of each stretch of pipe line, the type of material, the diameter, the economic value of a replacement, and complementary data on the condition, the construction date, and connection details, among others.


42

FIgURe 3.2: DeTail OF The pipe line neTWOrK in a SecTOr OF The ciTY OF liMa

N


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3.3.4 component vulnerability In terms of risk modeling, physical vulnerability may be understood as the susceptibility of an element to suffer damage caused by a specific hazard. It is measured in terms of its fragility, meaning the level of damage associated with the different levels of intensity of the corresponding hazard. Vulnerability can also be expressed in terms of expected physical losses, human losses, or environmental losses, or in terms of average annual direct or indirect economic losses. Along with the average annual loss values for the different levels of intensity of the hazard, for the purpose of taking into account the uncertainty associated with the description of vulnerability, a variation coefficient or standard deviation must be assigned to each vulnerability function, which usually varies with the intensity and is generally lower for the intensities at the two extremes (the lowest and the highest intensities).

Each structural type must have its own vulnerability function for each type of hazard. This function characterizes the behavior of the building during the occurrence of phenomena that represent a hazard. Vulnerability functions define the distribution of the probability of loss in function of the intensity produced during a specific scenario. They are defined using curves that show the expected value of the damage and the standard deviation of the damage with the intensity of the phenomenon.

Figure 3-3 illustrates some of the vulnerability functions commonly assigned to the main components of the system infrastructure (see CAPRA reference).

FIgURe 3.3: illUSTraTiVe VUlneraBiliTY FUncTiOnS

0%10%20%30%40%50%60%70%80%90%

100%

0 10 20 30 40 50 60 70 80

Dam

age

%

Displacement (cm)

Wells

Pip

e linesO

ther com

po

nents

Wells

0%2%4%6%8%

10%12%14%16%18%20%

0 50 100 150 200 250 300

Dam

age

%

Velocity (cm/s)

Rigid SteelRigid Asbestos-CementRigid Reinforced ConcreteRigid Plain concrete

Rigid IronMasonry Brick PVC

0%10%20%30%40%50%60%70%80%90%

100%

0 500 1000 1500 2000

Dam

age

%

Acceleration (cm/s2)

CanalStationsSmall surfaceBig surface

Old elevated tankUnderground tankMetal storage tanksAdministrative


44

3.3.5 risk assessment Risk is tied to the probability of adverse effects and negative consequences being caused in material, social, and environmental milieus. Therefore, risk assessment consists of estimating the probable impact of a certain hazard on the exposed elements (e.g. administrative buildings, infrastructure, population, the environment). The analysis may be made by means of a deterministic analysis, in which the probable impact is estimated based on one single event or scenario, or in a stochastic manner, integrating the analysis of multiple scenarios, each one with a different frequency of occurrence, to obtain generic risk estimation. On one hand, scenario analysis (e.g. an earthquake with a defined magnitude that originated in a tectonic fault near the area of interest) may be useful for being prepared for emergencies and an “ex-ante” damage assessment. On the other hand, a probabilistic risk analysis provides information for a complete set of stochastic events that defines a particular hazard and integrates all possible scenarios through a rigorous analytic process. Therefore, the risk may be expressed in terms of potential and average annual losses (human losses as well as economic losses), and compared to different conditions of hazard, exposed elements, and vulnerability, thereby providing valuable information for assessing, for example, the impact of the event and the options for reducing structural vulnerability. In addition, the risk may be expressed in terms of maximum

probable economic losses, which is essential information for establishing, for example, corresponding financial protection mechanisms.

Considering the basic objective of the probabilistic risk analysis explained above, it is necessary to suggest a specific methodology for calculating the frequencies of occurrence of the specific levels of loss associated with the exposed assets during certain periods of time, after the occurrence of a natural hazard.

Risk due to natural hazards is commonly described using the loss exceedance curve that specifies the frequency (usually annual) with which events that exceed a specific loss value will occur. So, the curve gives the ratio of economic losses to the exceedance rate of such losses.

Figure 3-4 presents a typical exceedance curve for an SP in the system. The curve presents the economic losses for the complete set of exposed assets with different exceedance rates. The economic loss value, p, is a random variable associated with a certain level of uncertainty. The loss exceedance curve may also be represented in terms of the return period of the events, which corresponds to the inverted exceedance rate. In this case, the curve is known as the curve for maximum probable loss considering the return period curve (see the graph on the right side in Figure 3-4.)

FIgURe 3.4: lOSS eXceeDance cUrVe in TerMS OF eXceeDance raTe (leFT) anD reTUrn periOD (riGhT)

TR 100 PML (3.9%)

TR 250 PML (5.1%)TR 500 PML (6%)

TR 1000 PML (6.9%)

1

0.1

0.01

0.001

0.0001

0.00001

Exc

eed

ence

rat

e [1

/ ye

ar]

0 100 200 300

Loss in USD MIllion0 500 1500 25001000

Return period in years

300.0

250.0

200.0

150.0

100.0

50.0

0.0

Loss

in U

SD

Mill

ion

TR 250 PML (5.1%)

TR 500 PML (6%)

TR 100 PML (3.9%)

TR 1000 PML (6.9%)

2000


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Other risk values usually calculated are the average annual loss that corresponds to the payment of all possible future losses by means of a constant annual quota. The average annual loss value may be represented for the entire portfolio of exposed elements, for each group of components or even for each individual component. Average annual loss is usually presented as the absolute economic loss value or as a relative value in respect to the exposed value of the corresponding component.

Table 3-2 shows the average annual loss value, to illustrate the analysis of the case mentioned above.

For more information on the modeling procedures, on the software, and on interpreting the risk analyses results, please visit www.ecapra.org.

3.4 general risk analysis for the sector

3.4.1 analyses made and assumptions For a preliminary risk assessment for the different Service Providers (SP) in the system, two types of analyses were made: a detailed analysis of two representative SP and an approximated general analysis to estimate the level of risk for the 52 sector service providers. Those results enabled a general assessment of the overall catastrophic risk for the sector with a high level of approximation.

A detailed risk analysis was made for each of the SP, SEDAPAL and EMAPICA, and the results of this analysis are presented in detail in an annexed report (see Volume I).

The approximated preliminary analysis of the 50 SP was made, taking into account the following assumptions and considerations:

• Theassumptionisthatthesectorcatastrophicriskiscontrolled by seismic events. This may not be true for many of the SP where the most common catastrophic risk is flooding or landslides. Nevertheless, for the sector at large, seismic events are definitely the most common catastrophic events.

• Theassumptionisthatthereisgeographicalindependencein the SP risk assessments, meaning that the assumption is that one earthquake does not simultaneously affect more than one SP. This assumption is not valid for SP that are in close proximity one to another.

• Theassumptionisthattheexposedvalue,thetypesofcomponents, and the vulnerability of each SP are based on the related information of the two SP for which the detailed analyses were made (see Volume I).

• Theassumptionisthatthecomponentportfolioforthe large SP has exposure and vulnerability similar to those of SEDAPAL whereas the component portfolio for the medium and small SP has exposure and vulnerability similar to those of EMAPICA.

Table 3.2: aVeraGe annUal lOSS

results

exposed value USD$ x106 2,845.21

average annual USD$ x106 18.353

‰ 6.450

Risk analysis results may also be presented using losses associated with specific scenarios such as, for example, a particular seismic event that is part of the stochastic events in the seismic hazard analysis. In that case, the average annual losses by component or for the complete set of components may be represented as an absolute economic loss value or as a relative value in respect to the corresponding exposed value. In the latter case, the parameter is an indicator for the level of physical damage that the component suffers in that particular scenario.

For the purpose of analyzing risk in the water supply and sanitation system, the risk analyses are made using the following computational tools developed by the consultant ERN-AL Consortium.

• CRISIS2007• ERN-Inundación(ERN-Flooding)• ERN-Deslizamiento(ERN-Landslide)• ERN-Vulnerabilidad(ERN-Vulnerability)• ERN-CAPRA-GIS


46

• The economic exposure valuation is based on thetotal number of serviced users in each SP and the corresponding unit values in the two analyzed SP. There is a great difference in the economic exposure valuation of large SP and of small SP whereas for the medium SP an intermediate value was used.

• Theanalysistakesintoaccountthespecificlocationof each SP from the perspective of a seismic hazard in a spot that represents a general, standard level of hazard for each SP.

• This analysis solely indicates the overall sector riskassessments and must not be used for any purpose other than the one established herein.

The analysis results are presented in Annex 2 of this volume, with a quantification of average annual losses and maximum probable losses for a 1,000-year return period. The results are compared against different management indicators classified by SP size; based on said indicators a general diagnosis of the sector risk profile has been made. Said diagnosis is presented below.

3.4.2 General diagnosis of the sector risk profile

3.4.2.1 disaster risk for the sector SP Each individual SP, as well as the sector as a whole, presents high risk assessments (for the sector, a maximum probable loss of USD 400,000,000 for one event with a 1,000 year return period). That is the result of the following mix: Peru’s high seismic hazard levels, high exposure levels (jointly the SP have a total approximate Exposed value of USD 6,000,000,000), and the vulnerability of its critical components.

The systems present a series of highly vulnerable components that will probably be the most affected after an occurrence of a future event. The seismic scenarios indicate important damages concentrated in components such as tanks, wells

or certain types of old pipe lines such as those made of plain concrete or asbestos cement.

Floods may also generate important sector losses with additional damage to critical components, such as sewer pipe lines due to pressurization and silting problems or partial or total damages to wells because they will become flooded and contaminated.

3.4.2.2 Financial capacity of the sector SP Given a few exceptions (SEDAPAL and probably a few other large SP), the financial capacity of the SP is quite low and, in most cases, the SP would not even be able to cover a percentage of the eventual losses that they may suffer due to significant seismic events or due to the occurrence of any other highly destructive event. Moreover, many SP would have problems financing the costs of eventual emergency relief and of reestablishing the service after the occurrence of a severe event. EMAPICA’s calculated probable loss values for events with a 1,000 year return period represent twice its annual operating income, whereas using the same indicator, SEDAPAL’s loss represents a little less than half of its annual operating income; that figure is still high from any point of view.

Given the characteristics inherent in the high-magnitude seismic events that may occur mainly on the Pacific coast of Peru, it is probable that, as happened during the earthquake in Pisco in 2007, several of the water supply and sanitation service systems will be affected if another similar event occurs. In such a case, it is likely that the State will have to bear the responsibility of the financial recovery and of financing the repair works.

After reviewing the different management indicators presented above, it can be affirmed that, even under normal circumstances, many of the SP have operational and financial problems. That situation may be seriously aggravated by the occurrence of a catastrophic event. That was the very case in the Pisco, Ica, and Cañete area after the 2007 earthquake and still to this day serious operational problems exist there.


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3.4.2.3 resources required for risk management Implementing sector risk management measures requires resource availability on the part of the SP individually and on the part of the sector as a whole. Immediate risk reduction measures, such as hazard mitigation works or infrastructure vulnerability reduction, demand important resources. Also, eventual financial protection mechanisms, such as risk retention and transfer schemes, would demand the availability of continuous available resources that should be part of each SP’s spending budget. Resources are also required for preparing emergency relief and contingency plans and for the logistics and organization that will allow the SP to be prepared in the event of an emergency.

In particular, the preliminary risk analyses made for the sector SP indicate that, to finance a risk transfer scheme under normal market conditions, each SP would require from 2% to 4% of its total operating income on an ongoing annual basis.

Therefore, the eventual implementation of a risk management policy requires proper planning, especially regarding the necessary available economic resources at an individual SP level and at a general sector level. In addition, the need to schedule technical training, personnel availability, logistics resources, and specialized consultants to optimize plan preparation and programs implementation must all be taken into account.

3.5 general diagnosis of the sector risk The water supply and sanitation sector is highly vulnerable and has a high level of exposure to natural hazards, mainly to seismic hazards; therefore, under current circumstances, the occurrence of a seismic event is expected to considerably affect sector operations and to lead to a slow recovery, taking into account the reconstruction and startup processes after the event. Annex 2 presents a more detailed analysis of the water supply and sanitation sector risk diagnosis.

A high-magnitude event will have a great physical impact on the ground zero area. That will lead to the interruption

of the water supply service in residential areas, commercial areas, and industrial areas, as well as in buildings essential to the population, such as hospitals. That in turn will lead to a non-favorable scenario with emergency situations due to the lack of water supply. According to international experiences, after a certain time without water supply, there is a problem with a high social component.

Due to the above, it is also safe to assume that there will be a high social impact that will mainly affect two sectors: the health sector and the residential sector (the population at large). In the first case, water supply is essential for emergency relief and when there is no proper service provisioning to hospitals and other buildings that are essential to the community, there is bound to be a problem with a high social impact. In the second case, although in the past the community has proven to be relatively tolerant during the first few hours after an event, that attitude gradually changes and then then are usually protests, which generates another social problem.

Environmental impact must also be considered a topic worthy of attention, given that the occurrence of catastrophic events that produce significant damages to the infrastructure may also, in the particular case of water supply and sanitation systems, generate chemical component spills, mainly at the water treatment plants. That may have a considerable impact on nearby populations, water sources, and vegetation. Sometimes industrial fires or fires generated by gas installations also occur and such firefighting generally requires water, which may not be available.

In recent years there have been important transformations in risk management administration and institutionalization in several countries in the Andean Region, including Peru. Nevertheless, it is common to find that the entities, except for a counted few, do not have enough resources available to handle emergencies or to prevent and mitigate risk. That explains the difficulty that they have to speak of advancements in the area of resource availability and


48

sustainable use of funds for their institutional development. It further shows a lack of clarity when it comes to integrating a risk management policy into social policy or to coordinating the operation of such a policy in decentralized social protection network schemes.

The above is proof of the imbalance between the increasing awareness of the need to have proper risk management institutionalism and the little availability of required budget resources for the normal performance of institutional responsibility. Likewise, it is worth emphasizing that Peru does not boast well-developed financial markets nor does it have an insurance culture. As will be explained further on, that makes risk diversification and the use of market mechanisms for loss transfer to specialized agents very difficult. In Peru, as in other Latin American countries, insurance penetration represents less than 2% and, although insurance companies are interested in increasing their market share for this sector, they always seek to insure good risks. To define what risks are good and what risks are bad, it is necessary to do risk quantification. It is worth clarifying that, when large insurance companies decide on that, they generally do their analysis on a case-by-case basis. Currently, they have the general perception that the SP cannot be insured for this type of risk or at least that most of their infrastructure cannot, in particular the underground infrastructure including the entire pipe line system, tunnels, and other components that are difficult to inspect.

If any disaster should hit now, most of the responsibility would probably fall on the State for it to provide aid to the different affected sectors and assist them in their recovery. To be able to properly handle an emergency, the State usually resorts to establishing funds for emergency relief, which, on certain occasions, are also used for risk reduction and mitigation prior to the occurrence of an event. Such funds are only one of the risk management policy instruments but they are generally among the financial mechanisms most prominently used in most countries.

Notwithstanding the broad usage of such funds, in many cases they fall short when it comes to the amount of resources allocated to them. Therefore, it is desirable for

each country’s emergency reserve funds to be governed through an optimum accrual and spending rule based on the quantification of the effects generated by recurring minor disasters, meaning disasters with a high recurrence rate but with little impact on the exposed elements.

In the case of Peru, the National Civil Defense Institute (INDECI) provides very limited resources to handle emergencies and risk prevention or reduction is minimal. That became evident during the period of time after the earthquake that affected Pisco and other nearby towns in August 2007. Regional governments and the national government are the ones called upon to generate the resources that can be used as a protection and compensation mechanism for the poorest households, so as to minimize the drop in social wellbeing. Also, through the new Peruvian risk management law, the Ministry of Economy and Finance (MEF) is empowered to establish financial risk management strategies, which means that, for the sector in particular and in general, topics related to contracting contingent loans, establishing reserve funds, taking out insurance and reinsurance or using capital market financial instruments must first be analyzed by said Ministry and the others in charge of risk management for the sector.

Risk management covers different aspects that must be gradually carried out after a policy has been traced. It should only advance to the next level after the milestones defined for the current stage have been met. The topic of risk management is so broad that it requires the participation of all of the stakeholders including the National Government, local or regional governments, the different sector agencies, and the SP themselves.

So, a general risk management strategy for the water supply and sanitation sector must be implemented. The chapters below will present the fundamental bases for implementing a series of general actions, starting with the SP gathering relevant information and ending with having the elements for developing a national risk management policy.

Generally speaking, the analyses made allow drawing the conclusion that it is only possible to create a sustainable


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financial protection strategy if risk management is strengthened in other fundamental aspects that constitute the first steps towards enabling or facilitating an eventual transition to risk retention and transfer schemes that will be coherent with the advancement achieved in the risk identification, risk reduction, and disaster management processes. Such processes must have a high degree of efficiency because they are directly related to the water supply and sanitation SP’s appropriate management and good governance.

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4.1 OverviewAccording to the general context of the analysis presented above, it is clear that faced with possible future catastrophic events that may significantly affect any of the sector service providers, it will be the Peruvian government’s responsibility to participate in the processes of emergency attention, service reconditioning, and reconstruction of the affected infrastructure, seeking to reestablish water supply and sanitation services as soon as possible and to provide new financial and operating stability to the service provider(s) affected by such events. In addition, the Government will be bound to efficiently and fairly attend to the affected families in low-income brackets, who lack protection and the economic means to bear financial costs of coverage.

Although limited, the above perspective is coherent with the countries’ modern “social policy” guidelines. Indeed, the idea is that the State must be in charge of solving the problems of the poorest citizens in the society, especially when they are victims of events that directly affect the population. Similarly, the State must seek to guarantee essential public utility service provision under any circumstance, once again, with special consideration for extraordinary situations such as the occurrence of an event of catastrophic proportions. Due to the above, the State’s role is essential in all issues related to risk management, not only those related to the poorest population but also in issues involving the companies that provide vital public utility services.

Proper disaster risk management requires a series of active duty before the expected catastrophic events take place. Out of all of the actions that can be carried out, most of them are the sector service providers’ direct responsibility, for obvious reasons, even though the process must be directly led by

Policy Elements for Risk Management and Financial Protection Strategy

IV.

the national government that must propose the general guidelines for the risk management action plan.

Therefore, it is necessary to propose some basic elements for a risk management policy for the water supply sector and a general financial protection strategy in the sector. This chapter summarizes the main elements of the measures needed to be able to conduct proper water supply and sanitation sector risk management.

4.2 elements for disaster risk management The current water supply and sanitation sector service providers in Peru are very different in size, capacity, and operating conditions. In general terms, most of them are subject to significant risks, in some cases potentially critical risks, which can generate situations of bankruptcy for the company in particular and place the possible service recovery operations in difficulty as well as the future economic and financial stability, not only for the SP itself but eventually for the whole sector.

In general, the SP have a very little knowledge of their own infrastructure in terms of description and physical characteristics and in terms of economic appraisal and eventual recovery or replacement costs in the event of catastrophic situations. Many of the exposed system components were designed and built many years ago and they do not generally comply with earthquake-resistant design standards or have the capacity to resist the impacts of other natural phenomena, such as inundations or landslides. In addition, none of the SP have sufficient resources for an updated inventory along the total extension of the network in terms of material, life cycle, connection types, and pipe diameter, among others, to solely mention the case of pipelines.


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Not having a good inventory of the different exposed elements negatively affects formulating a risk transfer strategy because there is no certainty regarding the risk to be transferred, the present condition of the components, the exact location of the components, and other component characteristics such as those mentioned above, to enable an appropriate quantification of expected losses.

From the perspective of the SP being able to implement specific risk management plans, it is above all necessary to have good quality information on the exposure and vulnerability of In many cases there is available information. Nonetheless, in terms of what is relevant to this type of assessment, there is not always a standardized format for the type of file, geographic projections, material coding, units of measure, etc… . That type of information is not only relevant to this type of study but also to proper SP operations because it is essential to have a complete description of the system, which can be useful for planning replacement or repair works for existing elements, for locating damages, etc... . When the information relating to water supply and sanitation system networks and components is only exists in a physical format, it must be digitalized, in order to have a geo-spatial database, which enables correct information use and interpretation.

There are few maintenance plans for existing networks and there are very limited economic resources allocated and very few human resources assigned. Usually, in spite of the fact that most of the SP may have network plans for ongoing maintenance, reconditioning, and enlargement, the values allocated in the budget are generally very limited and do not reach a level that would enable a vulnerability reduction strategy (see, for example, the case of SEDAPAL and EMAPICA in Volume I).

Due to the above and on top of that, to the aggravating situation of the considerable age of several segments of the pipelines, the bottom line is a portfolio of highly vulnerable elements. The occurrence of prior seismic events as well as of inundations and landslides can alter the total capacity

of the components although they did not generate direct damages to the components at the time of the event. In cases where high volumes of water flow through the sanitation pipes, network pressurization occurs, which generates a series of moments of considerable stress on the pipe walls. Depending on the type of material out of which the pipes are made, the stress produces zones of fragility that increase system vulnerability even more.

Few sector service providers have insurance policies to cover natural disasters and those that do have some protection mechanism are the companies classified as large SP. Most of the SP have insurance policies against the robbery of system elements and machinery and acts of vandalism but, although there is a considerable amount of perception regarding the different natural risks, mainly due to earthquake and inundations, in many cases the SP do not have the necessary resources to acquire all risk policies that include such aspects.

After conducting a general survey with sector specialists, it was possible to come up with the general perception concerning the comprehensive risk for the sector SP. It is discussed below.

• MostoftheSPdonothaveapersoninchargeofdisaster risk management issues.

• ThereisnocleardefinitionoftheriskstowhichtheSP infrastructure is exposed.

• Thereisnotechnicalinformationregardingthird-partyrisks associated with the company infrastructure.

• SeveralSPhavebeensubjecttoeventsofacatastrophicnature, which obliged the government to react and obliged the large SPs, in particular SEDAPAL, to help with emergency attention coverage and reestablishing the water supply.

• PracticallynoneoftheSPhaveemergencypreventionand attention programs or contingency plans in their safety and security programs.

• Practically none of the SP, except for SEDAPALand some other large companies, have an all risk


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insurance policy that covers earthquake and business interruption.

• Noneof the SPhavemanagement indicators forrisk issues.

The perception of the consulting group regarding the above comments is discussed below:

• SeveraloftheSPareawareofthehighlevelofriskto which they are exposed and of potential losses and damages that they can suffer due to events of different natures, such as earthquakes and inundations. However, they do not have and do not, under current circumstances, see the possibility of having financial protection instruments against such events.

• ThefactthatanSPhasanallriskinsurancepolicygives it the notion that, thanks to the policy, it will have the resources it needs to attend to the emergency and recover the system after a disaster occurs.

• Adetailedanalysisofthesignedinsurancepoliciescandrastically change an SP’s perception of the risk level that it retains, especially when fallacies are detected in the policies.

Furthermore, the Government situation is not much brighter. The following general perception exists at an institutional level:

• Thereisnoclearnationalpolicyregardingwatersupplyand sanitation sector risk management issues even though it is a high priority public utility that must have high levels of reliability.

• Thereisnoregulationorinstructionintheregulatingbodies related to the general topic of risk management, vulnerability reduction or financial protection in the SP, aimed at guaranteeing their stability after the occurrence of disasters.

• Thereisnostrategicplanforhandlingfuturedisasters

for which the possibility of occurrence is known but the time of occurrence is uncertain.

Overall, as occurs in many other countries in the region, in Peru there is no consensus of awareness regarding the possible effect of the occurrence of future disasters on the water supply and sanitation systems. Consequently, there are no basic elements for implementing a sound, stable policy for proper sector disaster risk management.

4.3 elements for specific policy

4.3.1 Overview A specific sector risk management policy must include the following aspects:

• General strategy for improvingriskknowledgeandperception at the government and related agency level and at the level of the SP themselves and of the population

• Risk prevention andmitigationplans bymeans ofadopting a series of structural and non-structural measures that must be viable from a technical, functional, operations, and financial point of view

• Contingencyplans for aneffective, efficient responseafter a disaster to attend to the population and achieve service continuity. Contingency plans must be developed by the sector SP in coordination with the other national risk management system agencies at all levels

• Systemreconditioningandreconstructionplansthatinclude definitive service recovery mechanisms aimed at contributing to the economic and social recovery of the affected population

• GeneralfinancialprotectionstrategyforthesectorSPbymeans of risk retention and risk transfer mechanisms.

Each one of the above elements is explained below.


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4.3.2 identifying the risk The risk identification process must cover the identification of exposed elements, hazards, and the vulnerability associated with each.

4.3.2.1 detailed system informationThe sector SP must have a detailed, updated, complete inventory of all system components and their characteristics.

It is essential to know, characterize, and document all of the exposed assets, to have a database that includes all of the important relevant information, characteristics, and comments regarding each SP’s assets. Said information must be periodically reviewed and updated in order to inform modifications, replacements, repairs, and acquisitions made. In addition, it is important for the information that so requires to have geo-spatial information references. To do so, it is necessary to have a geographical information system (GIS) that, besides serving as a tool for identifying the exposed elements, must be connected for use in field operations and when designing water supply and sanitation systems.

The databases must contain all network information broken down by the different comprising elements, thus enabling independent information handling, when so required, and maintaining one sole frame of reference. All of the SP, whether classified small, medium or large, must have this information.

4.3.2.2 identifying the exposed elementsFor the exposed elements, it is necessary to have an updated database with geo-spatial references, to enable a complete, correct characterization of the system. For formatting the information, a geographic information system (GIS) must be used, which, besides serving as a tool to identify the exposed elements, must be connected for use in field operations and when designing water supply and sanitation systems.

Said system must contain all of the network information organized by component type, thus allowing the possibility of working independently on each one of the components for which the SP is responsible, but with a common frame of reference. The system must be periodically updated to include all new acquired information and the modifications that the system has undergone either due to network update plans or by replacement due to damages to existing components.

The small SP must start by gathering existing information relating to the types of pipelines, materials, identification of stretches, age, and classification by type of connection, to then verify the accuracy of the information. If the information is solely in physical format, it must be digitalized so that it can be geo-spatially referenced with common characteristics, mainly to enable making the projections to be used.

Most of the medium SP and large SP have information on exposed elements in a digital format although, when an SP has various departments and each one of them is in charge of a specific system component, the information may be in different formats and systems of coordinates, so it must all be standardized. As in the case for small SP, to the extent possible a verification must be made, to determine with a greater degree of reliability that what is found in the information system coincides with the physical network.

4.3.2.3 Hazard identificationIn Peru natural hazards are classified into three main categories: earthquakes, inundations, and landslides. For earthquakes it is possible to determine maximum expected intensities for different return periods, using studies at a country level. Presently Peru boasts numerous studies of the issue. However, the presence of soft ground and considerable variations in the topography can greatly modify the surface intensity, thus increasing or decreasing the value on hard ground.


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Therefore, local and/or regional studies are required (depending on the extension of the zone under study and on the variations in the underlying soils within the area), to enable making a characterization of the dynamic response of the ground and then obtain the new surface values. Some towns have seismic microzonation studies that allow using estimation.

Interaction among different agencies is necessary to determine the roles that each one of them can have in identifying and calculating the different hazards. That would enable, using the greatest amount of information available, evaluated in the best manner possible, high-level studies with a high degree of completeness. That is important to emphasize because, as such, risk identification and calculation are not part of the SP’s daily labors, so it is desirable to have periodical publications of the results and, hopefully, a regulation concerning their availability.

Cases of flooding and landslide are more specific and localized and require detailed studies that can be conducted at the town level or even for specific zones or basins. In regards to flooding, it is important to have high-resolution digital elevation models, to enable making a complete, reliable analysis. Such analysis will allow identifying the contour of the floodable zone as well as different reference flood heights for various return periods and thus define low, average or high hazard zones.

In addition to the high-resolution digital elevation model, landslide analysis requires assessments of the local geology in the zone, mainly on the surface, to be able to characterize the ground and then, using different parameters, identify the zones that are most susceptible to ground movements. This type of study must also be conducted at a local or regional level.

The hazard identification plans can be generated at a national level and then go into more and more detail, in order to have a better view, depending on the availability of historical and analytical information regarding the problem at a provincial

department or city level. Here, the differentiation of how to address the problem of information by company size is not so clear, given that the collection and validation process for existing information is similar in all cases. Obviously, it will take more time initially for the larger SP because of the extension of their infrastructure, but, the assumption is that, for the very same reason, they already have good information and greater performance capacity.

4.3.2.4 Vulnerability identificationThis aspect must be processed to enable correctly identifying the risk because it relates the intensities obtained from the hazard analysis to expected component damage. In the Peruvian context, the proposal is to use the same vulnerability functions for the system components no matter what the classification of the SP (large, medium or small) unless there is information to enable capturing a greater level of detail, such as affectations due to prior events and local geological faults, among others.

4.3.2.5 Conducting risk studies The SP must conduct risk studies for their exposed assets, in order to have a good amount of information regarding possible future damages and losses as a result of the occurrence of severe hazardous events. Such studies are essential to determine, within an acceptable degree of approximation, what could happen and to propose interventions to reduce the risk. That is the best manner to respond before a crisis hits, and to be able to confront any future situation in economic and operational terms.

Using the risk studies, the SP must characterize the vulnerability of the exposed systems, by identifying the critical elements, meaning, determining what components and contents are most likely to suffer damage. There must be an examination of the buildings (operations centers and administrative sites, among others), the types of pipelines, the types of connections, and the components, such as wells, valves, and reservoirs, which may perform badly or that are susceptible to suffering damage if faced with a seismic event or an event of any other kind that can affect them.


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The studies must go into sufficient detail to enable making decisions regarding mitigation, contingencies, and financial protection. In some cases, more detailed assessments at a subcomponent level can be made, that is to say, pipe materials,, types of tanks, and structural systems, for more specific interventions.

4.3.3 risk reductionBased on the information gathered and on the results obtained from the risk analysis, it is possible to propose short-term, mid-term, and long-term risk mitigation programs. That can be done by confronting different topics that, in principle, should lead to the same result, that is to say, minimizing the losses associated with the occurrence of an event.

4.3.3.1 Hazard reductionPrograms to diminish the level of seismic hazard can be carried out just as programs to reduce the level of hazard in the case of floods and landslides. For the latter two, civil works can be built to minimize the impact on the population and on the exposed component elements. In the case of seismic hazard, it is not possible to perform works or to have plans for reducing their effects; therefore, risk reduction must be achieved, using the proposals presented below.

4.3.3.2 Vulnerability reductionVulnerability reduction implies performing works, whether they be social or civil works, aimed at considerably reducing the expected impact on a community and exposed set of assets before the occurrence of a catastrophic event. As it is impossible to reduce the level of seismic hazard, as part of the seismic risk reduction strategy, it is customary to design reconditioning for existing edifications. To do so, specific vulnerability studies must first be conducted for each system component.

Given the great diversity of components that comprise a water supply and sanitation system, it is necessary to conduct specific vulnerability studies for each component,

taking into account its characteristics, such as structural system, material, construction quality, current condition, affectation due to prior events, to name a few, to thus have a total view of the degree of vulnerability present in the element. As each element has a particular importance within the whole set, an order of priority must be established to define the order of intervention for said elements, starting with those considered critical and essential for proper system operations. Some essential elements in water supply and sanitation systems are treatment plants (water supply and waste water alike), reservoirs, and the main pipelines.

As part of a vulnerability reduction plan, at a short term it is desirable to gather information related to how the system works, from the hydraulic design perspective (identification of main networks, redundancy analysis, etc…) as well as from the administrative perspective. Keeping the above in mind, information must be gathered relating to each one of those elements and such information must include data regarding the location of the elements, calculation memoirs, properties of the materials used, and affectations due to the occurrence of prior events.

At a mid term it is desirable to have specific vulnerability studies of the different components and then to determine a comprehensive vulnerability indicator that can be defined using overstrain indexes in certain elements, comprehensive flexibility indexes or a combination of both. Once again, given the characteristics proper to each edification and tank, particular studies are required for each case and information should not be extrapolated from one component to another even though at first sight the two components have common characteristics.

Finally, as a mid-to long-term plan, the structural intervention or retrofitting work must be done on the edifications that have been classified as having a high degree of vulnerability. Here, the information from the previous two stages is required. Indeed, in addition to the result of the vulnerability of the components, it is desirable to know their importance within system operations and thus be able


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to generate an intervention work plan starting with the two elements with the greatest degree of vulnerability that are most important to operations.

Confronting the vulnerability reduction problem by reconditioning or reinforcing the existing structure is perhaps one of the approaches most used around the world. Nonetheless, by carrying out periodical edification maintenance plans, it is possible to gradually perform the same labor. To do so, the maintenance plan should start during the useful life stage of the components before they are affected in a manner that seriously compromises their functioning. That will allow periodical minor interventions to ensure their proper functioning.

4.3.3.3 mitigation plans The SP will carry out risk reduction or mitigation plans based on the results of the risk assessment studies and they can include them in their investment and maintenance processes at short, mid, and long terms.

The mitigation plans must include a cost-benefit analysis of the intervention measures to be established for the different subcomponents of the elements identified as the most vulnerable, proposing measures such as repair, retrofitting, replacement or modification for the purpose of decreasing their susceptibility and fragility. This type of analysis will enable comparing different possibilities of intervention or the actions to be taken, considering a decrease in future expected losses, the required investment and the expected effect. This comprehensive process must lead to establishing a priority among the activities to be carried out and that priority must be reflected in the risk reduction or mitigation plan.

The plan will be built as a step-by-step program in which the most appropriate measures to be taken are described. Nevertheless, short-, mid-, and long-term risk mitigation activities should be proposed and differentiated, each one according to the magnitude of the required interventions and to the SP’s capacity to carry them out.

4.3.4 comprehensive sector financial protection strategies Different financial protection options that can apply to the water supply and sanitation sector exist on the market. Annex 3 presents a summary of the most used available for the infrastructure financial protection instruments.

Among all of the options, the sector at large as well as the individual sector SP must consider risk retention mechanisms, such as the creation of disaster attention reserve funds, possible contingent loans, and establishing pooling figures to retain and share the risk with other sector SP, the municipalities, and the national government. Also, they should consider risk transfer alternatives, such as conventional or parameter risk insurance and reinsurance policies, as well as other available or feasible capital market financial instruments (such as catastrophe bonds and swaps).

For the Peruvian water supply and sanitation sector, considering the level of development and effectiveness of risk management, the instruments that must be considered initially and at a short-term are listed below.

• ReservefundsatasectorlevelandforthelargeSP• Contingentcreditsatasectorlevelandforthelarge

SP • Traditional insurance and reinsurance policy

schemes initially for the large SP and afterwards in a coordinated manner for the other SP.

Out of the above, the most important instrument that could be consistently applied at a short term is the one corresponding to an insurance and reinsurance strategy making use of traditional schemes.

To propose a risk transfer strategy, it is necessary to have detailed information on exposure and risk. Such an assessment must be made for the different types of risk whether they be for natural disasters, fire or political risks such as mutiny and a coup.


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The importance of existing insurance policies lays not so much in the fact that they exist and how long the protection lasts but rather in how they define the included coverage. For example, insurance policies can have named peril coverage or all-risk coverage, without the latter implying more coverage. Indeed, depending on the underwriter, the all-risk coverage policy may offer the same named peril coverage but the all-risk coverage may involuntarily exclude risks covered in the named perils coverage policy.

The process requires the participation of an expert administrator on the topic in each one of the SP, with the following responsibilities:

• Component inventory and database control andupdating

• Effectiveinsurancepolicyadministrationandrenewaladministration

• Claims, negotiations, claim assessments, andothers

• Neededpolicymitigationandadjustments• Generalriskmanagement.

The existence of contingency plans, maintenance plans, and policies for risk mitigation is especially important in the SP sector. Due to its ample, very important infrastructure, service supply, in this case water distribution and collection, can be affected, thus generating critical scenarios due to the high social impact involved.

4.3.5 contingency plans, emergency attention, and reconstruction

4.3.5.1 Contingency plans The SP must periodically formulate, test, and update contingency plans in order to prepare themselves and respond efficiently and effectively to emergencies caused by hazardous events.

Contingency plans must be based on prior hazard or danger assessments, among which events such as earthquakes,

inundations, and fires, among others, must be considered. Such events can lead to a simultaneous failure or a cascading failure of different components such as regulators, pipelines, treatment plans, and reservoirs. The plans must also include the failure of collateral systems such as electricity, gas, fuel, communications, and others. Contingency plans must contain guidelines for a rapid response to the events, which must be tested through simulations in order to optimize the SP’s response capability.

Contingency plans must have timely information as well as formulate reaction or response procedures to be followed when faced with the possible emergency situations that may arise. General response procedures as well as specific response procedures must be established, forming simultaneous reaction groups who, working in parallel, can act efficiently. The plans must define the personnel’s duties, coordinate activities, form action groups, and describe pre-established procedures.

The most important emergencies are characterized by an interruption of normal system operations and are caused by a situation or event, usually unexpected, either internal or external, which requires an immediate reaction in order to get things back to normal as soon as possible. The idea is to avoid effects on the system operations themselves and on the population and the environment, acting in certain cases jointly or in a coordinated manner with government agencies, communications media, and the community itself.

The specific contingency plan objectives are listed below.

• ToestablishgeneralandspecificproceduresfortheSP response to the possible critical situations or emergency situations that may arise, according to the risk analyses made.

• Todefinebasic response actions to face abnormalsituations that imply operations other than routine operations in an immediate manner, to reduce or avoid the adverse impact on the exposed elements.


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• To identify situations that entail carrying out apublic, legal or financial information strategy as a result of an emergency situation that associates the SP with the effects that populated settlements or the natural environment can suffer.

• To consider general and particular aspects relatedto central operations and to the main system components.

Specifically, a contingency plan provides the SP a guideline on how to respond to an emergency, in order for them to be able to follow the actions below.

• Acteffectivelyandefficiently.• Getbacktonormalassoonaspossible.• Ensurecontinuityinproductionactivities.• Giveinformationinaprecise,timelymanner.• Properlyhandlethecompanyimage.• Offer elements for proper legal and financial

protection.

The timely activation of a contingency plan in the event of a critical situation is very important, taking into account that most of the negative perceptions regarding an SP occur during the first moments of an emergency. The document gives guidelines for avoiding such misunderstandings and for handling the emergency as best as possible, generating simultaneous reaction groups who, working in parallel, can overcome the event without affecting the company credibility, the stock value, the profits, and other aspects of importance to the SP.

When preparing contingency plans, the SP must seek to:

• Define the duties of the personnel of eachcompany

• Doactivityplanningandcoordination• Describepre-establishedprocedures

• Giveinformationontheinventoryoftheresources• Doatrainingsimulationandareview.

A contingency plan works as the basic instrument for efficaciously facing any emergency situation, minimizing the negative effects that can be generated, coordinating different reaction strategies, and informing the community and the various competent institutional agencies of the situation at hand. This document contains general instructions that must be put into action when faced with particularly important emergencies.

In conclusion, as concerns reconstruction (replacement), the government is responsible for its building and service infrastructure. Therefore, it must estimate its expected losses or contingent liabilities and agree upon conscious retention mechanisms or instruments and/or on transferring said losses at all levels. Such instruments can be in place through agreements at the different levels of government, when their economic resilience so permits. In other words, the State is responsible for rebuilding public buildings or public goods. Therefore, it is the risk taker on behalf of the SP and it is desirable that, when so deemed convenient, it enter into a loss transfer agreement and have reserve funds to enable access to resources for rebuilding public goods. In the event of an extreme disaster, normally the national government supports the reconstruction of public goods at a local and regional level, given the inability of the local and regional governments to rebuild their infrastructure. In some countries, in order to avoid a moral risk (the Samaritan’s dilemma4 ) at a local level, the national government demands that the local governments show an effort to reduce the risk and that they do not act negligently regarding vulnerability interventions in risk zones. Using risk management indicators, percentages can be established for the national government’s participation in paying the insurance premiums and in rebuilding the State-owned public buildings at local and regional levels. As far as liability with private parties is concerned, it seems that the

4 The idea is that if persons (municipalities or provincial departments) are certain that they will have transfers, subsidies or private charity in the event that they suffer great losses as a result of a disaster or a negative shock, they prefer to reduce the optimum level of emergenciy allowances and of expenditure in insurance and risk reduction, thus obliging the State (central government) to bear said losses and investments.


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situation much depends on the circumstances, which has proven to be true in the past.

Because resources will be needed to be able to attend to the emergency, possible financing sources must be identified, among them, the ones listed below.

• Theapproximateinsurance and reinsurance payments that the country will receive for the insured government assets and infrastructure. Insurance in developing countries is an industry in its beginning stages, so it is safe to say that there is no insurance culture yet. After prior events, insurance companies have made most of their payments to the private sector, in particular to the large industries. In several countries insuring public goods is mandatory; however, the legal requirement is not actually enforced, in particular by decentralized territorial agencies or local governments. A simple way to estimate the value of the insured physical wealth could be the expenditure in insurance as a share of the GDP. For example, if it is equal to 2% of the GDP, that means that 2% of the losses are covered by the insurance companies.

• TheReserves available in the disaster funds that the country has in the year of the assessment. Several countries have formally established calamity funds or disaster funds, which have an annual budget and at times reserves accrued from prior years. In other cases, there is a main fund and funds for specific sectors located under the charge of different agencies or ministries, such as public works, infrastructure, health, and civil defense, among others, or there are decentralized funds at territorial agency levels. The value must be estimated as the sum of the Nation’s available reserves and those of the possible affected zones.

• Thenationalandinternational,publicandprivateaid and donations received. Usually, aid from abroad is granted to support an emergency response but few resources are received for the reconditioning and reconstruction phases. After a notable event occurs, mostly food and clothing, household goods, tents, and equipment are received. Money is seldom received. Although no detailed information exists on the support received from friendly governments, NGOs, and humanitarian aid and technical cooperation agencies, a realistic approximate assessment of such aid must be estimated as a percentage of the loss in prior events.

• Thenew taxes that the government could additionally collect in the event of a major disaster. Experience indicates that taxes from two to three per thousand have been levied on financial and banking transactions, but that type of tax can stimulate contention and a transfer of savings to foreign countries. In general, serious doubts created by the unpopularity of that type of measure exist and many believe that, every time a major disaster occurs, the government can increase its revenues by imposing new taxes. The value of a new tax must be estimated based on its political feasibility according to the possible financial figure that may be considered in each case.

• Thebudget reallocation that the country has, which usually corresponds to the government’s margin for discretionary spending, in a situation of budget planning constraints. In some cases, the value depends on the political decision of the applicable competent authorities; nonetheless, there are restrictions that hinder major reallocations due to inevitable public expenditure obligations, such as salaries, transfers, social expenditure, and debt service. Here, it is also worth including reallocation or deviation of loans


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from multilateral organizations, which have not yet been executed. If the possible budget reallocation margin is not more accurately obtained, it can be approximately estimated as the percentage of investments in capital goods as a percentage of the GDP.

• The external credits that the country can obtain from multilateral organizations and on the capital market abroad. Loan conditions with multilateral organizations are in general more favorable but they are restricted to the degree of sustainability of the external debt and to the service debt / exports ratio. In general, interest rates depend on the per capita income in each country. Access to credit on the international capital market depends on the country’s internal and external financial risk ratings, which determines the risk premiums and the commercial rates for the debt securities. At any rate, acceding to external credit means increasing the debt service obligations in the future and reducing the country’s limit for taking on new debt. Therefore, the maximum external credit value must be estimated based on an analysis of the obligations and constraints that the government has.

• Theinternal credits that the country can obtain from commercial banks and in some cases from the central bank if it is legal to obtain loans there from, meaning immediate liquidity. Also, in some cases, if there is a major disaster, it is feasible to obtain resources from international reserves although that type of operation is generally a problem and can represent a risk for the balance of payments. Credit with commercial banks also has limitations and costs and depends on the activity of the local credit markets; and generally it can be scarce. In a weak market an important credit can affect internal consumption, local investments, and the interest rate. The additional credit available must be estimated taking into account the country’s capacity to return the loan and the capacity of the capital market in that country.

4.4 Financial protection strategy for the sector and for the SP

4.4.1 introductionAs may be concluded from the systemic risk results presented in Volume 1 for SEDAPAL and EMAPICA, as well as from the different financial and management indicators presented in section 1.1.3, there are adverse conditions regarding disaster risk management throughout the sector. To contemplate an optimum risk retention and risk transfer financial strategy, it is necessary to first achieve notable results in management, risk identification, risk reduction, and in the handling of significant disasters, to thus gain the trust of the risk takers in the national and international insurance and reinsurance industry and capital markets.

Financial protection is without a doubt the last step in risk management that is usually able to be implemented after important progress has been made in the other risk management components. From an orthodox risk management point of view, financial protection is a complementary policy to cover residual risk. Therefore, it implies advances in the other risk management components.

Currently the national government of Peru is retaining most of the risk except for some situations in which the SP have some type of insurance scheme that enables transferring part of the potential losses. Nonetheless, after reviewing SEDAPAL’s insurance policy and the fallacies identified in the conditions of that policy, the national government would have to bear a considerable part of the losses resulting from a catastrophic event. That is a situation that must try to be avoided given the series of problems seen (and the water supply and sanitation sector is not alone) in the reconstruction process after the August 2007 earthquake in the towns of Pisco, Ica and Cañete.

Notwithstanding the above sector difficulties or constraints, some alternatives can be proposed to be explored. They are


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at least the most feasible if a climate of trust is achieved and significant risk reduction and emergency response preparation results are obtained. If the current market conditions and insurance industry conditions in Peru stay the same for the next few years (five or 10 years), it would be possible to propose an insurance strategy for the water supply and sanitation sector service providers, based on the general criteria below.

(a) Promote an insurance culture in the sector, seeking to achieve maximum SP coverage.

(b) Propose schemes that are easy to implement, to ensure the success of the initiatives.

(c) Minimize the cost of risk transfer for the SP, especially for the small SP and others with little financial capacity.

(d) Implement a first phase that will evolve through time, ensuring ever more efficient, reliable financials.

(e) Seek sustainability in regard to price and structure, to avoid strong price variations and insufficient coverage.

Following the above criteria and based on the above risk analysis results, two possible general insurance schemes are proposed to be explored. Annex 4 presents in more detail the final protection strategies proposed for the two service providers analyzed, Sedapal and Emapica. In addition, for a broader view of the topic, Annex 4 presents several international cases of financial protection in this sector as a reference.

4.4.2 alternative 1: individual insurance scheme for the Sp

4.4.2.1 introductionIndividual insurance for the service providers will probably be possible solely for the medium SP and the large SP with a certain financial capacity and mid-term stability. This alternative consists of promoting individual insurance schemes for each one of the service providers according to its own exposure and risk level assessments, in an attempt to generate internal financial capacity growth through government support, to enable subsidizing the risk transfer costs. The scheme is fast and easy to implement (and in specific cases could be implemented almost immediately, at least partially, depending on the political willingness to do so). Its success will depend to a great extent on the management capacity of each one of the service providers.

4.4.2.2 risk transfer and retention structure Figure 4-1 presents the typical risk transfer and retention structure for each one of the sector service providers that has the corresponding resources and that gains the interest of the insurance sector to at least partially cover the exposed assets.

This possibility is not viable for a very large risk (which is the current case) especially if there are no active capital markets strong enough to bear it. The problem in such cases is not the value at risk but the quality of the risks and the lack of information to assimilate them under a sound, convincing scheme for the insurance industry.


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4.4.2.3 negotiation conditions To negotiate a scheme of this type, some minimum conditions are required; they are listed below.

CoverageThe offered insurance policy must include as a minimum earthquake, fire, and third-party intentional damage or terrorism, as well as strike, mutiny, coup, civil commotion. Insurable value The insurable value must correspond to the final replacement value resulting from an appraisal process of all of the system components, without including the value of the land. It

is important to take into account that this value does not correspond to the accounting book value of each one of the assets (sometimes depreciated), but rather to the replacement value of each one of the components in the event that they are affected by a catastrophic event. Therefore, each one of the service providers must do an inventory and carry out an appraisal process of all of its assets, which must be done by a specialized firm preferably with experience in infrastructure risk adjustments (water supply and sanitation systems).

Liability limit The liability limit corresponding to the actual losses caused would be limited to the reported PML value corresponding

FIgURe 4.1: reTenTiOn anD TranSFer STrUcTUre

Insurable amount

Insured amount (Maximum insurance and reinsurance limit)Use PML 1,000 years for each SP

Effective Insurance LimitLimit imposed by the insurance company based on capacity and on the quality of the insured assets. In general, it would be equal to the PML value.

Deductible

SP’s own resources

Local or regional government contributions

RETENTION

EFFECTIVETRANSFER

Risk effectively transferred to the

insurance company

Natiopnal government Reserve fund

Municipal administration

UPPER TIERSWITH VERY LOWPROBABILITY OF

AFFECTATION

No protection


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to each service provider; that value is considered a first risk liability limit. Preliminary PML estimates for each one of the service providers is presented in Annex 2 of this report. Commercial premium The commercial premium to be negotiated would depend on the insurable value and usually would be in the range of 1.5 to 3 per thousand. The definitive value will be offered by the insurance company depending on the calculation of the estimated maximum losses, the loss history, the corresponding frequency analysis, risk evolution and exposure severities, and on the limit established as maximum insured amount.

Deductibles There are several schemes used to define the deductibles for this type of risk. In general they are set as a percentage of the insurable value and the correspondence table is determined according to the underwriter’s appreciation of the re-insurance market for each one of the affectations to which the insurable items could be subject. The value varies according to the coverage. There is also the option of the deductibles being determined as a percentage of the loss generated in each event, but that is not the most orthodox scheme. For other natural phenomena or events such as strike, mutiny, coup, civil or popular commotion, third-party intentional damage or terrorism, the deductibles to propose will normally be 10% of the loss in the affected asset with a minimum agreed-upon amount, for example, a number of effective legal monthly minimum salaries. In general, the following may be considered:

(a) For absolute values, establish minimum deductibles as a percentage of the asset, that is to say, define among the contents to what type of machinery under a range of insured amounts “X” deductibles would be applied. For buildings, determine what properties would have a standard deductible and what properties would be based on an inspection report and the subjective aspects proper to the policy itself would have an absolute minimum deductible, for example, for the water works (for example, in the Piura zone) according

to the ranges of insured amount, the values at risk, the history of loss events, and the severities after a natural disaster has affected said risks. Add factors inherent in risk, such as, for example, the capacity to generate service supply, the number of inhabitants receiving the service, the water works that could eventually take over when others become inoperative, the risks under concession, and the risks managed by local government. Establish a minimum deductible at a fixed value with an affectation percentage of the asset value, for example, 2% of the total insurable value or insured concession contract, thus defining for the insurer a fixed deductible based on which it can start to attenuate its exposure for the exposed risks, eliminating the severity by zones, ambits or geographic dispersal but covering all risks.

(b) Establish an annual aggregate deductible where all risks can have a deductible as a percentage on the asset value but the insurance coverage would only indemnify after a fixed value is exceeded, thus enabling concentrating the coverage in important loss events and leaving the loss frequency for a risk management plan and a management plan where the economy of scale achieved by reducing the premium would contribute to generating a risk improvement or recovery policy that would reduce the frequency of events and through time reduce the aggregate deductible given that the risks are transferable for similar characteristics to the other exposed assets.

The scheme can be ideal for the nature of risks that can occur when there is a lack of actual values and of risk knowledge for each location because all of the risks are included and can have access to total insurance coverage but exposure due to affectation frequency is deducted whereas the risk is regularized for the coverage particularly affected. In this manner, the risk is not completely written off against other exposures that equally exist but that historically have not been as affected. For example, An SP shows the


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risk of flooding as a constant in recurring claims over the past five years but, due to budget reasons, it has not been possible to complete a mitigation plan to reduce said vulnerability. However, the SP can have insurance against fire and earthquake, to which it is also exposed, but the claim history is not as dramatic.

(c) Define the deductibles as a scale on insurable amounts according to the PML, based on the values at risk by geographic zone, by area of influence, that is to say, inhabitants who depend on the service. Eventually, a selection of this type winds up being economic at a short term but very costly at a long term due to the low amount of indemnity after important events.

From the above, it may be deduced that knowledge of the risk is definitive when designing the insurance strategy. Therefore, it is necessary to assess the status of each risk, its quality, the values of the assets, the active and idle operating capacity, and how to manage it.

Possible exclusions In a situation such as the one above, the insurance company will propose standard market exclusions such as war, nuclear affectations, chemical/biological exposure, design errors, civil liability, and other market clauses for which the text of each is required. In those cases business interruption and especially business interruption generated by electronic equipment are normal. Therefore, special attention must be given to the need of having this type of coverage and to the corresponding demerit points table established.

Based on his or her criterion, the insurance company inspector can establish an eventual exclusion of the system components that are in bad condition or that are highly vulnerable. That is the case of old pipeline systems in materials such as plain concrete or asbestos cement, which are highly affected components, in bad condition or in disuse. The excluded components must be included in the assets that the SP must recondition, thus seeking to include the components in future effective policies.

Taking out the policy The insurance company will issue a matrix policy for which the policy taker will be the SP itself.

4.4.2.4 Costs and financing The direct costs associated with this risk transfer scheme correspond to the costs associated with the implementation of the schemes (inventories, information gathering, negotiations, administration, and others) and to the premium that must be paid by each one of the sector SP. In a complementary manner, to effectively attend to the emergency attention and to the reconstruction plan needs, the costs associated with generating a financial capacity must be taken into consideration, to cover net exposure, whether due to claim frequency or to claim severity and that must be defined in the policy as the deductible that each one of the SP must bear.

For portfolios such as those under analyzed, normally the different components would be classified with different types of rates although, for commercial effects, they would be presented as one sole rate for practical purposes.

Using the actual information on each risk or exposure, an exercise for rates, deductibles, secondary limits, and conditions would be done because they cannot be the same for all risks due to the exposed amounts and the increase or decrease of each as compared to the others.

It would not be a homogenous accounts receivable portfolio. Volatility is the premise due to the exposure and the condition of each location or set of components.

The financing alternatives for these premiums would be the following:

• DirectfinancingbytheSP.Onlyafewwillhavethenecessary resources as time goes by.

• Directgovernmentresourcesthroughasectorstrategy.This would have to be defined and implemented by the Ministry of Economics and Finance. Indeed,


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pursuant to recent risk management legislation, MEF is now the competent agency for defining disaster risk financial protection strategies in Peru.

• Additional resources through sector service feeadjustments (which would be very unpopular). That is mentioned because currently there is a request being processed by the Superintendence for a service fee adjustment, considering a series of sector aspects.

At any rate, a strategy is required to give the individual SP the capability of covering the minor losses that remain within the established deductibles.

4.4.3 alternative 2: Sector Sp group insurance

4.4.3.1 introduction This alternative would consist of promoting a group insurance scheme for all the sector SP, taking advantage of the capability and financial strength of the larger SP and thus covering the weaknesses and lack of resources of the smaller ones. After looking at all of the sector SP, it is evident that the service provider SEDAPAL represents near 45% of estimated total insurable amounts. If all of the large SP are taken into consideration, they represent more than 85% of the total insurable amount. Based on the above, an SP group insurance strategy can be used, provided that an adequate deductibles scheme is proposed (see the above-mentioned options for deductibles). Therefore, the proposed strategy consists of establishing one sole insurance policy for the whole sector, which can be designed and presented to the market, seeking for said policy to comprehensively cover the sector SP.

Upon technical insurance analysis and the validation of the PML studies, the insurance strategy would have to be defined under a first loss or first risk limit scheme where said limit covers the maximum loss defined for natural events included in the greatest risk by insurable amounts or by exposure zone if there is a high concentration of vulnerability and insurable amounts in a particular

geographic location. Simultaneously, an insurance broker would have to assess the maximum loss due to activities proper to the business activity and to the most exposed insurable risks or properties, to establish the insured limit, by comparing the expected maximum losses due to affectations caused by natural events and inherent risk.

First risk policies represent a lower price than 100% insured amount policies but they demand a lot of knowledge of the risk, a committed administration, and highly specialized risk studies conducted by acknowledged specialized firms with an established track record in relative loss calculation. It would represent temporary price savings but it would be highly volatile if an important natural event hits. That is why the PML calculation is definitive here.

It is also possible to cover loss of profit as a result of damage covered through a civil works insurance policy, the coverage of which must necessarily be implicit. Nonetheless, temporary deductibles would be higher than those for a named perils coverage insurance policy on the grounds of the series of activities to which the SP would be committed.

This scheme presents great advantages such as comprehensive sector coverage, contracting and administration facility, and low relative transfer costs. Nevertheless, this scheme presents difficulties due to the demanding contingency plans for each risk and for each activity, which must be in place. In addition, the information must be organized and the management, administration, and financing process must be centralized. It requires the participation and coordination of the Ministry of Economics and Finance now that it is the competent agency for establishing risk management final protection strategies, pursuant to recent legislation. In this case, MEF would be the sole agency to administrate the budget for the sector SP insurance.

4.4.3.2 risk transfer and retention structure Figure 4-2 presents the risk transfer and retention structure or typical financing for each one of the sector SP with the corresponding resources.


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4.4.3.3 risk retention and transfer structure negotiation conditions To negotiate this instrument, the minimum conditions for each of the SP to propose are established below.

CoverageThe insurance policy must be an All risk policy that as a minimum includes earthquake, fire and third party intentional damage or terrorism, strike, mutiny, coup, civil commotion.

Insurable valueThe insurable value must correspond to the final replacement value resulting from an appraisal process of all of the system components, without including the value of the land. It is important to take into account that this value does not correspond to the accounting book value of each one of

the assets but rather to the replacement value of each one of the components in the event that they are affected by a catastrophic event. Therefore, each one of the service providers must do an inventory and an appraisal of all of its assets, which must be done by a specialized firm preferably with experience in infrastructure risk adjustments (water supply and sanitation systems). For this case of a group policy for all the SP, it will be necessary to do a detailed assessment only on the group of large SP in the sector.

Proposals under the mode of named perils coverage should not be accepted and basic conditions and coverage for which no secondary limit is indicated will operate at 100% of the insured amount.

FIgURe 4.2: riSK reTenTiOn anD TranSFer STrUcTUre

Insurable amount

Insured amount (Maximum insurance and reinsurance limit)Use PML 1,000 years for each SP

Effective Insurance LimitLimit imposed by the insurance company based on capacity and on the quality of the insured assets. It could be less than the PML value.

Reserve funds

Contiengent loan RETENTION

EFFECTIVETRANSFER

Risk effectively transferred to the insurance company.

De�ne commercial premium to be paid

National government Reserve fund

Municipal AdministrationContingent loan

UPPER TIERSWITH VERY LOWPROBABILITY OF

AFFECTATION

No protection

Deductible (De�ne special deductible conditions with the insurance company, considering the range of the considered SP)


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It is probable that some of the coverage may be excluded but they can be covered through an annex which means that, for questions of reinsurance, the insurance company cannot give unlimited coverage regarding the risk value, but it is possible to cover the exposure at a secondary limit level through special conditions.

Liability limit The liability limit corresponding to the actual losses caused would be limited to the reported PML value corresponding to each service provider, reported in Chapter 3 or to the corresponding appraisal made using detailed studies. It is considered a first risk liability limit. Table 4-1 summarizes the probable maximum losses for the different portfolios analyzed as groups. Once again, for the other types of coverage, the

Table 4.1: prOBaBle MaXiMUM lOSSeS FOr The DiFFerenT Sp GrOUpS

Type of Sp quantity exposed Value pMl for Tr=1,000

[in US$] [%] [in US$ Million] [%]

Sedapal 1 $ 2,845,210,000 45.2 $ 195.14 6.86

Large+Sedapal 13 $ 5,339,690,069 84.9 $ 290.52 6.69

Medium 22 $ 845,923,639 13.4 $ 14.63 1.8

Small 15 $ 105,752,256 1.7 $ 2.08 2.59

all 50 $ 6,291,365,964 100 $ 414.18 6.58

SP must establish different loss limits based on the particular analyses for each one of the asset components (fire, machinery breakdown, theft, etc...).

Commercial premium The commercial premium to be negotiated will depend on the insurable value and usually would be in the range of 1.5 to 3 per thousand. The definitive value will be offered by the insurance company depending on the calculation of the estimated maximum losses and on the limit established as maximum insured amount.

By negotiating the premiums for the group of large SP practically 85% of the estimated commercial premium for the entire sector is covered.

Table 4.2: ranGe OF prOBaBle cOMMercial preMiUM ValUeS FOr The DiFFerenT Sp GrOUpS

Type of Sp quantity exposed value range of probable annual commercial premium

[in US$] [%] [in US$ Million]

Sedapal 1 $ 2,845,210,000 45.2 $ 4.3 $ 8.5

Large+Sedapal 13 $ 5,339,690,069 84.9 $ 8.0 $ 16.0

Medium 22 $ 845,923,639 13.4 $ 1.3 $ 2.5

Small 15 $ 105,752,256 1.7 $ 0.1 $ 0.3

all 50 $ 6,291,365,964 100 $ 9.4 $ 18.0


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Table 4-2 presents the ranges of values indicative of the commercial premium values for each one of the SP groups analyzed, based on estimated exposed values.

By negotiating the premiums for the group of large SP practically 85% of the estimated commercial premium for the entire sector is covered.

DeductiblesThe deductibles to be applied would be the same as those presented in Alternative 1. In the case of other natural phenomena or events such as strike, mutiny, coup, civil or popular commotion, third-party intentional damage or terrorism, the deductible will be 10% of the loss of the affected asset with a minimum agreed-upon amount, for example, number of effective legal monthly minimum salaries.

Possible exclusions After the insurance company reviews the exposed assets, it will propose the eventual exclusion of the system components in bad condition or those that are highly vulnerable. The excluded components must be part of the assets that the SP will recondition, seeking for such components to be included in future policy terms. The negotiation should imply a reduced commercial premium.

Taking out the policy The insurance company would issue a matrix policy, the insurer would be the MEF on behalf of the National Government and of the sector, as the new legislation made MEF the competent agency for risk management in Peru.

4.4.3.4 Costs and Financing The costs associated with this risk transfer scheme correspond to the premium that should be paid for an adequate risk transfer associated with the large sector SP and to the costs associated with generating a financial capacity to cover the first risk tiers; such values would remain included in the deductibles established in the policies.

The maximum deductibles in the case of the large SP could even consider significant amounts for earthquake with

values that could be around several million US Dollars. In general, the deductibles to negotiate would be in the order of: Deductible for earthquake: from 1.00% to 2.00% of the total insurable amount or amount under concession Other natural events: from 10.00% to 15.00% (flooding and heavy winds) Terrorism or third-party intentional damage: 10.00%. Electronic equipment: 10.00% of the loss value. Other events: 10.00% with absolute value minimums.

So, the financing alternatives for these premiums could be the following:

(a) The insurance scheme could be complemented by creating or strengthening a sector risk management fund to ensure minimum resources to cover the first risk tiers and that correspond to the deductible established in the policies and to the direct and indirect losses not included in the policies.

SEDAPAL has the most critical situation with an insurable amount of around US$ 2.845 billion; the deductible amount would be around US$ 45 million. It is worth mentioning that, in SEDAPAL’s currently effective insurance policy, the deductible for the SP is round US$ 100,000. The deductible is 1.00% of the value of the affected property with a US$ 90,000 minimum and for other natural events it is 10% of the affected asset with a US$ 90,000 minimum. So, it is easy to deduce that the risk for flooding or for exposure due to civil works can be very high, even higher than the risk for earthquake. The latter must have somehow been technically justified (through a probabilistic analysis).

According to the above, it would be appropriate to create a fund with an estimated capacity to cover the eventual deductibles of the large SP.

(b) Resources as a result of service fee adjustments. This is mentioned because currently there is a request being processed by the superintendence regarding a service rate adjustment, considering a series of sector aspects.


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4.4.3.5 additional considerationsIt is important to state that the insurance policies must include as a minimum a series of aspects of special importance. Some of the most important would be:

Debris removal clauseThe debris removal clause must be defined through joint work with the insurance companies and the adjusters, contemplating risk atomization from a geographic perspective and internal operations, above all for large risks.

Maintenance programs and plansMaintenance programs and plans must be available along with the maintenance logs that manufacturers have suggested and all part replacement records and spare parts inventory for future maintenance, especially for equipment manufactured more than ten years ago.

Claim control clauseIt is important to establish beforehand the fee of the adjusters who will be in charge of each specialty in the event of a claim, based on the demanding nature and degree of specialization of the associated activities. This is particularly important if loss of profit coverage is contracted because the response capability of the adjuster is critical to the insurance company and how that affects the temporary deductible is critical to the insured party. It is worth avoiding this clause for losses under US$ 50,000.

72-hour clauseThe policy should contain this clause for the recovery of catastrophic losses due to natural events because of the

number of times that it can affect the deductibles, considering the definition of the time range for an event or a quantity of related losses.

Knowledge of risk clause The insurance company accepts that the SP contracting the insurance has given the opportunity to the insurance companies to make an inspection visit of the goods and the risks to which they are subject, as well as the insured equity. Therefore, it certifies that it is knowledgeable of the risks and that it accepts the facts, circumstances, and, in general, the conditions regarding such risks. It is essential to avoid any reticence in the statement of insurability and the SP must allow the insurance company to know and identify the risks associated with the insured assets.

4.5 Implementation and interaction with sector SP

4.5.1 implementation Now that the different risk management policies have been explained, below a risk management plan is presented that has been applied to the water supply and sanitation sector in Peru. Short term, mid term and long-term plans are presented that can also be differentiated for large SP, medium SP and small SP.

For the water supply and sanitation sector risk incorporation process, it is important to define an order of priority for the activities presented below, starting with the risk identification process but also taking into consideration the SP classification that, in this case, was done based on company size.


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laRge SP

Short Term (3 years) Mid Term (6 years) long Term (10 years)

information strategy

The SP must collect, organize, and document information on the system exposed assets, including characteristics such as:- materials- diameter- age- type of connection - structural systems- location- maintenance and modification

history.

The information must be geospatially referenced. To do so, The SP must have an appropriate geographic information system (GIS) that, in addition, will serve as a tool to identify the exposed elements and thus facilitate water supply and sanitation system design and operations.

The SP must prepare a periodical information review, maintenance, and update plan, in order to reflect modifications, replacements, repairs or acquisitions.

asset appraisal

The SP must make a general preliminary appraisal of all of the assets using local and international indicators. The appraisal must include securitization, for physical and legal sanitation services.

The SP must have more complete, detailed appraisals of each one of the assets, by consulting expert appraisers and sector experts or specialists.

The SP must implement an ongoing asset appraisal and maintenance process and it must create an internal area devoted to the work of updating the exposed values.

risk studies

The SP must conduct a probabilistic risk study including all of the assets and components. Using the results, it must characterize the vulnerability of the systems, identifying the components and contents most apt to suffer damage.

In periods of about every five years, the SP must update the risk studies, which will allow it to include modifications, replacements or other changes in its systems.

The SP must include functional risk in the risk studies, to enable a better characterization of its risk situation.

contingency plans

The SP must have response procedures or protocols for it to follow in an emergency situation, based on the risk analysis. The SP must consider the need to act jointly or in a coordinated manner with other entities, the communications media, and the community.

The SP must do simulations to assess its behavior when confronted with hazardous events and then it must identify problems or opportunities for improvement.

The SP must have internal risk coordination by creating a specific risk management area to be in charge from then on of all internal risk management matters; the area will solely require help from consulting groups regarding specific topics from time to time.

Mitigation strategy

Using the results of the risk analysis, the bases for structuring and fine-tuning, the SP must prepare a risk reduction or mitigation plan, to enable it to carry out a short-term, mid-term, and long-term investment plan.

The SP must contract specific studies and designs for component intervention purposes, taking into consideration distinct intervention measures (repair, replacement or modification) aimed at decreasing the components’ susceptibility to being affected, and thus reducing their vulnerability, by mitigating the risk through structural measures.

Taking into account its particular possibilities, the SP must gradually carry out its mitigation plan by performing intervention work according to the priority established for each component.

retention and transfer strategy

The SP must have an individual all-risk policy, following the recommendations for the sector, and if it already has a policy, it must revise it and renegotiate it based on the recommendations established for public utility companies (SP).

The SP must consider other protection measures, such as reserve funds to cover the existing policy deductible, and the negotiation of contingent loans to enable attention and reaction if a disbursement is required before the culmination of the fund formation stage. In addition, the SP must optimize the policy and premium negotiation based on the risk mitigation strategy it has in place.

The SP must start to retain the risks that it can, according to its capacity to do so and must solely transfer the risks that are beyond its capacity, using the different available mechanisms to do so.


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laRge SP

corto plazo (3 años) Mediano plazo (6 años) largo plazo (10 años)



history.



asset appraisal



The SP must implement an ongoing asset appraisal and maintenance process and it must create an internal area devoted to the work of updating the exposed values.

risk studies

The SP must conduct studies using indicators or a proxy that enable it to have a comprehensive view of the risk and a general panorama of the system conditions.


In periods of about every five years, the SP must update the risk studies, which will allow it to include modifications, replacements or other changes in its systems.

contingency plans



The SP must have internal risk coordination by creating a specific risk management area to be in charge from then on of all internal risk management matters; the area will solely require help from consulting groups regarding specific topics from time to time.

Mitigation strategy





The SP must insure the constructions identified as critical, particularly buildings and reservoirs.

The SP must have an individual all-risk policy, following the recommendations for the sector, and if it already has a policy, it must revise it and renegotiate it based on the recommendations established for public utility companies (SP).

The SP must explore the possibility of forming a pool or of being part of a group all risk insurance policy with other sector small SP and medium SP.


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SMall SP




history.



asset appraisal



The SP must implement an ongoing asset appraisal and maintenance process.

risk studies

The SP must make a general assessment of critical components that may suffer damage or present problems when different hazards actually occur.

The SP must conduct studies using indicators or a proxy that enable it to have a comprehensive view of the risk and a general panorama of the system conditions.


contingency plans

The SP must have a basic emergency response plan based on the review and general identification of possible damages and consequences.



Mitigation strategy





The small SP do not have the economic capacity to implement a short-term retention and transfer strategy.

The SP must insure the constructions identified as critical, particularly buildings and reservoirs.

The SP must explore the possibility of forming a pool or of being part of a group all risk insurance policy with other sector small SP and medium SP.


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MInISTRy OF eCOnOMICS anD FInanCe (MeF)


emergency attention fund

The MEF must have resources that enable covering reconditioning and reconstruction costs that the SP cannot cover. To do so, it must have an approximate estimate based on prior damages.

The MEF must have resources that enable covering reconditioning and reconstruction costs that the SP cannot cover. To do so, it must make an estimate using risk models.

The MEF must have resources that enable covering reconditioning and reconstruction costs that the SP cannot cover. To do so, it must make an estimate using risk models.

contingent loans approval and processing

The SP must request and apply for contingent loans, which the MEF will study and approve.

The MEF must negotiate contingent loans in such a manner as to have the resources that the SP require in the case of an emergency occurring and there not being sufficient funds in the reserves.

The MEF must negotiate contingent loans in such a manner as to have the resources that the SP require in the case of an emergency occurring and there not being sufficient funds in the reserves.

insurance policy payment coverage fund

The MEF must assess the feasibility of making total payment or partial payment of each SP’s individual insurance policy.

If feasible, the MEF must make the total payment or partial payment of the individual policies of the large SP and medium SP.

If feasible, the MEF must make the total payment or partial payment of the group policies comprising different small SP and medium SP.

Group insurance

The MEF must conduct studies, provide the necessary resources, and assess the different alternatives.

The MEF must provide resources to concrete the terms of reference for the group policy.

The MEF must provide resources to concrete the terms of reference for the group policies comprising different small SP and medium SP.

riskmanagementplan:- information- asset appraisal- risk studies- contingency plans- mitigation plans- retention and transfer

The MEF must incentivize and finance the risk management scheme proposed for the SP. It must do so for each one of the activities in the scheme according to the time windows of each SP type (small, medium, and large).



Sp operating budgets

The MEF must review and approve each SP’s operating budget. It does that on an annual basis to study the possibility of paying the insurance premiums through central budget appropriation.



Work with territorial agencies

The MEF must make a diagnosis of how the municipal governments behave regarding financing and must study the possibility of their participation.

The MEF must hold conversations with the municipal governments to discuss their participation in financing the public spending related to mitigation works for risk reduction.

The MEF must finance the municipal governments’ public spending.

preparation of laws and regulations

The MEF must make a diagnosis of the sector and it must review international cases that could be applied due to having similar characteristics to those of the Peruvian context.

The MEF must prepare the laws and regulations and have them evaluated, reviewed, and discussed by distinct experts in the different areas that interact in the water supply and sanitation sector.

The MEF must have a mandatory regulation, the contents of which must include clear, concise risk management guidelines.


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naTIOnal SanITaTIOn DIReCTORaTe (DnS)


inclusion of risk management in the sector

The DNS must collect sector information, to start to propose a strategy to be followed. It must study and assess international experiences that can serve as an example of risk management.

The DNS must prepare particular sector risk studies to implement sector risk management strategies.

The DNS must update the sector risk studies to see if the risk management policy needs updating.

Technical standards

The DNS must make a diagnosis of the current sector situation and it must assess international experiences regarding the implementation of technical standards for the sector.

The DNS must prepare a technical standard that will be open for discussion. It must include the proposal, design, construction, operation, maintenance, and readability and reconditioning of water supply and sanitation systems, including aspects of risk management, so as to guarantee minimum safety and security conditions.

The DNS must implement the technical standard and make it mandatory.

Technical assistance

The DNS must boast expertise in risk assessment and risk management, in order to give orientation to the sector SP.



Supervision of studies on:- inventory- appraisal- vulnerability- seismic risk

The DNS must supervise that the different processes mentioned, which all of the SP must carry out, are carried out in the best manner possible and according to the specific time windows for each SP type (small, medium, and large).



naTIOnal WaTeR SUPPly anD SanITaTIOn SeRVICeS SUPeRInTenDenCe (SUnaSS)


Supervision information strategy

In coordination with the DNS, SUNASS must promote and supervise on an ongoing basis the different risk management processes that all of the SP must drive, according to the proposed time windows.



Service fee regulation

Upon having the necessary studies to explore service fee modification aimed at risk management, when preparing the directives and guidelines for the Optimized Master Plans, the SUNASS must consider incorporating measures and investment for risk minimization and/or for risk transfer.

SUNASS’ financial plans and service fee studies must take into consideration investment measures, operating expenses aimed at financing risk minimization measures, whether borne or transferred through insurance policies, financed by service fees or by transfers of the national, regional or local governments, based on the payment capacity of the users or on the financial availabilities of the mentioned governments.

SUNASS must evaluate if the risk management commitments stated in the Optimized Master Plans and in the service fees studies are being met.


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4.5.2 interaction with the agencies related to the sector Below appears a brief description of the possible interaction with each one of the sector agencies involved in implementing disaster risk management in the water supply and sanitation sector SP and, in particular, those involved with protection financial strategies for the SP.

Ministry of Housing, Construction, and Sanitation The National Sanitation Directorate (DNS) ascribed to the Ministry of Housing, Construction, and Sanitation (MVCS) is the governing agency for the sanitation sector. The DNS has a positive, sensitive attitude toward catastrophic risk financial protection for the comprehensive water supply and sanitation sector and is aware of the high risks that the sector bears and of its impossibility to react and cover, under current conditions, in the event of a considerable catastrophic event, as has been proven in the past, especially if it is a small SP. In principle, the Ministry would be attentive to the sector’s financial protection strategy proposals and would seek the best alternatives to establish general policies for the topic, which could be promoted by using the results of the conducted studies.

In summary, the aspects to be discussed with the MVCS would be the following:

• Define a national riskmanagement policy forthe sector.

• Implement technical laws and regulations forwater supply and sanitation system planning, design, construction, operations, maintenance, and reconditioning, including risk management aspects at all levels. (Colombian Water Supply and Sanitation Regulation (RAS).

• DiscussmakingitmandatoryforallSPtoconductinventory, appraisal, vulnerability, and seismic risk studies, to enable them to establish a short-term, mid-term, and long-term risk mitigation plan. Establish deadlines for conducting the studies and deadlines for implementing structural measures.

• DiscussmakingitmandatoryforallSPtotakeout insurance policies under the individual SP policy alternative.

• Complement theNational Sanitation Plan withthe recommendations of this study and discuss the methodology to be used.

Ministry of Economics and Finance The Ministry of Economics and Finance (MEF) has a great amount of knowledge of risk issues and is sensitive to them. It is currently involved in issues related to fiscal vulnerability reduction strategies and risk financing strategies, which is totally compatible with the objectives proposed in this consulting document. For the MEF, the study results are of the greatest interest, for it to direct strategies at a mid term and long term to help finance viable financial protection

RegIOnal gOVeRnMenTS


Supervision The regional governments must promote and supervise on an ongoing basis the different risk management processes that all of the SP must drive, according to the proposed time windows.

The regional governments must promote and supervise on an ongoing basis the different risk management processes that all of the SP must drive, according to the proposed time windows.

The regional governments must promote and supervise on an ongoing basis the different risk management processes that all of the SP must drive, according to the proposed time windows.

economic support

The regional governments must have a general diagnosis of each SP within their jurisdiction, to quantify the necessary resources for each SP.

Based on the resource distributions established by SUNASS and by the MEF for risk management in the sector, the regional governments must provide the lacking necessary resources to the SP that have previously identified their risks.

The regional governments must continue with the financial support to the different SP that have carried out positive risk reduction activities using the previously allocated resources for that purpose.


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instruments in the sector. The MEF should support and work on financing strategies for the sector SP financial protection processes, especially for the small SP and the SP with the least financial capacity.

In summary, the aspects to be discussed with the MEF would be the following:

• Approve and process contingent loans if saidinstrument is adopted for the retention strategy.

• Determine possible lines of credit for payingthe insurance policies or for the risk mitigation programs. Define who would be responsible for said credit, considering the fact that the policies are paid annually.

• Establish mechanisms for motivating systeminterventions and thus in some manner be able to take risk mitigation measures. Increase resources for the SP, depending on the mitigation works that they perform. Incentives and actual resource flow.

• Implementtheproposedriskmanagementschemesthrough the municipalities and interacting with the SP. Currently, the risk management program exists but no mechanism to motivate such work exists. Once the mechanism is created, it would be implemented by the Public Expenditure Directorate.

• ThroughthePublicBudgetDirectorate,discussthetopic of operating budgets for each one of the SP; this task is done annually to study the possibility of paying the premiums using central budget appropriation.

• ThroughtheTerritorialAgencyDirectorate,studythepossibility of the municipal governments participating in financing the public expenditure related to mitigation works aimed at risk reduction.

• Through theGeneralMulti-Annual SchedulingDirectorate that is the national public investment system (the technical filter for the MEF), promote risk prevention and mitigation programs.

• Also,throughtheGeneralMulti-AnnualSchedulingDirectorate, prepare the laws and regulations for taking of risk management aspects into consideration in new projects as well as for generating credit lines for the intervention of the most vulnerable system elements.

Presidency of the Council of Ministers and the National Risk Management SystemThe Presidency of the Council of Ministers (PCM) is the governing agency for the National Risk Management System (SINAGERD) and for the National Disaster Prevention Center (CENEPRED).

The aspects to be discussed with the PCM would be the following:

• Receive a detailed explanation of the current lawsand regulations regarding risk management issues and, in particular, how they apply to the water supply and sanitation sector or how they can possibly be complemented.

•Discusshowthelawcouldbeusedtoapplytheriskmanagement proposal suggested in this project.

•Discuss the following questions: Does this lawcontemplate the creation of a fund for emergency attention at a national level and for eventual reconstruction? Is the law directed to the SP or is it general? What would the interaction of a water supply and sanitation sector fund entail?

National Sanitation Services Superintendence The National Sanitation Services Superintendence (SUNASS) is the regulatory and control agency for water supply and sanitation service SP service quality, service rates, and investments. Its possible interaction with the strategy would be concentrated in an eventual regulation of the strategies that the SP must adopt regarding exposed asset inventory and asset appraisal, periodical vulnerability and risk analyses, and financial protection strategy definition. Likewise, it could also become involved in the possibility of modifying the service fees depending on risk reduction or mitigation strategy implementation and on the adoption of financial protection mechanisms.

In summary, the aspects to be discussed with the SUNASS would be the following:

• Study the possiblemodification of service fees toinclude risk management aspects, in particular the eventual financing of insurance policies and risk


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mitigation project or process financing in the SP. See what the proposal to modify said service fees currently under study contemplates.

• Projectwhat the supervision and control processeswould be like if laws and regulations or initiatives of the above agencies are adopted, such as risk management plans, technical laws and regulations, etc.

• Seek the answer to the questions:How can riskmanagement plans be implemented at the SP level in the Optimized Master Plan and how can the process be controlled?

• Offerguidelinesforadoptingcontingencyplansandcontingency plan supervision, performing simulations, and other related tasks. How can the SUNASS control that? What agency could demand it to do so, to ensure implementation?.

Banking, Insurance, and Pension Fund Association Superintendence The Banking and Insurance Superintendence (SBS) is an agency that has a great amount of knowledge about and is sensitive to catastrophic risk analysis based on rigorous methodologies that imply the assessment of hazard, vulnerability, and risk. Therefore, the Superintendence has analytical capabilities regarding catastrophic risk, which enables it to have well directed, productive conversations concerning financial protection strategy analysis for different sector SP, which is one of its basic purposes. Any alternative proposed for financial protection strategies founded in rigorous risk analysis would probably win the support of the Superintendence that would become an ally for implementing said instruments.

The aspects to be discussed with the Banking and Insurance Superintendence would be the following:

• Presentthetwoproposedrisktransferschemes,theindividual one and the group one.

• Discussthedemandsforinsuranceandreinsurancecompanies regarding sector insurance, based on the two above proposals. Discuss retention capacity, capital, reinsurance demands, and others. Make a summary of existing regulations on the topic.

Insurance and Reinsurance Companies As the insurance and reinsurance market in Lima is relatively small as compared to those in other Latin American countries, according to the interviews held with some of the main insurance company officers, there is a good degree of willingness to start participating in innovative risk transfer products or in traditional special infrastructure component insurance schemes, provided that there is a minimum of quality information in terms of the exposed components and their location, appraisal, and vulnerability, thus seeking to have reliable estimates of the risk level, to enable establishing fair, equitable risk transfer rates and conditions between the parties, thus seeking a balance between the risk actually transferred and the rates associated with the transfer of said risk.

In the opinion of the insurance companies, the reinsurance companies that work in Peru (such as, for example, Lloyds-Re, Munchen-RE, Suiza-RE, Parter-Re, and others) are equally interested in this type of innovative instrument or special infrastructure component coverage under similar conditions as those indicated above. In markets such as Peru, the coverage concept and capacity that the reinsurance companies assign will define the viability of a special innovative product or of catastrophic risk coverage in non-traditional special components or systems. On one hand, rigorous exposure and risk studies are the fundamental tools to gain the participation of the insurance sector with fair rates and conditions in accordance with the reality of the risk that the sector has. On the other hand, this information could lead to situations where the level of risk is so high that it is not viable to adopt determined protection mechanisms. But at the same time it will serve as the basis for proposing alternate mechanisms.

The Public Utility Companies SEDAPAL and EMAPICAThe public utility companies (SP) involved in this pilot study for catastrophic risk analysis and financial protection alternatives are aware of the high risks that they currently bear in terms of expected losses in their water supply and sanitation systems and the lack of specific instruments to enable them to establish a short-term strategy to improve their situation. In spite of no specific regulation existing in that regard, the SP are aware of the need of having specific


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financial risk transfer instruments and of making risk analysis to prioritize the protection of the main system components as well as of making a vulnerability analysis to enable them to establish short-term, mid-term, and long-term risk prevention and mitigation plans. Also, there is evidence of the low financial capacity of some of the sector SP, especially the smallest ones. Therefore, the strategies for achieving effective protection can be different depending on the size of the SP and may, in certain cases, require the participation of agencies at a subnational or national level, for them to be able to have viable proposals that can be implemented at a short term.

The SP must clearly understand the risks to which they are exposed and the possible scenarios if a catastrophic event occurs. They should also understand and assess the different possibilities of instruments such as insurance and reinsurance, reserve funds, and contingent loans, among others. The main challenge for the SP regarding the situation of risk that they identify is to be able to adopt a risk retention and transfer structure. Thus, the definitive factors are risk awareness and the SP’s financial capacity to adopt one of the mechanisms. Risk transfer strategies under fair conditions normally require carrying out prevention, maintenance, and physical vulnerability reduction activities and the existence of contingency plans in the SP.

To win the interest of the water supply and sanitation sector agencies, it is important to illustrate the probable maximum loss results, in order to justify and create awareness of the need for insurance and reinsurance coverage, reserve funds, and contingent loans, among others. The sector SP and the insurance and reinsurance companies must be familiar with these results. Once the losses are obtained using the risk models, the main challenge is to create the sector agencies’ interest in having a risk retention and transfer structure and to achieve that the insurance companies are willing to offer protection for the infrastructure when they do not consider it reliable if a hazardous event occurs.

Association of Municipalities At the SP level, the Association of Municipalities plays an important role because it offers the possibility of the SP

uniting (grouping them by their characteristics, such as size or location) in order to apply the possible strategies mentioned above.

4.5.3 Budget reallocations The authorizations for expenditure aimed at SP investment and operations must meet the following requirements:

1. They must be stated in the running annual budget that starts in January of each year and ends in December of the same year.

All of the municipal SP and FONAFE submit their budget to the MEF (DGCP); SEDAPAL does so in the month of September the year before. Upon due justification, preparation, and presentation of the budget to these agencies, following all effective directives and laws, (Budget Law and Indebtedness Law issued annually), the agencies approve the Budget that is later ratified by the SP directors at the end of the year before the budget is in place.

There may be a budget modification in March of each year, which is usually the case. Nonetheless, the budgets have to be balanced. Transfers and contributions that are duly justified can be considered and they can be authorized with the ceilings indicated by the MEF.

Investment projects declared viable under the National Public Investment System laws and regulations must also be incorporated.

2. They must be included in the National Acquisitions Plan

Having the budget and available financial resources are necessary conditions but they are not sufficient. In addition, the SP must include their operating expenditure or investment in the Annual Acquisitions Plan and report them to the State Electronic Contracting System (the Supervisory Agency for State Contracting). This is the agency in charge of supervising purchases, acquisitions, and public awards. The plan can be updated throughout the year without any


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problem. The purpose is to generate transparency in State purchases and acquisitions.

3. Emergency situations

Budget norms become a little more flexible when there is an emergency or catastrophe that must be acknowledged by a national authority. Based on such declaration, measures to attend the emergency are activated.

For example, from 2004 to 2005, there was a draught in Lima and the abnormal flow in the Rímac River affected SEDAPAL. Notwithstanding the knowledge of the abnormal flow in the Rímac River as of the summer of 2004, it was not until May of the following year that the basin authorities declared the river in a state of emergency. Based on that declaration, SEDAPAL was able to formulate projects to make investments and attend to the emergency: it perforated new wells, reconditioned reservoirs, etc... .

Such projects are easy to formulate but they require authorization by a Committee of Ministers that grants the final approval on the eligibility of the projects (in this case, it is called eligibility not viability).

Once the project is declared eligible, the budget is modified and an urgency direct purchase can be made upon the directors’ authorization, that is to say, without a public award process. (Please note that emergency is different from urgency. The latter is defined in the Law on Acquisitions as a sudden occurrence; it is possible that there is no emergency. For example, the SP runs out of chlorine).

As was seen above, notwithstanding the fact that funds may be available to attend to emergencies, the procedures for using them are not very flexible; nevertheless, they are attenuated to some extent in situations of emergency.

The possibility of the SP having financial resources for emergency purposes is practically impossible. Only SEDAPAL shows the capacity to carry out emergency operations but

in a limited fashion. It is uncertain how it would react to events greater than the draught that had a considerably minor impact as compared to the expected losses from catastrophic events such as those quantified in Report C.

Due to the same characteristics and management indicators of the different SP presented in section 1.1, SP access to credit is quite difficult because they do not have the capacity of indebtedness; so, obtaining resources from such sources is, once again, practically impossible.

4.6 Recommendations for strengthening disaster risk management and financing The recommendations relevant to strengthening risk management and financing it at a State level and also at the sector SP level are presented below.

1. Although it has been demonstrated that in few cases the existence of an ad hoc legislation has been of unequivocal importance for driving risk management policies, it is important to acknowledge that the existence of a legal and regulatory framework is important and essential as it can legitimize the actions to be developed by the distinct agencies, which enables defining functions and thus, to a certain degree, avoiding conflicts among the agencies when it comes to delimiting their areas of competence.

The above also allows risk reduction policies to take on national importance, if not as State policies at least as a policy that is part of the total planning process. Therefore, it is important to keep driving the creation of this type of institutionalism. However, it must be accompanied by an educational and training process for the government officers, in order to achieve institutional strengthening. This must be a highly participative process in which the different groups define their priorities as well as priorities at a regional level and at a country level. It is important to bear in mind that a plan is built gradually; it is not necessarily the result of a law or of a regulation.


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2. To improve and be able to perform effective comprehensive risk management, in general, the following actions are required:

a. Clearly define a comprehensive public policy for the issue at hand.

b. Harmonize or modernize the legislation, to be able to implement said comprehensive policy.

c. Consolidate or create integrated information systems.

d. Strengthen the financial capacity for prospective and corrective risk intervention, thus also strengthening loss retention and transfer mechanisms.

4.7 Recommendations for driving risk financial protection Some recommendations regarding the development of risk financial protection are presented below.

1. Awareness must be created of the importance of adopting potential loss diversification measures, especially for losses that concern damage to public constructions such as those seen in the water supply and sanitation systems. Mechanisms such as insurance or loss transfer to the capital market, which can be subsidized by the national government, enable decreasing the State’s general fiscal burden after a disaster occurs. After defining the State’s responsibility, its estimation, and fiscal capacity, financial protection instruments with a modest scope can gradually be established, which can be enlarged through time, according to economic conditions and the insurance culture behavior in the public and private sectors.

2. After defining the State’s responsibility, careful loss assessments and modeling must be done with different return periods, to enable defining an amount or probable maximum loss, and using them it will be possible to size the contingent liability that the disasters represent. Also the pure premium value of the different water supply and sanitation systems at risk must be estimated, to establish a strategy that will enable identifying what resources are required

to cover the losses, whether they are acquired through reserve accrual (funds), or by entering into contingent loan agreements, or through loss transfer to the insurance sector or to the capital market. In addition to establishing reserves based on the reality at hand, in order to reduce fiscal vulnerability, the best argument to promote risk reduction is to acknowledge the contingent liabilities (by means of vulnerability intervention) through prevention and mitigation measures that reduce potential damages to the country’s capital stock as well as their implications or social, economic, and environmental impact.

3. The first responsibility of the SP is to have the resources to enable them to rebuild or repair the affected elements in bad condition. Currently, that responsibility has fallen on the governments that have taken on the responsibility of rebuilding and repairing public buildings. Nowadays it is not possible to establish the percentage of public property insured, their premium value, and the conditions under which they are covered (deductibles). Therefore, it is desirable to develop management programs for existing public assets in which, as a minimum, that data is recorded as well as the relevant characteristics of the constructions. That will enable assessing their vulnerability, which must include the structural system, the number of stories, the date of construction, and the geographic location. As was mentioned above, once that information is gathered, it will be possible to granulate the impact of the intense natural phenomena at a very desirable level of detail.

4. After obtaining the results of modeling potential damages to the water supply and sanitation system portfolio, using different refined risk techniques, different deductibles, and different feasible protection tiers or maximum coverage, the negotiation with the insurance/reinsurance company or with the capital market can start for a special contract for mass, unified transfer of the risk of the different water supply and sanitation systems. If that can be concreted, the above decision implies each SP estimating the coverage costs


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from its own budget, weighting the value based on the exposed elements for which it is in charge, and defining a collection mechanism or a budget retention mechanism from the MEF.

5. In the event that a final protection scheme cannot be concreted at a national level, implementation among SP clusters in provincial departments are municipalities can be attempted. Currently, most of the SP do not have the capacity to contract this financial protection and history has shown that it is the government (mainly at a national level) that bears the losses and rebuilds the damaged elements after major events. As was explained above, although this is a recurring situation, it is not the most appropriate scenario and the national government could promote a strategy to motivate the territorial agencies to bear part of the responsibility or to motivate the SP to take on the task themselves. The national government could generate an incentive consisting of bearing a part of the premium that could be defined either by classifying the SP by size, or, more desirably, by incorporating different risk management indicators to reward the SP that have taken and applied the best measures.

6. To raise the efficiency of the insurance, it is important to promote refined catastrophic risk modeling of the different portfolios in the hands of the insurance companies, in such a manner as to have variable values for probable maximum losses and the value of technical premiums based on appropriate technical scientific information.

7. The different SP could explore taking out an insurance policy either individually (the large SP) or jointly (for large SP and small SP) with an offshore captive insurance or reinsurance company. This may reduce costs paid for insurance premiums and perhaps obtain better risk management. Using this figure, the SP can administrate their own risks and, at the same time retain the premiums that are paid for the insurance to companies that basically would do the fronting in each country. If this mechanism could be implemented, it would raise the financial efficiency of the insurance and reinsurance mechanism (one sole policy for mass risk transfer). That would represent better reinsurance conditions and the creation of reserves for the SP with the same financial protection objectives, enabling covering the deductible value.

8. The issuance of a CAT Bond can raise financial efficiency if the cost of the water supply and sanitation sector systems portfolio is significant. In time, this instrument is considered to become more and more competitive and feasible and, at any rate, it is a complementary option or alternative for covering the upper tiers of a financial retention and transfer structure, as was presented above. Likewise, contracting contingent loans to increase disaster fund reserves (mainly in the years after the year of its creation), cover the deductibles, reduce the premiums, and enlarge the insurance base for the sector is also a complementary mechanism that can raise the government’s financial efficiency and strengthen comprehensive risk management.

Peru: Disaster Risk Management in Water and Sanitation Utilities. Volume II annex 1

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5.1 OverviewProbabilistic risk assessment basically aims to determine the distributions of loss probability that the exposed assets may suffer due to the occurrence of natural hazards in given periods of time, integrating in a rational manner the uncertainties that exist in the different parts of the process. The basic question that the probabilistic risk analysis must answer is: Given that a set of assets is exposed to the effects of one or more natural hazards, with what frequency will there be losses that exceed a given value?

As the frequency of catastrophic events is particularly low, the above question cannot be answered by formulating purely empirical models of the occurrence process for such events. To answer the above question, probabilistic models such as the one described herein must be built.

So, in summary, the probabilistic calculation procedure consists of assessing losses for the set of exposed assets in each of the scenarios that collectively describe the hazard and then probabilistically integrating the results obtained using the frequencies of occurrence for each scenario as weighting factors.

Probabilistic risk analysis involves uncertainties that must be taken into account and that must be propagated throughout the calculation process. The next section describes the general calculation basis for meeting the objective stated above.

5.2 identification of the basic information required According to the project characteristics, an evaluation was made of the type of information required to make the necessary assessments on different topics in different levels of detail. Tables 5-1 through 5-4 summarize the main information required to make this type of analysis.

Annex 1: Probabilistic Risk Modeling Methodology

V.

Table 5.1: DeTaileD SeiSMic hazarD inFOrMaTiOn,

reqUeSTeD FrOM The SerVice prOViDerS (Sp)

SeiSMic hazarDS in ciTieS Or TOWnS

General reference information

Political-administrative boundaries*

Digital level curves or digital elevation model

Urban area limits*

Rivers and streams

Basic road network

Inventory of past seismic events and their effects

information regarding seismic hazards (based on national studies)

Local and regional tectonic information

Ground acceleration records for the area

Past event intensity maps

Seismic microzonation information (based on prior studies)

Seismic microzonation maps*

Related studies and reports

Surface and local geological maps

Geo-morphological map

Geo-technical zonation map

Ground deposition thicknesses*

Landfill area maps

Detailed geo-technical profile – existing soundings*

Statistical and dynamic geo-technical properties of the ground

Deposition wave velocities


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Table 5.2: DeTaileD BaSin FlOODinG hazarD inFOrMaTiOn, reqUeSTeD FrOM The Sp

inDicaTiVe BaSin FlOODinG hazarDS (for approximated analyses)




Geo-morphological map

Map of ground usage in the basin*

Plant cover map*

Geo-technical zonation map

Basin and micro basin limits*

Basin axis and drain pipe stretch*

Principal and secondary channels*

Topographical map scaled at 1:2000*

Digital level curves every 2 meters

Digital elevation model with a 30-meter resolution*

Urban area limits

General map of rivers and streams

Basic road network

Inventory of past events and their effects, including the boundaries of the affected areas and the characteristics of the damages

hydrological information

Existing studies of hazards due to flooding and torrential downpours

Location and characteristics of hydro-meteorological stations (minimum three stations per basin)*

Inventory of historical events, with their impact and effects*

Intensity-area-duration-frequency curves (as an alternative to the hydrological information)

Table 5.3: DeTaileD lanDSliDe hazarD inFOrMaTiOn, reqUeSTeD FrOM The Sp

inDicaTiVe lanDSliDe hazarD BY SecTOr (not particular slopes, information for indicative hazard analyses)




Geomorphological map

Map of ground usage in the area under study*

Plant cover map*

Geotechnical zonation map

Principal and secondary riverbeds*

Topographical map scaled at 1:2000*

Digital elevation model with a 30-meter resolution*

Urban area limits

General map of rivers and streams

Basic road network

Geo-technical information

Existing landslide hazard studies

Prior events with their impact and damages*

Inventory of potentially unstable areas*

Aerial photographs for photographic interpreting

Satellite images

Thickness of depositions that can slide

Geotechnical ground properties

Geotechnical properties for deep stratum (density)

Dominant types of faults by area*

Subsurface level measurements in critical areas


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Table 5.4: DeTaileD riSK, eXpOSUre anD VUlneraBiliTY STUDY inFOrMaTiOn, reqUeSTeD FrOM The Sp

riSK STUDY FOr inFraSTrUcTUre cOMpOnenTS: eXpOSUre anD VUlneraBiliTY inFOrMaTiOn

General System information

General description of the system and its components

Number of users

Total supply during normal operations and in emergency situations

Unbilled water and losses

Total valuation of the system and its components

Balance sheet and profit and loss statements

Billing statistics

Existing insurance contracts that include business interruption

Current contingency plans

Reports on events and damage statistics

Operating problems

Redundancy analysis

Tank and plant information

Location, in geographic coordinates

Tank capacity

Photographs of the surroundings and of the structure

Type of terrain on which it is located

Dimensions

Structure materials

Wall thicknesses

Retrofitting available for concrete tanks

Average tank level

Type of cover

Type of joints

Tank condition or prior damages

Approximate economic value

Ranking the importance of the element

Percentage of users attended during normal operations and in emergency situations

Table 5.4: DeTaileD riSK, eXpOSUre anD VUlneraBiliTY STUDY inFOrMaTiOn, reqUeSTeD FrOM The Sp cOnTinUe

riSK STUDY FOr inFraSTrUcTUre cOMpOnenTS: eXpOSUre anD VUlneraBiliTY inFOrMaTiOn

Degree of redundancy (percentage of the service that is affected if it stops operating)

information for pipe line systems by homogenous stretch

Digital information tier by stretch with geo-spatial information in standard format

Stretch identification number

Stretch length

Photographs of typical areas

Type of pipe line and materials (specifications)

Outer diameter

Wall thicknesses

Age

Type of joints

Depth

Landfill material

Types of surface loads

Maximum operating pressure

Instrumentation information (if available)

Prior reported damages

Unit economic value

Specific repair value

Relative importance of the stretch

Degree of redundancy (percentage of the service that is affected if it stops operating)

information on additional relevant elements

Intake pipes

Location of important valves

Location of pumping stations

Pressure reducers

Administrative sites

Location of maintenance equipment

Other important system components


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5.3.2 Basic risk calculation equationConsidering the basic objective of probabilistic risk analysis as stated above, it is necessary to propose a specific methodology for calculating the occurrence frequencies of specific levels of loss linked to the exposed assets during given periods of time after the occurrence of natural hazards.

Risk due to natural hazards is commonly described by using the so-called loss exceedance curve, which specifies the frequencies, usually annual, with which events that exceed a specified loss value will occur. The annual exceedance frequency is also known as the exceedance rate and it may be calculated using the following equation, which is one of the many forms adopted in the total probability theory:

(Eq. 5-1)

In the above equation, v(p) is the loss exceedance rate of loss p and FA(Event i) is the annual frequency of occurrence of Event i whereas Pr(P>p|Event i) is the probability that the loss may be higher than p, given the occurrence of Event i. The sum in the above equation is done for all potentially damaging events. v(p) inverted is the return period of loss p, identified as Tr.

As will be explained further on, the loss curve contains all the necessary information to describe, in terms of probability, the occurrence process of events that generate loss.

Loss p, referred to in Equation 5-1 is the sum of the losses that will occur in all of the exposed assets. It is worth pointing out that:

• Lossp is an uncertain amount, for which a precise value cannot be given in the occurrence of an event. Therefore, it must be seen and treated as a random variable and mechanisms for knowing its probability distribution after the occurrence of a certain event must be provided.

Great detail is required for the above-mentioned information according to the project characteristics, and even more so because the activity is carried out in densely populated areas where higher levels of resolution are required in the event of a hazard (calculation grid with 1 km to 3 km spacing) in order to properly cover the variations that the hazard may have.

5.3 Risk analysis

5.3.1 risk analysis procedure Risk assessment requires three steps in the analysis; they are described below.

• Hazard assessment. A set of events is defined with its corresponding occurrence frequencies for each of the hazards under study, thereby integrally representing the corresponding hazard. Each scenario contains its own spatial parameter distribution for building the distribution of probability of the intensities produced by its occurrence.

• Defininiton of the inventory of exposed elements. The inventory of exposed elements must be defined; it must specify the geographical location of the exposed asset and it must contain the following parameters that qualify the element:

- Physical value or replacement cost of the asset - Human value or estimated number of occupants - Structural type to which the asset belongs.

• Vulnerability assignment for buildings. A vulnerability function for each type of hazard must be assigned to each structural type. The function characterizes the behavior of the building during the occurrence of phenomena that represent a hazard. Vulnerability functions define the distribution of the probability of loss in function of the intensity produced during a specific scenario. They are defined using curves that show the average value of the damage and the standard deviation of the damage with the intensity of the phenomenon.

v(p) = Pr(P> p Event i)FA (Event i)∑Events

i=1


86

• Loss p is calculated as the sum of the losses that will occur in all of the exposed assets. Each of those amounts is a random variable and a certain level of correlation exists among them, which must be included in the analysis.

Given Equation 5-1, the probabilistic risk calculation sequence is the following:

1. For a given scenario, determine the loss probability distribution for each one of the exposed assets.

2. Based on the loss probability distribution for each asset, determine the probability distribution for the sum of those losses, taking into account the correlation that exists among them.

3. Once the probability distribution for the sum of the losses for that event is determined, calculate the probability of the loss exceeding a certain value, p.

4. The probability determined in Step 3, multiplied by the annual frequency of occurrence of the event, is

the contribution of that event to the loss p exceedance rate.

The same calculation sequence is repeated for all of the events, and this provides the result stated in Equation 5-1.

It is also worth pointing out that in Equation 5-1 no distinction is made among events that belong to different hazards. In fact, the sum of that equation could include, for example, seismic events and hurricanes or seismic events and volcanic eruptions. This can be done because the assumption is that events associated with a certain hazard as well as events associated with different hazards do not occur simultaneously. However, some potentially damaging phenomena do occur simultaneously; therefore, it is necessary to take special care when determining the distribution of probability of p in those cases, which will be analyzed in the following section.

Figure 5-1 presents a flow chart of the probabilistic risk assessment process using a multi-hazard approach.

FIgURe 5.1: prOBaBiliSTic riSK aSSeSSMenT MeThODOlOGY

RESULT

Calculate the occurrence frequency for the risk

Calculate risk measurements:- Damage as a %

- AAL- PRP - PML- RSC

- Effects on the population

For each hazard

For each scenario

For each portfolio

For each component

Loss probability frequencies for each scenario


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(because several hazards occur at the same time). For this project, the following expression is proposed for assessing the loss for each exposed asset; it corresponds to a cascading damage model, in which the order of exposure to the different intensities is irrelevant:

(Eq. 5-2)

where Pi is the loss associated with scenario i, Pij is the loss associated with scenario i on account of hazard j, and M is the number of simultaneous hazards considered in the temporality to which scenario i belongs.

It is important to remember that Pij represents random variables; therefore, Pi is also random. Nonetheless, if the distributions of probability of the Pij are known and reasonable assumptions regarding their level of correlation are made (e.g. that they are perfectly correlated), the moments of the distribution of probability of Pi may be determined using Equation 5-2.

5.3.4 UncertaintiesAs was shown in Equation 5-1 and as was stated above, the loss for a set of exposed assets during a scenario is an uncertain amount that must be treated as a random variable.

In general, it is not practical to directly determine the loss probability distribution for an exposed asset conditioned by the occurrence of a scenario. In other words, for example, it is not practical to determine the loss probability distribution for a building because a seismic event that recorded a magnitude of 6 occurred some 100 km away.

For methodological purposes, loss exceedance probability p, after an event, is usually expressed as follows:

(Eq. 5-3)

According to the table above, the seismic event –understood as the movement of the ground due to the passing of seismic waves–, the tsunami, and the landslides that may be induced by such movement would occur in the same temporality (temporality 1, according to Table 5-5) but in a different temporality from the one during which damages caused by wind, tide storm, and flooding would occur.

Therefore, loss assessment for a certain scenario is made taking into account that hazards that belong to the same temporality occur simultaneously. There is no simple ambiguous-free way to assess losses under such conditions

5.3.3 hazard temporality Some natural phenomena generate different types of losses that occur simultaneously. For example, a hurricane generates a field of strong winds as well as floods due to the rising tide and associated torrential downpours; therefore, the damages caused by wind and floods occur almost at the same time and cannot be considered independent events.

In the case mentioned above, three different hazards (wind, flooding due to tide storms and flooding due to excess rainfall) occur simultaneously and are associated with the same temporality.

Taking the above into account, the hazards studied in this phase of the project may be grouped by temporality, as is shown in Table 5-5. Table 5.5 : hazarD TeMpOraliTY

hazarD TeMpOraliTY analYSiS

TeMpOraliTY

Type of hazard 1 2 3

Seismic event

Tsunami

Flooding

Landslide

Pi = (1−Pij)M

j=1∏

∫ >=>I

dIEventIfIpPEventpP )|()|Pr()|Pr(


88

has. In the insurance industry, for example, the return periods used to define PML range from 200 years to at least 1,500 years.

5.3.6 probability of loss Value exceedance The loss curve, v(p), calculated applying Equation 2-1 indicates the frequency with which events that may generate losses equal to or greater than a given loss value p will occur. If the assumption is that the occurrence process of the events in time is the same as a Poisson process, then the probability that loss p may be exceeded in the period of time T, meaning in the next T years, may be calculated, using the following expression:

(Eq. 5-5)

where Pe(p,T) is the probability that loss p may be exceeded in the next T years.

5.3.7 Sole scenario analysis Probabilistic risk analysis is normally made for the complete set of scenarios specified in the different hazards. However, the analysis may also be made for only one scenario (only one of the addends in Equation 5-1). If the annual occurrence frequency for that scenario is 1, Equation 5-1 would show the probabilities of exceedance (no longer annual frequencies of exceedance) of loss values p, given the occurrence of the scenario in question.

This case has important applications in the field of territorial planning because its results, mapped, for example, in terms of average annual loss value, may be easily incorporated into territorial planning plans.

5.4 Hazard and risk analysis For this project taking into account the suggested scope, only seismic, flood and landslide hazards will be analyzed in independent temporalities, as those are the hazards that could generate catastrophes in the infrastructure under study. As for exposure, all exposed elements will be considered according to the information provided by the SP, including

The first integer term, Pr(P>p|I), is the probability that the loss will exceed the p value, considering a local intensity of I. So, that term takes into account the uncertainty that exists in vulnerability relations. Also, the term f(I|Event) is the probability density of the intensity, conditioned by the occurrence of the event. That term takes into account the fact that, because an event occurred, the intensity at the place of interest is uncertain.

5.3.5 Specific risk estimatorsAs was stated above, the curve calculated applying Equation 2-1 contains all the information needed to characterize the occurrence process of events that generate losses. However, at times it is not practical to use a complete curve; it is more convenient to use specific risk estimators that allow expressing the process using one sole amount. Below are the two most commonly used specific risk estimators.

(a) Average annual loss (AAL). This is the expected amount of annual loss. It is an important amount because it indicates, for example, that, if the occurrence process of damaging events were to remain unchanged from here to eternity, its cost would be equal to having paid the AAL amount every year. Therefore, in a simple insurance system, the average annual loss would be the fair annual pure premium. The AAL may be obtained through v(p) integration or using the following expression:

(Eq. 5-4)

(b) Probable Maximum Loss (PML). This loss occurs very seldom, meaning that it is associated with a very long return period (or, alternatively, with a very low exceedance rate). There are no universally accepted standards to define “very seldom”. In fact, selecting a certain return period to make a decision depends on the risk aversion that the person making the assessment

∑ i) ()i (1

EventFEventP|EAAL A

Events

i==

TpeTpPe )(1),( ν−−=


www.wsp.org 89

among others the whole water supply and sanitation pipe line system, tanks and tanks, wells, treatment plants, system administrative buildings and other components.

Hazard, vulnerability and risk analyses are made using the following computational tools developed by the ERN-AL Consortium:

- CRISIS 2007- ERN-Inundación (ERN-Flooding)- ERN-Deslizamiento (ERN-Landslide)- ERN-Vulnerabilidad (ERN-Vulnerability)- ERN-CAPRA-GIS.


90

The risk analysis results (see Volume I Sections 2.3 and 2.4) enable making a highly approximated overall assessment of the general catastrophic risk profile for the sector. This approximated preliminary analysis is made using the following assumptions and considerations:

• Theassumptionisthatthesectorcatastrophicriskiscontrolled by seismic events. This may not be true for many of the SP where the most common catastrophic risk is flooding or landslides. Nevertheless, for the sector at large, seismic events are definitely the most common catastrophic events.

• The assumption is that there is geographicalindependence in the SP risk assessments, meaning that the assumption is that one earthquake does not simultaneously affect more than one SP.

• Theassumptionisthattheexposedvalue,thetypesofcomponents, and the vulnerability of each SP are based on the related information of the two SP for which the detailed analyses were made (see Volume I).

• GiventhattheSPcasestudiesare forone largeSPand for one small SP, the assumption is that the

Annex 2: General Diagnosis of the Catastrophic risk for the Sector

VI.

component portfolio for all the large SP has exposure and vulnerability similar to those of SEDAPAL whereas the component portfolio for all the medium and small SP has exposure and vulnerability similar to those of EMAPICA. However, the assumption solely applies for calculating a general risk indicator for each of the 50 SP; therefore, detailed individual studies for each SP are required in order to calculate a more precise value.

• The economic exposure valuation is based on thetotal number of users attended in each SP and the corresponding unit values in the two analyzed SP. There is a great difference in the economic exposure valuation of large SP and that of small SP whereas for the medium SP an intermediate value was used.

• Theanalysistakesintoaccountthespecificlocationof each SP from the perspective of a seismic hazard in a spot that represents a general, standard level of hazard for each SP.

• This analysis solely indicates the overall sector riskassessments and must not be used for any purpose other than the one established herein.


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0

-2

-4

-6

-8

-10

-12

-14

-16

-18

AGUAS DE TUMBES

EPS GRAU S.A.EPSSMU S.R.LTDA

EMAPA HUARAL S.A.

EPS MARAÑÓNEMAPAB S.R.LTDA.

EPS SEDALORETO S.A.

EMAPA MOYOBAMBA S.R.LTDA.

EMAPA SAN MARTÍN S.A.

EMAPACOP S.A.

SEDACAJ S.A.

EPSEL S.A.

SEDALIB S.A.

EPS CHAVÍN S.A.SEDA HUÁNUCO S.A.

SEDACHIMBOTE S.A.

EMAPA PASCO S.A.

EPS SELVA CENTRAL S.A.

EPS SIERRA CENTRAL S.A.

SEMAPA BARRANCA S.A.

EPS TACNA S.A.

EPS ILO S.R.LTDA.

EPS MOQUEGUA S.R.LTDA.

SEDAPAR S.A.EMSA PUNO S.A.

SEDAJULIACA S.A.

NOR PUNO S.A.

EMAPAVIGSSA

EPSASAEMSAP CHANKA

EPS AGUAS DEL ALTIPLANOEMPSSAPAL S.A.

EPS - SEDACUSCO S.A.EMUSAP ABANCAY

EPS CALCA

EMAPAT S.R.LTDA.

EMAPA HUANCAVELÍCA S.A.C.EMAQ S.R.LTDA.

SEDAM HUANCAYO S.A.C.SEDAPAL S.A.EPS MANTARO S.A.EMSAPA YAULI

EMAPA CAÑETE S.A.

EMAPICA S.A.EMAPISCO S.A.SEMAPACH S.A.

EMAPA Y

EMUSAP AMAZONASSEDAPAR S.R.L. (Rioja)

-82 -80 -78 -76 -74 -72 -70 -68

750

720

690

660

630

600

570

540

510

480

450

420

390

360

330

300

270

240

210

180

150

120

90

60

30

0

EMAPA HUACHO S.A.

FIgURe 6.1: SeiSMic hazarD in perU, pGa, rp = 500 YearS


92

Tables 6-1 and 6-2 summarize the general results of the approximated risk assessment for all the sector SP. These tables show for each sector SP the estimated total exposed value and the probable maximum loss as an amount and as a percentage of the exposed value for each SP independently from the system for a 1,000-year return period.

Table 6.1: riSK inDicaTOr FOr The 50 Sp in perU (cOnTinUeS On TaBle 2-15)

iD name exposed value pMl for rp = 1,000

[US$] [in US$ million] [%]

1 EMUSAP AMAZONAS $ 7,256,742 $ 1.11 15.3

2 SEDA Huánuco S.A. $ 61,923,343 $ 7.37 11.9

3 EMAPACOP S.A. $ 39,619,888 $ 2.67 6.74

4 EPS SEDALORETO S.A. $ 150,184,201 $ 1.81 1.21

5 EMAPA CAÑETE S.A. $ 49,117,334 $ 6.30 12.83

6 EMSA PUNO S.A. $ 62,434,479 $ 13.14 10.52

7 EPSSMU S.R.LTDA $ 7,727,959 $ 1.20 15.57

8 AGUAS DE TUMBES $ 61,821,462 $ 8.65 14

9 EMAPA PASCO S.A. $ 19,367,881 $ 2.30 11.9

10 EMAPISCO S.A. $ 33,299,770 $ 4.86 14.59

11 SEDACAJ S.A. $ 55,993,484 $ 6.46 5.77

12 EPS TACNA S.A. $ 149,489,140 $ 10.89 7.28

13 EMAPAVIGSSA $ 8,790,677 $ 1.72 19.57

14 SEDACHIMBOTE S.A. $ 164,678,669 $ 12.87 7.81

15 EPSASA $ 98,652,251 $ 5.92 6.01

16 EMAPA San Martín S.A. $ 60,659,320 $ 7.22 11.91

17 EMAPAT S.R.LTDA. $ 19,431,773 $ 0.54 2.8

18 SEMAPACH S.A. $ 64,800,206 $ 8.80 13.57

19 EPS SELVA CENTRAL S.A. $ 32,797,269 $ 3.90 11.89

20 EMAPA MOYOBAMBA S.R.LTDA. $ 22,733,430 $ 2.70 11.9

21 EMAPA HUANCAVELICA S.A.C $ 8,532,748 $ 1.02 11.97

22 EPS MOQUEGUA S.R.LTDA. $ 31,054,919 $ 3.29 10.59

23 EMAPA Y $ 5,166,026 $ 0.70 13.48

24 EMAPA HUARAL S.A. $ 23,577,840 $ 1.56 6.61

25 EMAPA HUACHO S.A. $ 37,675,502 $ 3.74 9.94

26 SEDAPAL S.A. $ 2,845,210,000 $ 195.14 6.86

27 EPS ILO S.R.LTDA. $ 37,627,152 $ 4.43 11.77

28 SEDALIB S.A. $ 328,899,129 $ 29.69 9.03


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Table 6.2: riSK inDicaTOr FOr The 50 Sp in perU (cOnTinUeD FrOM TaBle 2-14)

iD name exposed value pMl for rp = 1,000

[US$] [in US$ million] [%]

29 EPSEL S.A. $ 315,903,249 $ 27.78 8.79

30 SEDAPAR S.A. $ 484,384,834 $ 35.01 7.23

31 EPS - SEDACUSCO S.A. $ 135,510,434 $ 6.83 5.04

32 EPS GRAU S.A. $ 383,293,227 $ 39.31 10.26

33 EPS CHAVIN S.A. $ 38,846,278 $ 3.94 10.14

34 EMAQ S.R.LTDA. $ 6,647,880 $ 0.65 9.73

35 EMAPAB S.R.LTDA. $ 5,840,611 $ 0.89 15.24

36 SEMAPA BARRANCA S.A. $ 28,504,424 $ 3.48 12.2

37 EMAPICA S.A. $ 53,767,100 $ 10.51 19.54

38 EMPSSAPAL S.A. $ 20,241,646 $ 1.49 7.34

39 EPS SIERRA CENTRAL S.A. $ 11,314,168 $ 1.74 15.35

40 NOR PUNO S.A. $ 9,088,288 $ 0.89 9.76

41 SEDAJULIACA S.A. $ 91,582,103 $ 6.58 7.19

42 EPS MANTARO S.A. $ 25,639,649 $ 1.53 5.98

43 EMUSAP ABANCAY $ 18,756,591 $ 1.41 7.5

44 EMSAP CHANKA $ 4,645,208 $ 1.06 11.41

45 EPS MARAÑON $ 11,497,695 $ 0.74 6.42

46 SEDAM HUANCAYO S.A.C $ 138,135,730 $ 15.11 10.94

47 EPS CALCA $ 3,154,674 $ 0.31 9.71

48 EPS AGUAS DEL ALTIPLANO $ 6,437,072 $ 0.63 9.73

49 EMSAPA YAULI $ 3,341,921 $ 0.38 11.51

50 SEDAPAR S.R.L. (Rioja) $ 6,310,588 $ 0.97 15.4

Figure 6-2 shows the schematics for the results obtained for the 501 sector SP in terms of PML as a % and the equivalent results for PML as an absolute value in US$ million.


94

87

15

291

11

20

16

51

28

33 2

3

14

36 2425

9

3919

504226 46

521 34

47

388

4

17

PML for Tr = 1,000 years,in US$ million

0 - 1515 - 30

30 - 45

45 - 195

35

N N

10 15

19

4443

3138

4840

4130

22

623

1227

0 - 44 - 88 - 1212 - 1616 - 20

PML for Tr = 1,000 years

32

Furthermore, the analysis was made for each of the 50 sector SP groups and for the entire set of sector SP. Table 6-3 summarizes the corresponding results.

FIgURe 6.2: General riSK inDicaTOrS FOr The Sp in perU prOBaBle MaXiMUM lOSS (pMl)FOr a 1,000-Year reTUrn periOD (Tr)

Table 6.3: prOBaBle MaXiMUM lOSS FOr The DiFFerenT Sp GrOUpS

Type of Sp number of Sp

exposed Value pMl for rp = 1,000

[US$] [%] [in US$ million] [%]

SEDAPAL 1 $ 2,845,210,000 45.2 $ 195.14 6.86

Large+SEDAPAL 13 $ 5,339,690,069 84.9 $ 290.52 6.69

Medium 22 $ 845,923,639 13.4 $ 14.63 1.8

Small 15 $ 105,752,256 1.7 $ 2.08 2.59

All 50 $ 6,291,365,964 100 $ 414.18 6.58


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Figure 6-3 summarizes the probable maximum loss results for the different sector SP groups.

6.1 Financial risk management indicatorsThe above statistics enable establishing a series of indicators, to be used by the sector SP and by the sector as a whole for financial risk management purposes. The proposed indicators are the following:

- Probable maximum loss for 1,000 years as a percentage of the estimated exposed value for each SP.

FIgURe 6.3: prOBaBle MaXiMUM lOSS FOr The Sp GrOUpS

$ -

$ 50

$ 100

$150

$ 200

$ 250

$ 300

$ 350

$ 400

$ 0

$ 1,000

$ 2,000

$ 3,000

$ 4,000

$ 5,000

$ 6,000

$ 7,000

Sedapal Large+Sedapal

Medium Small All

Type of SP

Value Exposed value [US$] Probable Maximum Loss [US$]

- Average annual loss (estimated at 5 per thousand of the exposed value) as a percentage of annual operating income.

Figures 6-4 and 6-5 summarize the results for this indicator for each sector SP.


96

FIgURe 6.5: aVeraGe annUal lOSS aS a percenTaGe OF The OperaTinG incOMe

FIgURe 6.4: prOBaBle MaXiMUM lOSS aS a percenTaGe OF The eXpOSeD ValUe

0

2

4

6

8

10

12

14

16

18

20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25S

edap

al 27 28 29 30 31 32 33 34 35 36E

map

ica 38 39 40 41 42 43 44 45 46 47 48 50 51 All

Pro

bab

le M

axim

um L

oss

SP identification number

0

2

4

6

8

10

12

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25S

edap

al 27 28 29 30 31 32 33 34 35 36E

map

ica 38 39 40 41 42 43 44 45 46 47 48 50 51 All

Ave

rage

Ann

ual L

oss

SP identification number


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6.2 general diagnosis of the sector risk situationOn one hand, as was presented in Section 2.1.3, the management indicators and the financial indicators for the SP are discouraging and the improvement of SP operating aspects is required for them to achieve better performance in the area of risk management. On the other hand, the sector shows high risk valuations (probable maximum loss of US$ 400,000,000 for the sector for one event with a 1,000 year return period) because of a combination of high hazard levels, (mainly seismic hazards (see Figure 2-14), flood hazards, and landslide hazards, among others) and high exposure levels (Jointly, the SP have an approximated exposed value of US$ 6,000,000,000) based on the elements that comprise the different system components, which (as discussed in Volume I) present high vulnerability in respect to the above-mentioned hazards.

The financial capacity of the SP, with a few exceptions, is quite low and, in most cases, the SP would not even be able to cover a percentage of the eventual losses that they may suffer due to significant seismic events or due to the occurrence of any other highly destructive event. Moreover, many SP would have problems financing the costs of eventual emergency relief and of reestablishing service after the occurrence of a severe event. Calculated probable loss values for events with a 1,000 year return period for EMAPICA represent twice its operating income whereas for SEDAPAL those same values represent a little less than half of its annual operating income; that is still a high figure from any point of view.

The resources that each SP must assign correspond to the premium calculated for the cases of SEDAPAL and EMAPICA in Volume I, using the amounts calculated therein except for possible reductions in the commercial value due to deductibles and the exclusion of a few components in the insurance policy. In addition, amounts allocated for vulnerability reduction based on maintenance and/or retrofitting plans for existing

components, which may also lead to reductions in premium values must be included in the resources.

Moreover, it is discouraging that the estimated average annual loss is an average of 4% of the SP’s operating income as that makes it very difficult to propose the implementation of a possible risk transfer mechanism. The consultants consider that, in practice, it would be difficult to pay an average annual loss of that magnitude. Although no risk standard exists, based on experience, a favorable percentage for the above relation would be under 0.5 %. The decision regarding what value the SP is willing to bear is up to each SP, taking many factors into account.

Because of the characteristics innate in high magnitude seismic events that may mainly occur in the Pacific coast of Peru, it is likely that, as occurred during the seismic event in August 2007, several service provision systems may be damaged if another seismic event with that magnitude should occur. In such an event, it is probable that the State would bear the responsibility of financial relief and of financing the repair works.

In regards to future seismic events, the systems have many high-vulnerability elements that will probably suffer the most damage after the occurrence of high-impact events. The above conclusion is valid for both of the assessed systems because, in general terms, they have in common material exposure and vulnerability characteristics as well as the same expected magnitude of intensity for seismic events, as may be seen in Volume I. The seismic scenarios indicate a concentration of significant damage in components such as tanks, wells or certain types of old pipe lines, such as those made of plain concrete or asbestos cement.

Also, floods can generate important losses for the sector as they cause additional damage to critical components, such as sanitation system pipes, due to pressurization and silting problems, or partial or total damage to wells in the form of flooding and contamination.


98

When it comes to facing possible expected risk situations, evidence shows that most SP would not be able or would be very limited in their ability to handle emergencies and even less so when it came time to initiate reconstruction and repair processes. Only SEDAPAL and probably a few SP more (in the large SP group) would be able to handle eventual emergency situations. Nonetheless, it is safe to say that practically no SP would be able to initiate repair or reconstruction processes given one of the possible catastrophic event scenarios. The National Sanitation Services Superintendence (SUNASS) classified the different sector SP into three categories, taking into account the great seismic hazards to which the Peruvian SP are exposed and the high risk values presented.

Upon reviewing the different management indicators presented in Section 1.1, it can be affirmed that even under normal circumstances many SP have operating and financial problems. That situation may be seriously aggravated by the occurrence of a catastrophic event; as was seen in the Pisco, Ica, and Cañete area after the 2007 seismic event; indeed, the SP there still face serious operations problems.


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7.1 Transfer and retention instruments

7.1.1 Financial risk transfer In recent years it has been amazing to witness the long-term upward trend in the number of natural or social disasters in developing countries. Add to the above, of the societies’ greater vulnerability to events of great magnitude, such as earthquakes and inundations, which has increased the expected loss of human life as well as the expected loss of physical capital. The accelerated urbanization process and the growth of poverty have overpowered conventional schemes for traditional social assistance and protection, leaving broad sectors of the population without any possibility of reaction.

Although it is true that institutional changes have been implemented, which have introduced modern schemes to confront the disasters, the problems of organization and resource allocation to risk prevention and mitigation activities persist. In parallel, financial markets have become globalized, permitting nationals to have access to external resources and financial derivatives that may reduce the population’s exposure and family equity exposure after the occurrence of natural phenomena. Consequently, the countries must promote and use the risk transfer coverage mechanisms developed in the capital markets, thus minimizing private losses and the State’s fiscal exposure. Humanitarian aid is not sufficient and does not solve the problems, the government’s cannot sustain their policies in what has been called the First Lady syndrome (Wilches, 2000). In reality, global experience shows that natural disaster insurance has two great advantages: it stimulates prevention directed by the insurance companies and guarantees post-disaster reconstruction activities financing and efficiency.

Extreme disasters are characteristically low-frequency, high severity phenomena for which it is difficult to predict the

Annex 3: Risk Transfer and Retention Instruments

VII.

time when and the place where they will hit. Due to their characteristics, the losses that such events produce can cause solvency problems insurance market, augment premium prices, and reduce the available insurance and reinsurance supply, thus generating great distortions that can diminish efficient market functioning. The capital market has provided an answer to that problem by developing financial instruments (complementary to the insurance industry) that enable transferring and financing the financial risk that the losses that can be suffered after the occurrence of a disaster represent to the insurance and reinsurance companies (in economic terms, this is called disaster risk). Therefore, a study of the financial mechanisms available in insurance, reinsurance, and capital markets is presented below. They can be alternatives for the State to finance and transfer the possible losses generated by extreme disasters. More specifically, the study seeks to define the functioning and structuring of each one of such instruments, to contextualize its current position in the mentioned markets and, in a later phase, using the State’s fiscal exposure estimations based on the responsibilities that it must bear in the event of a disaster and related risk scenarios as references, to analyze each financial instrument’s technical and legal viability and its fiscal and budget viability, its cost, and possible disbursement processes.

7.1.1.1 insurance and reinsurance industry This financial figure enables transferring the risk (understood in this case as the potential economic loss) to an insurance company. Usually insurance is based on the law of big numbers (insured events are seen as independent one from another; the probability of many of them occurring simultaneously is low). However, for disaster insurance such as disasters caused by earthquakes or hurricanes, the situation may be different. Indeed, the loss can occur to many properties in a large area at the same time. In such cases, it is said that the losses are correlated. The less the correlation, the less the loss or risk for a particular insurance company.


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Insurance is a product aimed at a market; it has a value for the customer and it has a price (or premium). But the insurance business has a characteristic that distinguishes it from most other consumer products: the cost of the product for the insurance company is determined only after the product is sold. Its cost depends on the claims paid during the effective term of the policy. Therefore, expected losses and other costs must be estimated beforehand. Such estimations are the labor of actuaries because the past cannot necessarily be used to project the future in these cases. Actuaries must rely more and more on scientific knowledge and on engineering when they attempt to quantify the probability of events with a low frequency and high severity as well as their effects on exposed elements.

Insurance policies include some form of deductible, meaning that the insured party must cover the first portion of the loss. So, the insurance company is solely responsible for the damage to the property after the amount exceeds the loss percentage established in the deductible up to a maximum quantity coverage limit, also specified beforehand. To reduce the magnitude of the losses, the company resorts to high deductibles or to coinsurance figures in which the insurance company pays a fraction of any loss that arises, which produces an effect similar to a deductible. In turn, insurance companies use the reinsurance industry to transfer and manage their own risks. Therefore, to cover the excess loss, insurance companies usually resort to reinsurance companies and they enter into coverage contracts as of an agreed-upon amount that may, furthermore, also have a limit or where, as of a certain amount, the loss is shared in a proportionate manner determined beforehand. Reinsurance companies underwrite policies from different parts of the world and, thus, risk is geographically distributed.

When risk ambiguity is high, that is to say, when there is great uncertainty regarding the probability of occurrence of a specific loss and its magnitude, the value of the premium will be greater. Actuaries and underwriters show their aversion to ambiguity by defining higher premiums when they perceive that the risk is not well specified. When

they cannot distinguish between the loss probability for categories of good risk and bad risk, they make an adverse selection. That occurs when the insurance company assigns the same premium to the complete population of properties, which can lead to only the owners of bad risks buying the insurance.

So, if coverage is solely bought for bad risk, the insurance company can suffer an important loss on each policy that it sells; therefore, it is recommendable to differentiate the premium between good risks and bad risks. That must be done to avoid owners of good risks from manifesting their aversion and not showing any interest in paying for coverage because they consider it very high. Although there are several approaches for facing this type of situation, the most appropriate one, based on the degree of knowledge, is to perform an expert audit or a professional examination to more accurately determine the nature of the risk. However, the cost of such study can mean an increase in the premium unless the policy taker pays for the audit. Obviously, this problem of adverse selection solely occurs when the persons have better information on their loss probability than the person selling the coverage. If one of the parties does not have better information then both parties must base themselves on the same information and there may be one sole blanket premium value based on the average risk. In that case the owners of good risks and the owners of bad risks may be equally interested in buying the policies. In recent years the public’s greater understanding of the vulnerability of buildings and of the role of construction codes has frequently resulted in owners questioning insurance companies that do not establish a difference between a building built using standards or retrofitted to standards and another building that does not comply with such characteristics.

Another aspect to be taken into account is moral risk. It refers to an increase in the loss probability due to the policy taker’s behavior. It is a very difficult matter to monitor or control. One of the ways to face this situation is to introduce deductibles and coinsurance in order to


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stimulate or motivate careful behavior after the coverage is acquired. Those aspects, in addition to the correlation or simultaneous nature of the losses caused by one sole event, usually result in an increase in the value of the premium, which in many cases has led to a very low demand for coverage. Therefore, often insurance companies have not found it feasible to supply coverage and have drawn the conclusion that the risks under consideration are not insurable because they do not enable normal product development.

Insurance companies need answers to questions such as the following:

• What is the average annual loss? Based on thatestimation, can the required value of the policy premium be defined? That is to say, how can what

creates a difference when determining the premium to be charged be identified?

• How can the company adjust the premium fordifferent site conditions, types of building, and construction qualities? Every building is different due to its structure and particular conditions; some are built on rock and others on soft ground. Due to such circumstances, the average annual loss for each building can be different.

The average annual loss or Pure Risk Premium is the expected value of the loss that would occur in any given year. It is the annual amount that should be paid to achieve, at a long-term, an equilibrium between paid premiums and covered claims. A hypothetical example is given in Figure 7-1. With a premium of 0.15 per thousand, all future losses are covered at a long term.

FIgURe 7.1: lOSSeS DUe TO SMall eVenTS anD larGe eVenTS DUrinG a prOlOnGeD periOD OF TiMe

4.50%

4.00%

3.50%

3.00%

2.50%

2.00%

1.50%

1.00%

0.50%

0.00%

0 2409

45.0%

40.0%

35.0%

30.0%

25.0%

20.0%

15.0%

10.0%

5.0%

0.0%

PP=0.15‰

Losses by event Accrued loss


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Furthermore, the probability of the maximum loss in a defined period in years for the portfolio of each company must be determined. That estimation is known as probable maximum loss (PML) and there is no standard for it (for a Return Period of 200, 500, 1,000 or more years). That information is fundamental for companies and for regulators alike, in order to guarantee solvency and thus know if funds are required additional to those available for attending the loss exceedance that may occur.

In general, governments have exerted strong pressure to maintain the availability of disaster insurance at a price within the reach of homeowners; at the same time insurance companies wish to increase their prices for this type of coverage in order to reduce their risk and remain profitable and solvent after a major event occurs. This conflict has created significant tension in high risk areas. It has been one of the factors that have stimulated establishing complementary insurance and reinsurance mechanisms.

It is often said that buying insurance should be mandatory, in order to distribute the risk and make disasters insurable. However, some critics state that, if the objective of the policy is to make the owners of low risk buildings subsidize the owners of high risk buildings then, rather, a mandatory lien (tax) should be imposed. Indeed, it is not clear why insurance must be sold to cover old buildings, given that the policies usually have coverage for replacing destroyed building, and the value of the new building in those cases would be much greater than the value of the old building.

Another argument against mandatory insurance is that strategies for increasing insurability would not be possible given that the insurance company would not have the opportunity of selecting the risks and controlling the PML. Notwithstanding, some countries think that it is interesting to promote mandatory insurance, at least up to a predefined maximum amount. That is the case of Turkey; indeed, after the 1999 earthquakes, the Turkish Catastrophe Insurance Pool was created. Due to the above, one of the proposals that some countries espouse is that the national government should offer disaster insurance even if it is not mandatory. That proposal has been made due to the fact that the

insurance industry is reluctant to offer coverage due to its high possibility of losing.

It has also been proposed that government programs could accrue premiums and earnings from tax-free investments and thus, accrue funds at a much higher rate than insurance company rates. It has further been argued that a program of that type could reduce the heavy situation that post-disaster aid in the form of loans and subventions represents to the government. One of the most important points is the possibility of deriving mitigation for reducing potential damage and being able to associate it with an insurance program of a government nature.

Nevertheless, although they appear to be very reasonable arguments, those propositions also enter into conflict with some sociological, economic, and actuarial principles: the “veracity” of those government programs (the cost of opportunity of the funds), the expected benefits of a competitive insurance market (i.e. efficiency and competitive rates) and the consumer not being able to select (the ability of deciding to buy the coverage). Simply put, this type of controversy leads to wondering in political terms what the government can do fast and what the private insurance companies can do best. Without further ceasing to wonder what the most appropriate orientation for spending scarce government resources is among all the demands and social commitments that compete for public budgets?

Insurance per se is not considered a mitigation measure because it rather redistributes the loss instead of reducing it. A carefully designed insurance program can, however, stimulate the adoption of mitigation measures, by assigning a price to risk and creating financial incentives through discounts applicable to premium rates, lower deductibles and/or higher coverage limits, conditioned to the implementation of said risk reduction measures.

Pooling or mutual funds is a figure where, as occurs with insurance companies, insurance or an operation is obtained through which the number of interested parties threatened by analogous risks become organized to be able to indemnify those who suffer a claim using the collected premiums, but


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the insured party in this case, upon signing the policy, acquires the dual condition of insured party and mutual fund party, with the rights and obligations of all of the associates. That type of figure has been used by corporations and recently by municipal governments in some countries. From the above, it may be concluded that, although they are not a panacea, insurance companies and reinsurance companies play an essential role in sharing the risk that individual properties have in the event of a disaster, using the principles of portfolio diversification.

In addition to insurance for specific assets, a country that has an appropriate comprehensive risk management system or program may be in a better position to negotiate contingent coverage in the case of extreme events. Countries can do this by pooling, by forming retention groups, and/or by taking out reinsurance with more favorable premiums and high deductibles, given their prevention achievements (which is described further on herein as the role of mitigation). Available insurance instruments can help countries manage their risks in a more efficient, effective manner. That is to say, that if a country does not buy insurance, it may, at any rate, obtain the availability of a contingency fund with the same industry, to cover unexpectedly high losses, provided that it has a good risk management plan that promotes prevention and mitigation.

The role of reinsurance and its modalities The insurance company uses reinsurance to limit time fluctuations in the claims for which it is responsible and to protect itself against insolvency after a disaster hits. Different types of reinsurance exist; they are important for finding the best transfer schemes using this mechanism.

Proportional reinsurance. With this type of reinsurance, premiums and claims are distributed between the direct insurer and the reinsured party in a fixed proportion. It may be in the form of quota share treaty reinsurance or excess of loss treaty reinsurance.

• Quota share reinsurance. In this type of reinsurance, the reinsurer bears a fixed quota of all the policies that the insurer has underwritten in a determined type of insurance. Said quota determines how the direct

insurer and the reinsurer divide the premiums and the claims. Due to its simplicity, this form of reinsurance is easy to handle and usually has cost savings. However, its defect is that it does not allow collecting the risk of the greatest losses well enough, so it generates a risk portfolio that is not very homogenous.

• Excess of loss reinsurance. In this type of reinsurance, the direct insurer retains the totality of the risk up to a maximum limit of the insured amount. After that limit, the reinsurer bears the rest of the insured amount. The reinsurer’s obligations are limited to losses no greater than a defined multiple of the maximum limit. From the distribution between retention and assignment to reinsurance, a proportion of the insured risk is obtained that determines how the premiums and the losses are to be divided.

Non-proportional reinsurance. In this state type of insurance, claims are distributed according to the losses that are effectively caused. The direct insurer defines a specific amount up to which it responds for the totality of the losses. That amount is known as the priority or deductible. When losses exceed said priority, the reinsurer must respond for the payment of the rest of the losses up to the respective agreed-upon coverage limit. Unlike proportional reinsurance, here the reinsurer must calculate the price of the reinsurance based on statistical information and on the distribution of hazard probability. One of the types of non-proportional reinsurance is excess of loss reinsurance.

• Excess of loss (XL) reinsurance. This is the type of reinsurance most used for disasters or catastrophic risk. In this type of reinsurance the value of the losses determine the proportion of the risk to be assigned. In this modality of reinsurance, the direct insurer is fully responsible for the loss up to the amount that determined the priority in a total number of policies for a predetermined type of insurance in the contract, no matter what their insured amount. The reinsurer must pay the losses that exceed the amount set forth as the priority. The reinsurer only participates in the payment of the losses that exceed the priority.


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7.1.1.2 the international insurance market The world insurance and reinsurance market is feeling growing pains. First, the greater number of persons in the cities and the growing value of capital stock raise the losses caused by disasters more and more. Second, climate change generated by contamination of the environment allows forecasting more frequent, more intense disasters. And finally, the terrorist hazard represents a new disaster front that requires risk transfer mechanisms.

Market structure. Due to the magnitude of the losses caused by disasters, their low frequency of occurrence, and the size of the area that they affect, insurance and reinsurance against said phenomena usually distribute the risk in time but not in space. That results in the contracts between primary insurers and reinsurers being long-term agreements, so that the reinsurer can recover its losses by renewing the contract in the years in which there is no calamity. The international disaster insurance and reinsurance market is organized in several levels depending on the magnitude of the loss. The primary insurers are in the first level; they are in charge of directly insuring companies, families or the public sector. Insurance companies tend to retain a large part of the risk regarding events with high probability and a low damage value. They rather seek reinsurance when faced with events of low probability and a high damage value, such as disasters. They do so to avoid the possibility of insolvency when faced with the corresponding indemnities after a disaster of great proportions. The reinsurers occupy the second level. Reinsurance companies bear the risk that the primary insurance companies cannot handle. Once again, depending on the solvency capacity of the reinsurance companies and on the magnitude of the disasters, they seek to get rid of the risk through reinsurance contracts with other larger companies or by designing financial instruments through bond issuance and financial derivatives to distribute the risk in the capital market. The levels of capital handled in the insurance and reinsurance market worldwide are quite small compared to those handled in the global capital market. Designing such instruments has enabled broadening the capacity of the reinsurance market, thus allowing the emergence of higher

levels of priority and of limit in excess of loss contracts, as is explained further on.

Market prices. World insurance and reinsurance prices tend to be very unstable. After a catastrophe of great proportions, insurance and reinsurance premiums soar dramatically. After disasters such as hurricane Andrew and hurricane Katrina, the Northridge earthquake, and the September 11, 2001 terrorist attack, to name but a few, insurance and reinsurance prices nearly tripled. Such increases tend to vanish in time but much more slowly than they appear. That price behavior can be explained by the reinsurers’ intention of prices compensating the losses in which they occur after a disaster, as contracts between insurers and reinsurers are long-term agreements. Another factor that influences this cyclic behavior of prices is the review that insurance companies make of the potential damages that a disaster may cause. After the review insurance companies may be willing to suspend the insurance or to increase the premium as a condition to continue the contract. The empirical study conducted by Kenneth A. Froot (2001) shows that, for a part of the reinsurance sector in the United States, the premiums for excess of loss contracts are a lot higher than the expected losses. The study also shows that insurance companies tend to reduce their level of reinsurance as the magnitude of the disaster increases and the probability of occurrence decreases. That indicates that, contrary to the theoretical literature on the topic, insurance companies usually retain risk.

Market flaws after a disaster Demand constraints. The demand for disaster insurance is limited by various constraints. According to the World Bank document for disaster management using financial mechanisms, policy efforts must turn away from ex post disaster attention and concentrate on damage reduction (mitigation through structural measures) and on insurance against material losses. Part of the ex post disaster attention has consisted of the State absorbing a good portion of the costs for immediate aid, reconditioning, and reconstruction in the devastated areas. That manner of confronting the disasters demotivates the demand for disaster insurance.


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Indeed, because individuals know that, after a disaster hits, the State will bear the costs of its effects, they do not have enough incentive to acquire disaster insurance policies or take measures to mitigate or reduce their vulnerability. Another cause of the demand constraints regarding disaster insurance is that the probability of occurrence of a catastrophic event and of payment by the reinsurance companies is perceived as being very small, so insurance companies tend to ignore the small risk, and even more so if they have not been exposed to a disaster. In addition, research in the fields of behavioral psychology and economics has shown that individuals tend to underestimate the risk of suffering losses (Kahneman and Tversky). As a result, the certainty equivalents that individuals would be willing to pay to avoid the risk are under the level of the expected risk. Finally, in developing countries, the persons most vulnerable to disasters generally have very restricted incomes and no access to the insurance market.

Flaws in the supply. A study conducted by Kenneth Froot (2001) discusses a restriction in the supply for the highest tiers of the reinsurance industry, which tends to raise the premiums very much over the expected losses. According to that author, the causes for the restriction are explained below.

• Given the fact that reinsurers dealwith high losscoverage, they face difficulties in obtaining external liquidity in the capital markets, to be able to supply those levels of protection, which makes increasing their capacity much more expensive.

• Somereinsurersmayhavemarketpowertocoverthehigh loss tiers so they are interested in maintaining entry barriers against those who would like to have that type of coverage.

• Thereinsurers’corporateorganizationis inefficient.The company managers may be seeking objectives other than the objective of maximizing the associates’ benefits.

• The frictional costs for reinsurance are high dueto it being a non-liquid financial instrument. The

negotiation of insurance contracts represents high transaction and management costs.

• Problems of moral risk and adverse selectionexist. That is to say, there is uncertainty regarding accurate loss assessment in the high tiers due to the lack of accuracy of the models and of available information.

Insurance mechanism constraints One of the disadvantages of resorting to the disaster insurance system is that the government and the private sector are exposed to the price fluctuations in that market. Prices seem to have a cyclic behavior that tends to a sudden increase after a disaster occurs and to a slow decrease in the years thereafter.

Furthermore, excess of loss insurance where the contract priority and limit are determined by the loss amount that the insured party suffers can generate moral risk and adverse selection problems. As was mentioned above, the problem of moral risk manifests itself after the contract is signed; the insured party becomes disinterested in implementing mitigation measures that tend to reduce the amount of its losses. The problem of adverse selection manifests itself before the contract is signed when there is symmetrical information between the insurer and the insured. The latter can hide information about a risk regarding which the insurer has no knowledge. The most exposed insured parties who hide a greater quantity of risk are willing to pay very high premiums. Therefore, if there are insurance supply constraints, the agents most exposed to the risk will be those with insurance coverage.

To elude such problems, excess of loss contracts may be implemented in which the priority and the limit are determined by an objective index or parameter of the behavior of natural disasters. However, those alternatives expose the insurer to a phenomenon known as basis risk. Basis risk is determined by the danger that the influence of external factors to the disasters imply for the insurer on the basis (index or parameter) on which the excess of


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loss contract is stipulated. For example, the bankruptcy of a large insurance company due to mismanagement can ostensibly affect the market’s loss index without a disaster having necessarily occurred.

The counterparty risk is another risk that is run when resorting to the insurance and reinsurance market for transferring the danger of economic losses due to natural disasters. That risk represents the danger that the insurer will become insolvent after a disaster and will not be able to attend to the claims of the insured. Reinsurance companies that attend to the highest market tiers have resorted to the mechanism of catastrophe bonds to counteract said risk.

7.1.2 Transfer and financing on the capital market The capital market is a new protagonist in catastrophic risk transfer. A basic characteristic of the most sound economies is a well-developed capital market system. Such systems localize savings and investment capital in several economic sectors by localizing rules based on risk and profitability. In practice, the financial risk is packaged and transferred to investors through financial instruments, and also through their own funds (such as common stock), stocks or derivatives (security options, future interest rates, foreign trade, futures contracts for merchandise). Therefore, the possibility of transferring the risk from the sectors that bear it (owners in the broad sense of the term) to the capital markets also exists and is being used more and more.

As was mentioned above, in countries prone to disaster risk, the lack of a level of capital in the local and international insurance and reinsurance sector sufficient enough to back the financing required after a disaster generates a scarce supply of reinsurance, disproportionate increases in insurance and reinsurance premiums and, in general, greatly distorted market operations. On some occasions, based on the magnitude of the disaster, local capital markets are not capable of absorbing the demand for resources and liquidity that such type of disaster requires. Even global insurance markets have seen times when a slight increase

in the frequency of disasters has led them to very low levels of capital and solvency. Finally, local governments are not able to finance the losses for that type of disaster either, due to limited fiscal capacities.

Even where a large portion of private property is insured, in most cases government assets as well as the infrastructure are completely unprotected. And that does not even take into account the responsibility that the government has towards the poor population or population with scarce resources who is unprotected because it cannot acquire the available insurance on the market. Traditionally, the government’s option for disaster risk coverage has been to seek resources for reconstruction purposes after the occurrence of a disaster, resources that in most cases stem from credit lines with banks and other available sources of capital on the market. Nevertheless, the financial burden that this type of mechanism generates for the stakeholders involved in the insurance contract and the fact that this type of financing mechanism does not enable financing large disasters has led to seeking sources of risk coverage and of financing capable of covering that type of loss.

In that context, the global capital market has become a financing and risk transfer alternative. It is estimated that this market currently has a value of around US$ 30,000 trillion, of which the United States represents approximately one third, and that the losses generated by a disaster represent an amount near the price movements that occur in that market in one day. So, the capital market has the capacity, in terms of resources, to finance and absorb the financial risks that a disaster can come to generate (Andersen, 2002). Although some developing countries do not have large access to this type of market, multi-lateral institutions can facilitate entry by creating contingent loans and entering into regional agreements to enable regional risk diversification, among others.

Since the mid 1990s, world capital markets have seen some financial innovations that enable handling financial disaster


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risk in an alternative manner. These alternatives are not a substitute for the insurance and reinsurance markets; on the contrary, they are a complement because they can mainly be used to transfer part of the risk of the insurance and reinsurance companies to the global market because the latter has the sufficient available capital to absorb the risks and payments derived from this type of event. In addition, these alternatives allow capitalizing the local and global insurance sector, for it to become a self-sustainable sector at a mid term and at a long term.

There is no theoretical reasoning against the risk that investors run in the case of a disaster being able to be securitized. Currently, market forces have accelerated the convergence between insurance and capital markets, thus allowing issuers who have ambitious growth plans or excessive exposure to disasters to be able to now directly access other sources of capital. Furthermore, investors have the opportunity to invest in new kinds of assets that are not correlated to other debts or risk funds but earn an attractive return. The risk of a portfolio with conventional securities decreases when non-correlated securities are added and the significant improvement in risk management methodologies and modeling techniques can lead to investors not familiarized with insured disaster risk being able to understand and accept risk quantification.

Table 7-1 summarizes some of the benefits for risk disaster issuers (sellers) and investors (buyers).

Securitization has costs: commissions, risk analysis, placement in external companies for tax reduction, accounting and/or regulation aspects, legal costs, and related printing costs. Such costs increase the securitization deductions and the time and learning involved in a new product. Currently, securitization is promising; the feasibility of having a low-cost catastrophic risk alternative that can be obtained from the traditional reinsurance market is not. In time it is reasonable to think that there will be some very competitive sources for catastrophic risk placement, especially after resolving aspects relating to regulations, accounting, and taxes.

Now, going back to conceptual elements regarding capital markets, one manner of classifying such markets is by determining if the securities are “new”, that is to say, if the investor is acquiring them directly from the issuing company or if they are being traded among different investors. In the first case, the market for new securities is called the primary market and in the second case the market for already issued securities (or those traded among investors) is the secondary market. In addition to providing more liquidity to the market, the secondary market allows the companies that issue the security or financial asset to determine the degree of receptiveness that the investors may have to new security issuances. That last point enables an analysis of financial instrument demand to be seen in upcoming sections. Using these basic concepts as a starting point, the financial instruments used for financing and transferring disaster risk in the main capital markets are presented below.

The objective of this section is to present some financial instruments that are currently available on the main capital markets, which may be a financing alternative for facing disasters in the Andean sub region. A basic definition of the structure of each one of the instruments will be given, and its overall appraisal in the market will be explained. In general, there are two types of instruments that must be accurately described: financing instruments and risk transfer

Table 7.1: BeneFiTS FOr caTaSTrOphic riSK SellerS anD BUYerS

issuer investor

New risk capital sources Attractive valuation

New risk capital capacity Non-correlated diversification

Innovative financial structures

Sophisticated risk estimation

No credit risk Competitive behavior

Stable prices


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instruments. With financing instruments, the issuer of the securities or instruments must at some time return the capital that the investor facilitated in exchange for the securities. Risk transfer instruments have higher returns, but the investor runs the risk of losing its capital as well.

7.1.2.1 Catastrophe bonds Catastrophe bonds (CAT bonds) are fixed income financial assets. As with any other bonds, the investor purchases a security for a certain value (principal) that will be returned at the end of a certain period (bond maturity date). During the time interval, it receives coupons (cash flows based on the interest that the bond offers) with a certain periodicity. In general, in a CAT bond issuance process the two parties (the issuer and the investor) use a special purpose vehicle (SPV) as an intermediary in the risk securitization process through the bond5. A special purpose vehicle is an independent legal entity that issues the CAT bond, receiving payment from the investors that purchase the security. In turn, the SPV establishes an insurance contract with the insurance company, through which the latter is covered for the risks set forth in the bond in exchange for periodical premiums that are used by the SPV to pay the coupons to the investors. The amount that the SPV receives for the sale of the bond is deposited in an investment company or in a trust company that collaterally issues treasury bonds which do not have any credit risk. On one hand, insurance companies seeking to cover their risk through the bond have incentives to use an SPV due to the

benefits that they offer in terms of taxes and the accounting requirements that they offer because they are generally located in areas that have fewer restrictions of that type. On the other hand, investors use an SPV to avoid the risk of solvency that the insurance company may occasionally face6.

The mechanisms used in the bond contract to determine the circumstances under which all or part of the principal and/or the coupons must be used to finance a disaster are called triggers. There are two types of triggers: loss-based indemnities or index-based payments. For the former, compensation is determined by the amounts that the insurance company issuing7 the bonds insures. Although this alternative provides good loss coverage for the issuer, it can generate problems of moral risk and of adverse selection8. For the latter, the basic idea is to use indexes influenced by the insured party, which have a direct relation with the disaster risk coverage that the bond or security is offering. Examples of such indexes developed in the United States are listed in Table 7-2.

Besides those indexes, some contracts are entered into using parameter indexes that furnish information on geological or climate conditions, such as, for example, the Richter scale for seismic events in a predefined area. Unlike in the first case, here there may be a base risk, that is to say, the risk that the index does not properly reflect the true losses generated by the occurrence of a disaster.

5 Asset scuritization is defined as the issuance of securities (in this case CAT Bonds) using one or more assets as collateral for the issuance (Fabozzi and Modigliani, 2003). In this case, the assets that back the issue are the insurance premiums received by the insured parties.

6 Patricia Grossi and Howard Kunreuther (2005). Catastrophe modeling: A new approach to managing risk, Springer Science.7 Although, as was mentioned above, in most cases the issuer is the SPV, it is solely an intermediary. It is the insurance company that actually requests the resources in this type of

transaction; therefore, the assumption is that the insurance company is the bond issuer.8 In this context, moral risk occurs when the insured party disregards the preventive measures after having having entered into the insurance contract, and thus it may report excessive

losses. Adverse selection occurs when one of the parties to the contract has additional information using which it attains more favorable terms in said contract (Andersen, 2002, Lewis and Davis, 1998).


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9 David Hofman and Patricia Brukoff (2006). “Insuring Public Finance against Natural Disasters. A Survey of Options and Recent Initiatives”, IMF Working Paper 199, August.10 J J Fernández Durán and M M Gregorio Domínguez (2005), “Valoración actuarial de bonos catastróficos para desastres naturales en México”, El Trimestre Económico, Vol.

LXXII, No.288, octubre-diciembre.

The issuance of financial instruments such as CAT Bonds allows transferring risk to private investors. Although these financial instruments have not been around a long time, they have undoubtedly enjoyed significant growth in recent years, showing advantages for investors and bond issuers alike. To mention just a few statistics, in 1997 CAT bond issuances represented a value of US$ 510 million; that amount practically quadrupled by 2005. That is to say, CAT bond issuances have represented a little over USD 2 billion. It is true that a good percentage of those issuances were made by companies in the United States and in Japan for hurricane and earthquake risk coverage, but they are starting to be used more frequently by the governments of developing countries such as China, Mexico, and the province of Taiwan9. The Mexican government’s successful CAT Bond issuance worth US$ 160 million was particularly interesting; it had an interest rate of 2 ½ percentage points over the LIBOR.

Even though their frequent use will take some time, it is good to remember the advantages that CAT bonds have over other financial risk coverage schemes: “i) There is no credit risk with a CAT bond, that is to say, there is no possibility that the insurance company or the reinsurance company will not pay the government because the money for paying the losses was delivered by the investor when it purchased the bond; ii) if a catastrophic event occurs, the government immediately has funds with which to face the disaster; it

Table 7.2: caTaSTrOphe inDeXeS

property claim Services (pcS)

The index that PCS uses is based on losses in California, Florida, Texas, and six other states in the United States. Losses are based on industry studies and on PCS visits to disaster-affected areas. Unlike the Guy Carpenter index, the PCS method for calculating losses is not transparent.

Guy carpenter index

This index solely measures damages for building owners; it is based on payments made by a determined group of insurance companies in each geographic region. The index is based on non-weighted averages of the loss/value ratios reported by such insurance companies.

risk Management Solutions (rMS)

Unlike the PCS index and the Guy Carpenter index, this index is based on loss estimation using models. Developed using catastrophe modeling technologies, it focuses on a mix of type of exposure, geography, and hazards.

does not have to wait for the insurance company or the reinsurance company to pay; iii) the cost of the bond for the government may even be lower than the insurance premium of an insurance company willing to insure the damages caused by the catastrophic event, if any; iv) the CAT bond is not correlated to the financial market so it is useful for investment portfolio diversification; v) a bond issuance can avoid big maladjustments in the government’s budget due to the occurrence of catastrophic events that may make it necessary to increase taxes or impose a special tax to finance government spending for repairing the damage caused by the disaster”10 Nonetheless, as was mentioned above, a CAT bond is not an alternative for replacing insurance except in relatively exceptional cases in minor tiers or coverage. The CAT bond is without a doubt interesting for high tiers and relatively big portfolios where the cost of insurance would not be optimum.

According to the above, governments or insurance companies can become issuers of this type of bond and can transfer to the market part of the risk that they insure. Furthermore, investors perceive this type of financial instrument as an attractive investment alternative not only because it offers greater return but also due to other factors such as the relatively low probability of occurrence of a disaster, the lack of correlation between the credit risk of these bonds and market movements, and the possibility of reducing the


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risk of loss via the diversification of securities in different zones (there is a low probability of two natural disasters hitting in two different zones at the same time).11

Comments on institutional factors regarding CAT Bond issuanceSub-national governments in particular are subject to two types of financial constraints. The first one is inter temporary budget restriction and the second one is indebtedness ceilings imposed by fiscal laws and regulations and by the legislative branch. Indebtedness is an essential instrument that enables a sub-national government to carry out its investment activities in diverse sectors; therefore, any limit imposed in that heading may constrain the government’s actions. A CAT bond issuance must not be a constraint for sub-national authority actions. The resources obtained from investors are not for financing current fiscal deficits. Rather, they are aimed at providing liquid resources for facing future contingent events. Therefore, they must be kept to be able to meet the commitments acquired with the bond holders, as well as to rebuild the public infrastructure after an earthquake. In addition, the complete bond value is not to be repaid to the investors but only a proportionate amount thereof; thus, a percentage of the bond can be determined to be a kind of tax contingent to the occurrence of an event. Under such circumstances, the CAT bond issuance must not reduce the indebtedness limit of the sub-national government that issues the bonds nor must it affect the mid-term sustainability status of its finances. In reality, CAT bonds are similar to the balance of payment credits that the IMF grants, which are solely effective upon the occurrence of a monetary or balance of payment crisis.

7.1.2.2 Contingent surplus notes Contingent surplus notes are in the family of financial instruments called options. Options are derivative financial instruments, that is to say, that they derive their value

from the price of an underlying or base financial asset. Unlike futures contracts, an options contract is defined as a contract that grants the right (but not the obligation) to buy (call option) or sell (put option) an underlying asset (such as, for example, foreign exchange, stocks, bonds, and indexes, among others) on a future date at a price established today. Two parties participate in an options contract: the issuer or option seller and the buyer. One party, the issuer, sells the option to the buyer in exchange for an option premium or price; it is also the party to the contract that bears the obligation of option compliance. The other party, by definition the buyer, solely acquires a right (but not an obligation); therefore, its maximum loss will be the premium or price that it paid for acquiring the option.

The price of an option on the market basically depends on six factors: the current price of the underlying or base asset, the price at which the base asset is appraised in the option contract (strike price), the time until the expiration of the option contract, the expected volatility of the price of the underlying or base asset throughout the effective term of the option, the short-term risk-free interest rate, and, finally, the advanced cash payments on the active base. The effect that each one of these factors has on the price of an option depends on the type of option (call option or put option) under analysis.

Option price valuation or determination models start with arbitration arguments. Binomial formulation models are among the simplest whereas models that seek to more precisely determine the price of an option in order to build portfolios based thereon start with the Black-Scholes option valuation model. Finally, it is worth mentioning that the benefits that either of the two parties can obtain from price changes when quoting the underlying asset depend on the type of option (right to buy or right to sell) and on the magnitude of the price differential (the difference between the price set forth in the option contract and the market price).

11 In some cases, the impossibility of occurrence of two mutually exclusive events in the zone is also attractive in this type of security (for example, draughts and inundations).


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In the case of disaster risk, contingent surplus notes are put options, the underlying or base asset is a debenture bond, the option sellers are investors and the option buyers are insurance companies that wish to have future financing instruments in the event of a disaster. So, such notes grant the primary insurance company the right to issue debenture bonds in the event of the occurrence of a disaster12, and the investors are bound to acquire those debenture bonds when the insurance company exercises the option. Therefore, contingent surplus notes are a financing instrument, not a risk transfer instrument, which can be useful when immediate liquidity is needed after a disaster.

7.1.2.3 Catastrophe options traded on the stock marketAs is indicated by their name, these options are derivative financial instruments in which the underlying or base asset is an insurance industry index13 (PCS, RMS or Guy Carpenter index, among others) that reflects the amount of resources that insurance companies have had to disburse to cover their insurance policies (insurance claim payments). Such options are sold by investors and may be acquired or bought by insurance or reinsurance companies. So, the options grant insurance or reinsurance companies the right to demand that the option investors or sellers make cash payment when the index (underlying asset) exceeds a certain amount. Under those terms, catastrophe options are disaster risk transfer instruments (not financing instruments). To valuate this type of option, arbitration arguments are also used, based on which binomial models and Black-Scholes models are derived. Finally, it is worth mentioning that these options are currently traded on the Chicago Board of Trade (CBOT) and on the Bermuda Commodities Exchange.

7.1.2.4 Catastrophe equity puts These are put options. Here, the buyer of the option is an insurance or reinsurance company and the seller of the option is an investor. Such options grant the buyer

the right to sell a share of its equity to investors at a pre-negotiated price. So, if the losses that a disaster causes exceed a certain amount, the insurance company exercises the option and sells a share of its equity to investors, thus obtaining immediate liquidity. Due to its nature, the aim of this type of financial instrument is to finance risk, so it does not enable risk transfer. These options are also currently traded on the CBOT and on the Bermuda Commodities Exchange.

7.1.2.5 Swaps de catástrofeSwaps are derivative financial instruments defined as an agreement in which the two parties are bound to “exchange” payments with a certain periodicity. The quantity of each payment corresponds to a ratio or rate of a notional principal.

With catastrophe swaps, the insurance company is bound to make certain periodical payments to the investor14

and, in exchange, the investor will make payments to the insurance company after a disaster or it can also make all of the payments generated by an insurance portfolio when a disaster hits. The above-mentioned indexes are used (PCS, RMS, etc…) to determine when the investor must make the payments to the insurance company. Due to its nature, this financial instrument can be classified as one that enables risk transfer.

7.1.2.6 Weather derivativesThese financial instruments derive their value from a base asset that, in this case, are indexes that reveal information on weather conditions, such as, for example, temperature indexes, seismic activity, draught, flooding, and hurricanes, among others. Basically, the instrument consists of a contract through which the buying party receives payments when said indexes exceed a certain limit. So, this instrument enables risk transfer.

12 Although they can also be non-conditional.13 With this type of financial asset, the use of an index instead of another underlying asset can generate an additional risk called base risk. Base risk simply put means that the index

may not properly reflect the losses in the assets, caused by the disaster, so it is possible that, through this option, the insurance company may not be able to cover the risk after certain types of catastrophic events.

14 In a certain manner, due to the nature of the financial asset, these payments, as well as payments made using other financial instruments, are similar to the payments that an insurance company makes to a reinsurance company.


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7.1.3 Financial risk retention

The losses generated from natural disasters can represent very high values that may actually surpass the risk coverage levels that can be attained using a single financial instrument. However, such losses can be segmented into different ranks or tiers and a determined financial instrument can be used in each one of the tiers. Therefore, in most cases, the best option for the primary insurer, which may be the government, is to combine insurance/reinsurance with other financial instruments on the capital market and even retain losses always using an appropriate financial criterion, by means of reserve funds, contingent loans or debenture bonds or through an off-shore captive reinsurance company owned by the insured.

In general, risk retention can be unconscious or passive when the possibly affected person does not know that he or she is at risk, due to ignorance or to a deformed or superficial perception of the reality; such a situation can be very serious. Risk retention can also be obligated if there is no other alternative for eliminating, reducing or transferring the risk and it must therefore be retained. Retention or “non insurance” is a figure used when coverage is not justified, for example, because the asset is obsolete or because the possibility of loss is extremely low and may be disregarded or because the loss is so high that transferring it would cost as much as the losses produced. Moreover, given the situation of economic soundness, maybe only the most serious risks are covered and the others remain uncovered. Nonetheless, in such a scenario an important natural disaster could cause the economic collapse of those affected.

Self-insurance is also considered a figure for risk retention. This strategy consists of taking measures to control the risk and bear potential losses. Self-insurance aims to improve the ratio between premiums and guarantees offered by the insurance companies and thus lower risk costs. Some think that self-insurance cannot be considered a type of insurance, for the reasons listed below.

• Thereisnorisktransfertoanotherentity.• Itisnotusuallybasedonthelawoflargenumbers.

• Oftenreservesarenotaccruedforthefuturepaymentof losses.

• It can force using resources or reserves allocatedotherwise, in the event of exceptional losses.

Using this type of policy, the “tax” factor intervenes, depending on whether or not the insurance premiums and the payments made after a disaster or on account of retained risks may be considered expenses that can be deducted from the revenues or if they are subject to special taxes. Usually, the creation of funds and reserves for total or partial retention are not favored by incentives; therefore, on many occasions it has been stated that the situation should necessarily be reviewed. At a government level, it is commonly mandatory, at the end of each annual fiscal period, to return unused resources to the national treasury and, for this type of national or agency reserve, exceptions must be made to the budget laws and figures must be sought to solve such a problem. One alternative is to create trust accounts. The above circumstance has been one of the reasons for which many developing countries have not been able to create efficient reserve funds for risk reduction, post-disaster reconstruction, and even for emergency attention. It is worth mentioning that at times such funds have not been duly estimated due to a deficient risk assessment, so it is not strange that the necessary resources are not received during the normal budget disbursement process. Possibly in developing countries it is necessary to set up funds that enable a balance between risk reduction investment (prevention-mitigation) and risk transfer.

In developed countries when it is impossible to obtain insurance coverage or to pay the required premiums, partial self-insurance has been a feasible alternative. Under that figure, a first portion of the loss is retained in exchange for a reduction in the cost of the premium. In principle, under a strict prevention policy, this system permits lowering the risk cost, which in turn leads to lower premium payments. Simultaneously, the owner now bears the losses caused by minor events, which means that recovery after that type of event is more expeditious. As occurred in the scenario of an insurance company, the “excess loss” can also be managed


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using “first risk” or “partial value” partial self-insurance. Finally, such funds can also operate as “captive” insurance companies and reinsurance companies created to cover their own risks and those of others. The figure consists of the “reserves” being constituted using the paid “premiums” and the deductible benefit can be obtained. In general, conscious risk retention is a specially important figure because well-formed reserves with sound technical engineering and financial analysis bases allow retaining certain risks and negotiating the residual risks with insurance and reinsurance companies and even becoming part of a pool or part of a captive or participating in the capital market.

7.1.3.1 disaster reserve funds Disaster risk management requires the joint action and coordination of several stakeholders: the government, families, and financial market and insurance market operators. Given that the different stakeholders almost always have different interests, “prisoner’s dilemmas” can arise that leave the society without protection; they can only be overcome upon introducing institutional mechanisms that favor cooperation and retrofitting of commitments. Of course, the stakeholder that can reach an efficient balance is the government because it has the resources and the instruments to carry out direct, efficacious actions.

Bearing the above in mind, a fund can be created with resources aimed at disaster attention. The resources accrued in such an account must be maintained in liquid assets, that is to say, in the form of securities or bank accounts that can be rapidly paid up without incurring in large transaction costs. An alternative for obtaining resources for disaster funds is to issue government bonds. However, that source of resources may be seriously limited if the markets consider that the fiscal situation is deteriorating and, therefore, requires high risk premiums that can make it practically impossible to place new securities on the market.

A reserve fund or a stand-alone trust fund can allow contributing one’s own resources to cover minor damages or damages that would not be covered by insurance when the

affected government agencies cannot cover them out of their budgets. If the decision is made to create reserves to cover the first retention tier or the deductibles, in the event of a mass negotiation, it could be expected that a budget heading for each insured entity could also be transferred to the fund to accrue the reserves aimed at attending to damages before they become a priority. Also, the fund could receive said resources from the entities under the condition that the resources be specifically used to cover their particular losses. That situation would be consistent with the figure that each entity is in charge of paying premiums and allowances in order to have reserves to cover the deductibles. That kind of reserve fund administration would not be very complex and the very nature of the reserve fund would allow it to play that role.

Furthermore, a fund of this type could receive the disbursement of a contingent loan contracted for the same purpose because the fund would facilitate the reconstruction and repair contracting process. Therefore, a fund for minor disasters based on an accrual rule and optimum spending can be proposed, which can be defined based on cost studies for minor disasters. The unconscious behavior of accrual and spending of some reserve funds that exist in the region, the annual amounts of which have been gradually dropping, is a scenario that indicates that there will not be an increase in minor disasters or a change in the rate of future losses, which could be a very optimistic assumption that is not very precautionary given the regional trends. The creation of one or more secondary accounts for the purpose of accruing reserves for minor disasters and of covering the deductibles or retained losses after an extreme disaster would be especially important, to stimulate a culture of precautionary savings that to date no existing reserve fund has had. That could be done gradually if it is properly supported. Unfortunately, notable reserves or rapidly accrued reserves can generate the temptation to use the accrued resources to other ends and even critiques, given the opportunity cost that they generate. Therefore, from an economic perspective, a contingent loan can be a justifiable alternative, depending on the cost that having said availability represents.


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Other reserve fund possibilities exist, such as those that can be designed under the figure of compensation funds, for example, for insuring small and large municipalities alike and with the participation of the insurance sector and of the national government.

7.1.3.2 Credit linesThe government can resort to national or international banking markets and request funds on loan to cover direct costs after a disaster or to engage in contingent loans. In the first case, there may be problems obtaining resources due to the fact that, in a disaster situation, credit demand increases in all sectors, thus making resources and the financial risk more costly. Intermediaries will be less willing to grant loans and rationing problems may worsen. Also, if losses are excessive, perhaps the government cannot obtain the necessary resources and it may need to resort to the help of the central government or to international banks. The latter may actually be adverse to granting loans to the central administration if there are no central government guarantees, and even more so when government debt bond risk ratings have significantly deteriorated for all practical purposes.

Credits are usually used in the highest range or tier (the tier with the greatest loss levels) when there is no way to transfer the risk or when it is necessary to limit the loss. In other words, if the losses that a disaster causes exceed the levels already covered through reinsurance and through some financial instruments, the exceedance can be covered by a line of credit from a multi-lateral institution, such as The World Bank or the IADB. This is habitually the last option espoused.

Contingent loansWith this line of credit, the insurer must pay a commission on the agreement, which usually ranges from 0.25% to 0.375% per year or for a longer period. The agreement guarantees that the institution will lend the resources at the time the losses caused by a disaster occur or exceed a certain value. To determine that, trigger indexes or well-defined circumstances are determined, such as the national government declaring the event a disaster.

This figure has been a mechanism by means of which governments can facilitate forming insurance consortiums by taking out loans that enable increasing available reserves for risk retention; nonetheless, there is no disbursement if there is no claim that implies the need to use the funds. As the State is the guarantor of this type of loan and because it pays the commission, the State becomes a facilitator for the growth of the local insurance industry, insurance becomes less expensive for the citizens and for the government itself, and reserves are made that will enable a better position for the consortium to negotiate with reinsurers. Currently The World Bank consolidates a contingent loan line called Catastrophic Delayed Joint Down Option (CAT DDO) under the figure of free immediate application (for investment programs, structural adjustment, etc...) for the purpose of promoting risk mitigation. The country must demonstrate that it has an explicit total risk and related investment management program (pursuant to budget fiscal period legislation) and that its resources are for free allocation. If this mechanism is to be used as a contingent loan after a disaster, a one-time payment of 0.25% must be made upon signing the contract but there are no annual commissions during a three-year period. If damages occur, the interest rate for the loan is 2% or if it is used for investment the rate is LIBOR plus four percentage points (3.5+0.04) with a seven-year grace period and a 17-year term.

It is necessary to clarify that institutions that grant this type of line of credit, generally speaking multi-lateral institutions, direct their efforts for the countries to autonomously diversify the risk, generate incentive systems to encourage private stakeholder risk diversification, and promote the mitigation of physical damages.

7.1.3.3 the role of vulnerability mitigation As was explained above, available mechanisms exist on the insurance and reinsurance market and on the capital market, which serve to properly finance the part of disaster risk that “can be diversified”; that is to say, the losses in wellbeing (in terms of physical integrity and assets) that a disaster causes. However, the other part of disaster risk


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“cannot be diversified”; it can solely be reduced by using mitigation measures that allow diminishing the possible loss levels that a disaster may generate before the disaster actually occurs.

So, in theory, the strategy that a society deploys to reduce losses caused by a disaster consists of taking ex ante mitigation measures to reduce its vulnerability. After reducing the risk that “cannot be diversified” to a minimum, the society must focus on using the insurance market and the capital market to distribute the risk that “can be diversified” and thus have sufficient resources to guarantee the recovery of the physical integrity of its members as well as of their assets after the disaster. This section gives an overview of the mitigation measures that experts on the topic recommend.

Andersen (2002, p.20) states that mitigation measures not only reduce the level of average annual losses but that they are also a necessary condition for local insurance market development and viability. Pollner (2001) identifies four strategies that can reduce a country’s vulnerability to a disaster:

• Physical measures. This refers to all measures that the stakeholders of a society can take, to reduce the physical vulnerability of their assets. The measures must be the ones with the greatest impact on reducing the losses that a disaster can generate.

• Structuralmeasures.This refers to measures that enable modifying the structure of the constructions or assets that disasters place at risk. Some such measures are to design construction codes and put them into practice. The author suggests designing agencies to be in charge of enforcing such codes in constructions in process. The financing for said institutions may come from the private sector (insurance companies, banks, and building owners), given that the reduction of possible losses that such an institution would generate would be sufficient incentive for those stakeholders to allocate resources

to such financing. In some cases, the problem is that the codes are not easy for a common proprietor to understand; that may generate a lack of incentive to apply them.

• Non-structural measures.This refers to all other measures including identifying areas prone to risk, allocation control, and use of the ground. Designing maps to identify the areas most prone to distinct types of risks and making an inventory of the physical assets and constructions that figure on such maps allow the market to have more available information for establishing insurance policy prices, which will lead to greater efficiency. This type of measure requires interaction with research centers and disaster prevention centers, planning offices, and decentralized cadaster offices. In addition, given the incentives that insurance companies have regarding the reduction of possible losses, they may contribute with the information that they use for appraising this type of risk, and the benefit will be more complete databases.

Through its underwriting policies, the insurance industry has the capacity to generate incentives for private stakeholders for them to take mitigation measures to reduce possible losses after a disaster. Therefore, it is necessary to have public information, for the insurance company as well as the insured party to know the specificity of said measures and, in turn, when it comes time to cover the risk, be able to determine if the insured party has implemented them.

7.1.4 Transfer and retention through a captive insurance company According to the nature of its activity, a “captive” company is an insurance or reinsurance company organized by an economic group for the benefit of the companies that form the group. It is organized pursuant to a special foreign legislation, such as the one in the Bermuda Islands or in the Cayman Islands where strong insurance and reinsurance emporiums exist and has a business domicile and offices in the country of organization from which it operates either


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with its own infrastructure or through the facilities offered by an administration company for duly acknowledged and accredited captive insurance or reinsurance companies, in order to insure or reinsure, from abroad, the risks of its own economic or business group or institution to which the captive insurance or reinsurance company belongs.

The objective of organizing a “captive” insurance or reinsurance company responds mainly to the need of reducing the costs paid for insurance premiums and of achieving better risk management, by pursuing the fiscal advantages that certain legislations offer. Through this figure or legal instrument, the interested parties are able to manage or administrate their own risks and, at the same time, retain the insurance premiums paid. The risks to be insured by the “captive” company are selected in such a manner that significant risks are insured by insurance companies other than the one that the economic group has. Premiums are set by the “captive” company belonging to the company or companies contracting the insurance. Said premiums are paid to the “captive” insurance or reinsurance company abroad in its domicile and the risk is insured from there. In many countries the expense incurred by the insurance takers that are companies in the group to which the “captive” company belongs can be deducted from their income tax because those countries consider that insurance premium payments are a necessary expense in generating revenues.

For example, if the company is organized in a country such as Panama, Panamanian law expressly states that there is a tax exemption for the revenues or income that the “captive” company receives on the premiums as well as on the earnings or profits that it obtains due to its business activity as well as on the profits that it will pay to its stock holders due to the fact that said profits are derived from foreign or offshore operations, that is to say, they are generated abroad because they stem from insurance contracting outside of the territory where the “captive” company solely effects administration operations. There is, therefore, a dual benefit. On one hand, the expense for contracting the insurance with the “captive” company can be deducted from the amount of taxes to be paid if the fiscal law in the country of the contracting party so

permits. On the other hand, because the “captive” company is part of the same group to which the insurance contracting parties belong and because the profits of said “captive” company are exempt from income tax, the earnings remain within the group or the entity that owns it.

As may be appreciated, “captive” insurance or reinsurance companies are instruments specially designed for foreign operations, for the specific objectives mentioned above. It can solely be used by foreign entities or groups with a domicile outside of the country in which the captive company is organized. Indeed due to the very nature, purpose, and operation of “captive” companies, the use of a captive insurance or reinsurance company by a company established in the country where the risk occurs would invalidate the nature of being “offshore”. “Captive” insurance and reinsurance companies can insure and reinsure virtually all types of risks; therefore, by organizing one such company, the entity or group that owns it can transfer part of its own risks to the “captive” company belonging to the group and leave other risks insured with conventional insurance companies.

7.1.4.1 Captive company goals By creating and operating a “captive” insurance company, an institution, company or economic group seeks the advantages below.

1. This figure enables a cost reduction in premiums and the payments made are maintained within the company equity as the premiums are received by the “captive” insurance or reinsurance company. As is well-known, all insurance or reinsurance companies in the insurance market must cover and pay a series of administrative and operating costs that they pass on to their customers. Upon insuring the risks with a “captive” company related to the business group, such costs can diminish considerably because there is no need to cover a series of superfluous expenses in which the insured party takes no part. In addition, because the “captive” company is part of the same corporate group, the premiums are maintained as revenues in the same equity.


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Moreover, in the conventional insurance world, when it comes time to renew the policies, insurance companies generally have no special consideration whatsoever for the insured parties with a good insured risk behavior. Through the “captive” insurance or reinsurance company the premium can be adjusted when there is a low claim level.

2. The figure serves as a vehicle for the repatriation of the group’s financial resources because the resources are allocated to the “captive” insurance or reinsurance company. In many countries, the repatriation of funds abroad is difficult due to existing controls. With the premium, a company can legitimately support remittances of funds abroad because they are conserved by a company related to the same economic group.

3. It also serves as a risk management instrument. Given that the “captive” insurance or reinsurance company is part of the same business group, the risk can be better managed because the needs of the insured companies are better known.

4. The insured company can fiscally deduct the premiums paid pursuant to the provisions set forth in its internal fiscal law because they are considered a necessary expense for the production or conservation of its source of revenues. In most countries, before determining the amount or income that is subject to tax, the fiscal taxpayer can deduct insurance costs from its revenues or gross income, considering them a requirement for safeguarding or protecting the business activity from all risks that, in the event of a disaster, would affect the source of production.

5. Depending on the country where the “captive” company is organized, the premiums paid to it are not subject to income tax payment in the domicile of the captive company and the profits or dividends that it pays are not subject to fiscal deduction either. The law can exempt it from paying taxes on all of the income that it obtains from foreign risk insurance. By virtue of the above, the profits or dividends that the “captive”

insurance company distributes to its shareholders are not subject to tax either.

6. The figure enables direct access to the reinsurance market, thus representing savings in brokerage costs. Due to the fact that the “captive” insurance company is part of the same economic group, it can directly process the reinsurance of the risks for its related companies, without them having to bear the brokerage costs that a non-related insurance company would charge.

7. It offers flexible, tailor-made coverage. The fact that the “captive” insurance company is part of the same economic group enables preparing insurance policies according to the precise needs of the insured parties.

8. It enhances the flow of funds. Given the relation that exists between the insured parties and the “captive” insurance company, premium payments as well as claim payments are more rapid. Because the premiums remain in the same corporate equity, that allows the “captive” insurance companies to use the premiums for their own investments, which in turn represents a benefit to the group as it maximizes the return on its resources.

The above are merely some of the operating, financial, and fiscal benefits and advantages that may be obtained by organizing a “captive” insurance company. The can all be attained with proper orientation and planning by the administration company selected to manage the “captive” company. Indeed, the administration company is responsible for having technical studies conducted, to gain the above-mentioned advantages and shape them to need.

It is true that that the legislation in different countries may offer different benefits, advantages, and flexibility for potentially organizing and operating a “captive” insurance company. However, to clarify, that does not imply that a “captive” insurance company is a ghost company, a paper company or that it is located in a “godless, lawless” jurisdiction. Nor does it imply that the country in which it is organized does not have proper supervision for this type of company and for its business activities.


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7.1.4.2 other captive alternativesOn some occasions a company that wishes to provides its insurance itself to cover the risks that its operations have may not be sufficiently capable (in economic or event administrative terms) to maintain its own captive insurance company. To satisfy such risk coverage needs (outside of the traditional insurance market), the industry has created the “rent-a-captive” concept), based on which the company shares its captive company with other companies of a similar scope, by “renting” part of its capital. To put it more simply, distinct companies (nor related to one another) use the same captive insurance company to cover determined risks, by entering into certain agreements in which –at times– no capital contribution to the captive company is required. The “rent-a-captive” concept does have a downside, common to most companies: the captive company is one sole entity as far as third parties are concerned, so its entire equity can be called upon to cover justified claims. Therefore, the companies that have entered into an agreement to “rent” the captive company do not have the certainty that, in the event that another of its users puts its equity in danger, the corresponding capital quota allocated for the exclusive coverage of their risks will not be affected by a legitimate claim. That is to say, there is no guarantee that the part of the captive capital allocated solely to the risk coverage of a determined company will not be used to cover another user’s risks. To avoid the above-mentioned operational weakness, the insurance industry itself conceived a protected cell company (PCC) in which the capital is segregated into distinct “protected cells”, thereby separating each cell and separating the equity that each cell comprises from the risks or mishandling that the other equity segmentations (cells) may suffer. In other words, using its distinct cells, the company is able to cover each one of the risks of the different companies, without the coverage of one specific cell affecting the other cells. Based on the above, in simple terms a PCC is defined as a company whose company stock is composed of assets contained in distinct parts or segregations called ‘cells’ (cell assets) that are considered separate and independent one from the other and is also composed of assets that do not constitute ‘cells’ (non-cell assets) that are also considered independent. The company’s main feature is that the company’s portion

of capital allocated to a determined cell does not respond to obligations that the company bears relating to another cell or to non-cell assets. In summary, a PCC structurally implies a core capital, a cell capital, core assets and obligations, and cell assets and obligations. The assets that comprise each cell and the cell core constitute a kind of trust fund allocated to exclusively respond to specific obligations and creditors.

7.1.4.3 Captive company organization procedurePursuant to the laws of each country, creating a “captive” reinsurance company is a simple, low-cost process. It is basically achieved by following the steps below.

• Contractaconsultinggroupofprofessionaladvisors(insurance manager, attorney, auditor, and an actuarian) to carry out the captive company organization process with due specialized technical support. The consulting accompaniment includes the preliminary incorporation of documents, the request to the Ministry of Finance of the country chosen for the creation of an international company –a country that does not adhere to the regulation that the company must have 60% local ownership –, registration of the company as an insurance company with the corresponding authority, payment of the minimum capital required, and operations start-up.

• Establishtheaddressofthemainofficeinthecountryin which the “captive” company is organized. The address must be the place where all commercial, accounting, and administrative documentation for the captive insurance company is kept and establish the identification of the directors and of references.

• Obtain a bank certification accrediting that theinterested party has funds and resources available for the capitalization of the company, once it has been organized.

• Submitthenameoftheresidentrepresentativeofthe“captive” company and a technical report on the types of risks to be insured as well as reinsurance company activity projections.

• Determinethecompanystockisdependingonthetypes of risks to be insured. For general risks, usually the paid-up capital is US$ 150,000 whereas for long-


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term risks or a combination of the two, the paid-up capital that the owner or the interested party must contribute is US$ 250,000. The figure may vary according to the laws of each country in which the captive company is organized.

The first step is fundamental and, to take that step, the country would have to contract a consulting group for an integral assessment and then go through the formalities for the organization and operational start-up of a captive reinsurance company owned by the national government or sub-national government in the country deemed most convenient (Panama, Bermuda or the Cayman Islands, to mention the closest). Said assessment will take into consideration all financial, legal, administrative, and tax aspects required for meeting the goal of the assessment. The main tasks that the consulting group must carry out in the country chosen for said assessment, without prejudice to the obligation of developing and carrying out all activities necessary for the organization and start-up of the captive company, include but are not limited to the following:

1. According to the instructions and information furnished by the interested government, offer advice on and prepare the Business Plan to be submitted in the domicile of the chosen country, including required actuarial projections based on the selected risk and scenarios;

2. Advise the interested government on the preparation, coordination, and processing of the documents required for organizing the captive company, from beginning to end. Said activities include but are not limited to:

• Theformalityofreservingthenameofthecaptivecompany;

• Writinguptheby-lawsandotherrequiredlegaldocuments;

• Preparing and coordinating the completion ofthe preliminary incorporation forms and going through the corresponding formalities;

• Preparingandfilingthepreliminaryincorporationforms with the corresponding authorities (for

example, in Bermuda: the Bermuda Monetary Authority (BMA) and the Insurance Advisory Committee (IAC));

• Processingandfollowingupontheapprovaloftheincorporation process;

• Processingtheincorporationandtheregistration,including processing payments and fees, if any;

• Coordinatingthecapitalcontributiondraft;• Filing the request for license for the captive

reinsurance company;• Processingandobtainingthelicenseforthecaptive

reinsurance company;• Renderingareporttotheinterestedgovernment

upon completing the captive company organization process and, others required, if any, upon request by the interested government, to be able to answer all of the consultations that it makes regarding such process.

The organization of the captive company must be performed within the contract execution term of around ninety (90) days and the value of the process will be approximately US$ 40,000.

7.1.4.4 Possibilities and benefits for the countriesIn this alternative the analysis focuses on the economic benefits that each country can obtain based on the characteristics of its portfolio and the values included in the insurable amount. This mechanism allows going further on in the traditional insurance chain where insurance companies receive the premium of several risks for the losses of some but with a focus on the portfolio level, which at times does not allow a risk in particular to benefit on its own. With the characteristics of the risks involved in this type of analysis, insurance alternatives that go beyond the optimum price for the insured party other than the traditional ones can be analyzed because they enable the insure party to obtain financial revenues as a consequence of its need itself to cover its equity and contribute to its development with the return enabled through a self-insurance structure.

So, it is necessary to involve an insurance company under the figure of fronting, that is to say, for transferring a good


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part of the generated premiums to the reinsurance company that would take the risk overseas or abroad. The company can do minimum risk retention if it so wishes or it can simply transfer 100% of the invoiced premiums. For assignment purposes, there is no limitation on the transferred amount but there is a limitation on the retained amount. That is to say, the insurance company would be restricted when making its retention, if it should do so, as a result of existing technical equity exposure constraints. Given that the figure of “captive” company works outside of the country involved, effective insurance constraints would not apply to it. Said constraints would be effective for the company doing the fronting, but if it does not retain a large share, it would not impact its overall technical result, especially because its expected profit on the administrative benefits is minimum: there would be a low spending margin, there would be no insurance broker, and the benefits from the reinsurance program return commission would be low. In other words, the financial premises are different from those used in the other cases described above.

In conclusion, this mechanism can be summarized as follows:

1. Self-insurance using the figure of organizing a captive company gives the benefit of exploiting the government’s strength as a risk administration company. When duly managed, the probability of effects that would return to the insured party itself at a mid term as a result of the underwriting can be reduced to a maximum, without having disregarded the need to cover itself against equity volatility when facing the inherent risks.

2. The insured party is the insurance company owner so there is no transfer of associated costs when taking out an insurance policy; therefore, its local benefit is optimum and, in turn, it may also obtain benefits from the synergies that it develops with the reinsurance market.

3. The fee paid for the “captive” company license is recovered in the first effective policy year and in the insurance company’s first year of operations; therefore, at a mid term the growth in equity will be guaranteed

by itself as will the tax benefits and the legal benefits of having the off-shore company.

4. In the event that changes occur in the international reinsurance market, the company can benefit from them through the particular texts and clauses that are negotiated for the special coverage real estate portfolios of the countries.

5. Pursuant to their fiscal policy, the governments may improve their return on investment abroad, thus benefiting from the opportunities that they are granted by enjoying off-shore equity.

6. The captive company may be beneficial for difficult-to-insure risks or high-cost risks as it will have improved costs, as a result of being tied to other risks and of their possible retention in sight of the equity that it owns; it may be able to retaining up to 100% of such risks and thus eliminate dependence on the local market.

7. Generally speaking, the figure of a captive company allows governments to include other risks with the same characteristics, such as, for example, real estate from other jurisdictions or entities that would enable increasing risk dispersal and obtaining even more advantages when contracting risk transfer structures. So, budget allocations and executions for each fiscal period may improve. Likewise, the possibility of including marginated sectors of the society in an insurance policy at affordable costs could be explored; that may be done using this figure and including total subsidy mechanisms or even private sector participation.

8. In the coverage negotiations all of the assets of the national government and subnational government and of public utility SP may be included for the purpose of obtaining benefits in price and in coverage scope, thus optimizing the public budget.

9. To simplify the insurance contracting system, a public award may be conducted or a private bid invitation


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extended to reinsurance brokerage companies with proven experience in organizing off-shore companies, to thus procure the structuring for the optimum transfer structure in regards to scope and benefit and, above all, without falling into non-compliance of the insurance and reinsurance policies set forth by the various superintendences.

7.2 Combining financial protection alternativesMechanisms available on the insurance market and on the capital market are not substitutes for one another; they are rather complimentary and must be used simultaneously in a combined structure to cover different risk tiers. Within this structure distinct types of stakeholders participate, among them, insurance companies, reinsurance companies, private investors, investment banks, financial brokers, and multilateral organizations, which implies that although this institutional structure exists, the regulatory framework for the use of this type of instrument is outside the national sphere. Therefore, in addition to the detailed study specifying the design and strategy for placing the financing structure, it is necessary to work on achieving multilateral agreements that enable the access of local institutions to international markets and to establishing agreements that enable consolidating a common regulatory framework for the distinct national and international institutions that participate in the system.

As was mentioned above, insurance and reinsurance prices are seriously distorted by supply and demand constraints. A more sound institutional and regulatory structure and a transparent information system will notably contribute to reducing this type of constraint. However, until it is possible to implement said changes, it is of vital importance that the central government and the regional governments become aware of the importance of adopting disaster risk diversification measures, especially those concerning damages in the physical infrastructure. Mechanisms such as insurance allow decreasing the government’s fiscal burden after a disaster

occurs. After defining the State’s responsibilities, making an estimation of them, and seeing the physical capacity, agreements can be entered into between the State and insurance and reinsurance companies through which risks can be covered by designing proper financial instruments or transfer instruments.

After reviewing how different mechanisms work for transferring risk to the market, it is important to highlight the responsibilities that the State must bear regarding possible disasters: on one hand, the infrastructure and public constructions and, on the other hand, the low-income population who does not have the resources to acquire insurance policies and who, besides, usually lives in the most fragile, vulnerable zones. In general, there is a consensus that the private sector, as well as the mid-income and high income populations, must necessarily acquire insurance policies in the private sector. However, there are inefficiencies in local insurance markets that lead to supply problems for the insurance companies (high prices and constraints as to the number of policies offered for this type of risk). Under such terms, the only type of State intervention that is suggested to cover those sectors of the population is proper insurance market regulation and for the State to seek the capitalization of said market15.

After defining the State’s responsibilities, simulation exercises can be done that allow determining the optimal financing and/or transfer structure in terms of cost effectiveness. In summary, the process that must be carried out at the time of choosing the appropriate financial structure consists of the following steps:

1. Using catastrophic risk models, it must calculate the probabilities of occurrence of certain types of disasters, and also gather information on exposure (responsibilities, premiums, etc.) to determine its losses due to potential disasters and establish how much capital it would need to finance the risk in which it is incurring.

15 That can be done through strategies aimed at educating stakeholders on self insurance so that they do not sit and wait for State aid after a disaster, and also through a transition scheme at a long term to allow taking the low-income populations to self insurance directly in the private sector (Pollner, 2001).


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2. Compare the cost of using the State’s capital to the cost of insuring, reinsuring and/or securitizing the risk (using available financial instruments).

3. Using optimization algorithms, determine the combination of capital, credit, reinsurance, and securitization to minimize the total cost of covering the disaster risk.

In that context, the data to be used to calculate the financial instruments is basically:

• Informationderivedfromthetechnicalanalysisofthedistinct disasters (vulnerability, affected population, estimations of loss levels, etc...). Information on possible triggers (indexes).

• Insurance/reinsurancemarket andCATbonddata(profitability rates, tradability indicators, issuers, risk-free rate, Special Purpose Vehicles).

Using that information, distinct forms of financing can be proposed and simulations can be done to find the form that generates the minimum cost for the State. So, the State must define the level of risk that it retains for its own assets, the infrastructure, and the low-income populations. It is important to mention that the risk exists that it may not be the most efficient thing to do, given the implications of greater centralization that it would entail, in addition to high costs in terms of listings in Stock Exchanges where the financial instruments used for the risk coverage are traded, and the possibility of not successfully managing the portfolio.

7.2.1 retention and transfer structure designA financing structure is configured by allocating one or more financial instruments for each one of the distinct loss levels. Table 7-3 summarizes said instruments.

Contingent loans and reserve funds are the financial instruments that in general would be the most appropriate for financing retained tiers due to the existence of accessible markets and to their level of tradability. CAT bonds and the insurance and reinsurance system, far from being mutually exclusively options, are mechanisms that complement each other and allow more efficient risk diversification.

Each mechanism enables covering determined intervals of the loss amount, which makes it possible to structure a tiered risk coverage system. Insurance contracts allow covering the first loss tiers; however, in order to reduce the value of the State’s premiums, a significant first tier can be covered using disaster reserve funds and contingent loans with multilateral organizations. In some cases the insurance companies need the reinsurance system to cover them if the size of the loss exceeds their solvency capacity. Due to the high amount of loss, the final tiers in the disaster risk coverage structure may be borne by the capital market using CAT bonds and by multilateral banks using another credit figure. The use of CAT bonds for said tiers enables eliminating the counterparty risk that would exist if insurance contracts were entered into for such loss levels. And contingent loans have the great disadvantage that, if the decision is made to use them, the government increases its debt with the multilateral bank.

Table 7.3: DiSaSTer riSK cOVeraGe Financial

inSTrUMenTS

Insurance and reinsurance

CAT bonds

Contingent surplus notes

CAT options traded on the stock market

Equity CAT options

CAT swaps

Weather derivatives

Contingent loans


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The priority or deductible is the amount up to which the insured party (for reinsurance, the primary insurer) retains the totality of the risk, that is to say, that up to this point the insured party responds for the totality of its losses. As of an amount equal to the priority or deductible, the insurer (or reinsurer) responds for the claims filed up to a maximum amount known as the limit. The insurer (or reinsurer) is then bound to cover the losses that exceed the deductible up to the amount established by the limit. The distance between the deductible amount and the limit amount is known as a tier. According to the size of the disaster, the insurance and reinsurance market can organize itself in several tiers. The cost of insurance and reinsurance by tiers is generally determined by an indicator known as Rate on Line (ROL). The ROL is defined as the premium on the coverage limit.

After obtaining the information exposed above, both the government and the insurance companies are able to decide on the rate for an excess of loss contract. Now,

there are variations of the excess of loss contract, especially implemented by the reinsurance system, in which the priority and the limit are not determined by the amount of loss that the insured party suffers, but rather by insurance market loss indexes or by objective parameters such as rainfall or seismic activity, which are used as parameter indexes or triggers. To calculate the premiums for these contracts, a relation must be established between the losses suffered by the insured party and the factors that determine the priority and the limit.

7.2.2 Financial optimization analysisThe distinct retention and transfer structure tiers are established depending on the solvency of each one of the participating stakeholders and on the convenience of the cost terms for the government of ach one of the distinct sources of financing available. It is common to observe that for different amounts of losses caused by a disaster the costs of each source of financing can vary. An example of this is the excessive increase of insurance premiums for the highest

FIgURe 7.2: reTenTiOn anD TranSFer STrUcTUre

Total insurable amount

Probable maximum loss (PML)

Upper limit

Lower limit

Deductible

Does not require protection

Long-term complementary actions (CAT bond, taxes, long-term loans, etc.)

National GovernmentWorld Bank / IADB

Insurance and reinsurance

Contingent loan

Reserve fund

TRANSFER

RETENTION


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coverage tiers due to the greater degree of uncertainty that disasters of great magnitude represent. Therefore, it is essential to establish the costs of each one of the sources of financing for distinct amounts of losses.

After acquiring that information, the optimum configuration of the distinct available financial mechanisms using cost minimization algorithms within the structure by assigning a coverage tier to each source of financing. That is to say that once the costs of the different sources of financing are known for each one of the probable loss amounts, the optimum percentages that each mechanism must cover can be established. That information enables establishing and assessing the insurance and reinsurance contract conditions and the feasibility of issuance, for example, of a CAT Bond.

It is important to mention that world insurance market and capital market conditions are constantly changing; therefore, it is vital to constantly monitor changes in costs of the distinct risk transfer mechanisms and financing options. That allows economic policy designers to take advantage of the different opportunities that the market offers for risk diversification and cost reduction.

Once the financing source cost information is acquired, financing structures must be designed and then those that cover the same risk level with the lowest costs are selected. The optimization problem to be faced is similar to the one presented in Figure 7-3.

This figure graphically represents the costs of each one of the financing sources that the State has available for covering disaster risks. The graph shows that it is not optimum to finance the totality of the resources (K) using one sole financing source, and that at certain intervals there are other financing sources that can be less costly.

Therefore, it is necessary to build a total cost function to represent the weighted sum of the three financing sources, as follows:

(Eq. 7-1)

Where CT(k) the total cost function (that depends on the level of capital or the quantity of the required resources), CT(k) represents the cost of being financed with its own capital, RE (k) is the cost of being financed via reinsurance companies, and finally MC (k) is the cost of being financed through the capital market. Parameters a and b define the share that each one of the sources will have within the financing structure. The parameters, in the case of the State (national or sub-national government), are control variables because they represent the decision of which financing instrument to use for each one of the tiers of possible losses after a disaster. By defining parameters a and b cas share percentages, a + b ≤ 1.

FIgURe 7.3: FinancinG cOSTS

Co

st

Amount of Resources ($)

0 k1 k2 k3 k

Own capital Reinsurance Capital market

)()1()()()( kMCkREkCPkCT βαβα −−++=


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After establishing the cost functions of each financing source and the total cost function, then proceed to do the cost function minimization, by controlling parameters a and b. Redefining the total cost function including the control parameters in the domain, gives:

(Ec. 7-2)

and the State’s problem can be defined as:

There are optimization algorithms that allow finding the optimum (in this case the minimum) by explicitly defining the function. However, to solve this problem there is no explicit total cost function, but there are data series using which the functional form CP(k), RE(k) and MC(k). can be numerically built. In addition, the restriction that parameters a + b ≤ 1 and a, b ≥ 0 have limits the set of values that such parameters can take. So, the problem to be solved must be treated using numerical methods, finding the total cost function values for different values of the parameters a, b. Afterwards calculate those values using a computer program that can also find the smallest of those total costs function values, along with the corresponding values for a and b. This type of analysis must be done in order to estimate the most convenient or optimum financing structure for each government.

7.3 need to protect public assetsThe government plays an important role in establishing public policy and regulations to affect risk transfer and support. Some government regulations (building codes, norms, ground use regulations, etc...) and incentive policies (taxes, low-cost loans, subsidies, etc...) can reduce the potential

of a disaster. In addition to its role as decision maker and regulator, the government at all levels (national, provincial, and local) is also an important owner of assets. Damage to public buildings and infrastructure can cause different types of losses: loss of lives, economic losses, operating losses, and loss of cultural heritage. The government manages its risks by applying prevention-mitigation measures, by transferring the risk (usually through insurance16) and by retaining risks or through self-insurance17. Selecting what technique to adopt is a complex decision because it not only depends on the cost and on the goals intended to be reached but also on public opinion.

Experience has shown that the government also bears some of the financial risks associated with damages to private property such as residences, through the role it plays as post-event recovery financing agent. The cost of government allowances for healthcare, operating response activities, temporary lodging and post-disaster repair and reconditioning have been increasing through time to a point of concern. In general, the increase in population and in exposed assets has resulted in a situation in which, as new disasters occur, the consequences are greater and greater and the attention and recovery costs are growing. Vulnerability has not been sufficiently reduced. Many reports by CEPAL, the World Bank, the IADB, and other international organizations such as reinsurance companies contribute statistics for Latin America covering the last two decades which illustrate this situation. Clearly, those costs should also be considered risks for the government because although they do not correspond to what is normally acknowledged as “risk borne” they somehow influence the decisions of the government institutions or agencies regarding risk financing. Also, the protection of historical buildings is cultural heritage due to their intrinsic value, which means that they cannot be replaced if they are seriously affected or destroyed. Under such circumstances, it can be said that the risk management policy is governed by the social values more than by a cost-benefit analysis.

16 Public real estate insurance is contracted independently by each government agency; there is no pre-established strategy to orient an efficient insurance contracting process.17 Risk retention is basically done unawares and due to a lack of budget resources. In general it is not the result of a strategy of convenience for public agencies.

)()1()()(),,( kMCkREkCPkCT βαβαβα −−++=

0,1..

),,(,

≥≤+ βαβα

βαβα

as

kCTMin


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Events that may have high consequences and a low probability of occurrence, such as seismic events, do not tend to be of large concern to a community, especially if many years have passed since the last disaster. Often that situation leads to the public sector not placing much importance on the topic of risk management. Typically, for the government, public opinion is the force behind many of the decisions regarding risk management; therefore, such decisions are loaded with political implications. In some cases the decisions are clearly governed by the public’s perception of the risk rather than by the cost-benefit ratio or the society’s safety. Risk reduction or mitigation measures are somehow related or connected to the availability of post-disaster humanitarian aid. Local and provincial department governments normally have national aid that works as cost-free insurance. Unfortunately, that demotivates the above governments from maintaining local funds for mitigation and preparation. Different risk management strategies provide different benefits that are usually complementary. A risk transfer mechanism such as insurance may pay part of the repair costs and reduce the economic loss caused by damage to buildings but this mechanism can do little to protect life, to avoid a loss of functionality, to protect equity, and to mitigate other derived social costs. Therefore, risk management must be integral. From the seismic engineering perspective, for example, reinforcing the structures is the most effective technical strategy that can be selected for risk reduction because that mechanism favorable influences a reduction of all of the types of losses to which the government is exposed. However, the factors that limit adopting it have always been the cost involved and the feasibility of implementation. Although retrofitting should be performed before the presence of a hazardous event, it is often done as part of reconditioning damaged structures after a seismic event because that is when there is more availability of funds. Fund sources notably vary at each jurisdictional level and, in fact, at a local level it is usually possible to have access to provincial department or national resources. And at a national level, it is usually possible to receive support from multilateral organizations, which analogously wind up serving the function of facilitating contingent loans without prior negotiation or agreement.

The government sector has diverse risk transfer options through insurance, including private insurance in the form of risk pooling and mutual funds among government agencies. Risk pooling is defined as risk transfer elements for which several private entities or dual economy entities (the latter meaning entities made up of private capital and government capital) mutually share the responsibility with pre-established exposure, cost, and usage parameters. Another option that may be considered is transferring the risk to capital markets using financial instruments. Usually, the decision to look for insurance arises from an absence of government support programs or systems. The national government essentially acts as a cost-free insurer; indeed, it frequently covers part or all of the repair costs for the affected public infrastructure. Furthermore, earthquake insurance is not easily available or may be very costly for the government (high premiums and deductibles). One of the main reasons for which taking out insurance at acceptable rates is not a viable option for public sector facilities is the lack of detailed building inventory data, which makes it difficult for insurance companies to estimate policy prices. In general, public agencies purchase a general commercial insurance policy for earthquake coverage but without detailed information to differentiate or separate limits by building.

On some occasions, it may be interesting to combine commercial insurance with self-insurance or to have insurance with a limit and to directly bear the remainder. In some countries where private insurance has not been feasible, local governments have established an insurance pool that, with some limits, covers costs for emergencies, repair, and even other obligations. Such risk self-insurance funds are at times aimed at specific sectors such as schools or hospitals. Although earthquake insurance is not common under this figure, there are cases of captive insurance companies, such as the one recently founded in which the governments of 16 Caribbean countries participate, to cover emergency attention expenditure after a hurricane or earthquake. To the extent that they accrue reserves, such mechanisms or funds are able to obtain very favorable insurance and reinsurance rates because they commonly offer geographic diversity and big portfolios. In other words, risk retention is also an option that may be considered when good information regarding the


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risks that can be retained and those that can be assigned exists. In that case the proper thing to do would be to estimate the value of the premiums and maintain such values in a fund that could give returns.

On some occasions, it may be interesting to combine commercial insurance with self-insurance or to have insurance with a limit and to directly bear the remainder. In some countries where private insurance has not been feasible, local governments have established an insurance pool that, with some limits, covers costs for emergencies, repair, and even other obligations. Such risk self-insurance funds are at times aimed at specific sectors such as schools or hospitals. Although earthquake insurance is not common under this figure, there are cases of captive insurance companies, such as the one recently founded in which the governments of 16 Caribbean countries participate, to cover emergency attention expenditure after a hurricane or earthquake. To the extent that they accrue reserves, such mechanisms or funds are able to obtain very favorable insurance and reinsurance rates because they commonly offer geographic diversity and big portfolios. In other words, risk retention is also an option that may be considered when good information regarding the risks that can be retained and those that can be assigned exists. In that case the proper thing to do would be to estimate the value of the premiums and maintain such values in a fund that could give returns.

Undoubtedly, good information on the economic costs and benefits associated with a specific risk reduction strategy is very important for decision makers. At any rate it is necessary to know how easy or difficult it is to implement the strategy, what social and community benefits it would entail, and what indirect effects it would have. It is worth mentioning that government agencies often need to be treated as private

companies when it comes to risk management decision assessment. To conclude, the complexities involved in this process currently make establishing risk reduction, transfer, and retention strategies a real challenge.

Structure retrofitting may be the best technical option for saving lives and reducing damage but it can be prohibitively costly. In that case, some complementariness between transfer and retrofitting may be the most feasible option. Prevention cost and post-event recovery cost interchange ratios can orient financial risk management decisions. The cost of public sector damage due to natural disasters is a cost that may be very high for taxpayers who pay taxes. Public agency employees must explore insurance contracting alternatives for the coverage of public structures and must invest in effective risk reduction measures from a cost perspective. One way to meet that purpose is to cover just a low percentage of the damages to those structures using government funds for recovery actions. Indeed, one of the manners in which public building losses have been covered has been by implementing an ex post strategy of collecting taxes after the disaster. That is merely a community-based insurance figure where all of the residents wind up sharing the payment of a portion of said insurance. An example of that type of ex post decision was the tax on financial transactions to support the reconstruction in the Colombian Coffee Growing Area after the earthquake in 1999. Not in all cases does the population find such a measure acceptable. Nonetheless, it is important to indicate that in recent years legislators and public servants have become more aware of the fact that disaster recovery is the responsibility of the public sector. Precisely for that reason, Colombia has taken steps to design appropriate risk retention and transfer strategies taking into account insurance, incentives, taxes, and the effective application of earthquake-resistant construction standards.


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8.1 International cases

8.1.1 experiences in colombia

8.1.1.1 earthquake insurance evolution in ColombiaAmong the countries of Latin America, Colombia is one of the most advanced concerning its earthquake insurance operating policy, given the fact that such insurance was initially conceived as an add-on to fire insurance. One of its most notable features is that earthquake insurance has been mandatory since 1984 for all financial sector institutions, not only for their own real estate but also for the real estate that serves as a guarantee for mortgage obligations. That legal provision is met without major difficulty. Also, more recently, the legislation for horizontal property has improved making it mandatory to insure common areas in buildings, which normally go unprotected. Apparently very few buildings have yet to adapt to such demands.

From the very beginnings of earthquake insurance in Colombia, it was established that the premiums retained by the insurers were subject to a special technical reserve, to substitute the current reserve for risks, equal to 80%, which was to be indefinitely accrued from one fiscal period to another. It is worth mentioning that the reserve was politically and technically founded on the fact that, given their nature and the bases on which they are calculated, premiums could only be considered charged when they were allocated to the payment of an insurance claim. The reserve18 had to be almost totally invested in securities that could be exchanged for Banco de la República (Colombian Central Bank) foreign exchange certificates that, issued in United States Dollars, with a reasonable profitability, contributed to the necessary soundness of the companies and protected them against an eventual devaluation of other

Annex 4: Water Supply and Sanitation Sector International Financial Protection experiences

VIII.

investments in national currency. Earthquake insurance was subject, on one hand, to a deductible of 2% on the insured amounts and, on the other hand, to a mandatory co-insurance, to be borne by the insured party, of 20% on the loss value. Moreover, the regulation stated that a company’s maximum liability as a result of one sole event in the area of greatest exposure could not exceed 10% of its equity, and that said liability was estimated under the figure of Probable Maximum Loss (PML) as 25% of the insured amounts. In the event of an exceedance of that maximum liability, the company was legally obliged to take out reinsurance. Since then, rates have ranged from 0.75‰ to 2.6‰, a value similar to those established in other Latin American countries such as Peru, Chile and Mexico where earthquake insurance commercial rates range from 1.0‰ to 1.2‰, from 0.8‰ to 0.9‰, and from 1.8‰ to 2.2‰, respectively; the last one depending on the CRESTA zone and on recent effects. In addition, the average rate-on-line (ROL) for XL Cat coverage for Peru, Chile, and Mexico are 1.4%, 1.2%, and 3.0%, respectively; once again, the last one depending on the CRESTA zone and on recent effects can range from 2.5% to 5.0%.

It is important to mention that countless analyses and debates arose in the mid and late 1980s regarding the adequacy of the rates at that time, if the broker’s commission was reasonable or insignificant (2.5%), if that area of insurance offered short- or mid-term profitability, if the mandatory co-insurance was excessive, and even if the risk of earthquake could actually be insured through private sector mechanisms. The absence of soundly based rigorous risk studies has always generated great concern regarding the possibility of being involved in a business with little reliability. Indeed, such analyses even meant strong critiques by specialists concerning the role of the National Calamities Fund (FNC in Spanish) (created

18 There has been relatively little change in regulations. Currently 100% of the technical reserves must have similar backing through investmenrs abroad. 2000 Decree 94 and 2001 Decree 2779.


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through 1984 Decree 1547) that, among other functions, had been assigned the support to be given to private insurance companies when indemnities “exceeded available resources corresponding to what they had retained on their own “. Since it was created, the FNC has never played that part of its role. It was clear that a fund without a stable source of financial resources, which had to depend on the budget items allocated to it in the national budget, could hardly be a true reserve fund and could hardly serve as a reinsurance fund. The concern for the potential losses due to disasters as well as the need for a sound State catastrophic risk compensation figure led to proposals (Ossa), at that time, of building a fund or consortium similar to the one that has existed in Spain since the mid twentieth century, without the government paying much attention to those types of notions. A broader description of such types of financial mechanisms used in several countries will be presented in the analysis of alternatives in this consultant’s next report.

In 1990 the insurance market in Colombia was liberalized and the Banking Superintendence modified the requirement of maintaining reserves from 25% to 15% (this value is usually estimated based on a PML, which in the case of Colombia appears to be the PML corresponding to a 1,500 year return period). As earthquake coverage is tied to reinsurance, in 1993 due to an increase in reinsurance costs as a result of the impact on the market caused by Hurricane Andrew that hit Florida in 1992, a mandatory co-insurance of 25% was included in the insurance contracts after the one that had been mandatory until 1991 was suspended. It is important to mention that, in the case of Hurricane Andrew, repayment of insured losses may take more than 100 years. In 1994 and in 1995 the national insurance industry attempted to smooth out the imbalances of the years before and the cost of earthquake insurance actually dropped in 1995 even after the Northridge earthquake in 1994 caused new uncertainty regarding the availability of resources for reinsurance at an international level. Here it is important to state that USD 8 billion out of the USD 12.5 billion in estimated losses in California were homeowner losses. Afterwards, a new increase was recorded due, on one hand, to the Lothar Winter Storm in 1999 and to the storms that in 2000 caused losses in the order of USD 20 billion

in Europe, but more particularly, on the other hand, due to the notable decrease in reserves caused by the events of September 11, 2001. Usually, as the years go by, reinsurance costs start to drop but more recently hey have shown new increases as a result of the losses caused by the hurricanes in 2004 and more specifically by Hurricane Katrina in the United States in 2005. Due to that last event insurance coverage cost almost twice what it had before. In some cases the cost of reinsurance tripled, which was directly transferred to users. In addition, limits were diminished for the larger companies. With the exception of the insurance company Previsora that retains near 66%, that situation is reflected by a notable increase in insurance, given that most of insurance companies do fronting, that is to say that they practically do not retain risk but rather play the role of insurance brokers, contracting insurance on behalf of reinsurance companies. In the mid-1990s earthquake insurance in Colombia represented around 7.6% of the premiums issued in the damage sector. That share had been increasing since 1977 when it represented less than 1% of them. The evolution of premium values has shown ongoing growth. As was seen with fire insurance, until the mid-1990s the behavior of the construction sector and of housing loans generated an induced demand for this type of insurance and variables such as the number of industrial, commercial, and residential establishments; the value of housing stock, and the construction or industry GDP could explain their evolution. According to econometric studies conducted by Fedesarrollo, the value of earthquake insurance premiums (fire and business interruption) went from representing 0.12% of the GDP in 1997 to 0.13% of the same variable in 2010 (Fedesarrollo 1998).

Currently, earthquake insurance represents 9.6% of the premiums issued in the damage insurance area. That is a modest share if compared, for example, to automobile insurance that can be in the order of 37%. In fact, the total amount paid by all of the insurance companies due to the earthquake in the Colombian Coffee Growing Region in 1999 was around USD 200 million. To illustrate, La Previsora paid near USD 30 million out of which it bore near USD 1 million and the rest was assigned due to excess loss to the reinsurance company.


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Along the same lines, the rates for earthquake insurance and for damage insurance in general have been governed by market values that, after the introduction of new foreign companies in the market as of 1995, dropped to levels of under 0.5‰ in major cities such as Bogotá where the pure premium values without including local ground effects were estimated at around 1‰. That is to say that the fact that premiums are mainly influenced by market values without properly taking into account the technical calculation bases can lead to this business being a double-edged sword for the insured and the insurers alike. That does not seem very commendable as, from the technical perspective of this insurance area, the premium value charged in some cases does not cover the pure premium or technical premium of the insured risk.

8.1.1.2 aguas de manizales8.1.1.2.1 Company descriptionDue to its operating excellence, Aguas de Manizales S.A. E.S.P. is one of the leading companies in Colombia, as is reflected by its management indicators such as: unbilled water index of 27%, water supply and service coverage 99%, sanitation service coverage 98%, service continuity 100%, micro-measuring coverage 100%, collection efficiency 99%, water apt for human consumption. In addition, since 2001 it has all of its water supply and sanitation service processes certified under ISO 9001 standard version 2000 and since 2008 the meter laboratory has been accredited under NTC ISO/IEC 17025 standard.

Furthermore, Aguas de Manizales S.A.E.S.P has been a pioneer in managing and assessing the first Provincial Department Plans in Colombia. The first one was developed in the provincial department of Cesar three years ago; the goal was to improve coverage, quality, and efficiency conditions for public utility domiciliary water supply and basic sanitation service provision. Currently (2010) it is ding the management and assessment for the Provincial Department Water Plan for the provincial departments of Magdalena and Caldas.

At 2009 closing, Aguas de Manizales S.A. E.S.P. boasted 91,332 water supply subscribers and 87,511 sanitation service subscribers.

Since it was founded, Aguas de Manizales S.A. E.S.P. has operated the water supply and sanitation systems for the urban area and a large part of the rural area of the municipality of Manizales, besides its commercial activities. That has enabled it to offer integral water supply and sanitation system operation services or to be specifically in charge of one of more components in the value chain for this business:

• Hydrog raph i c ba s in admin i s t r a t i on andconservation

• Technicaloperationsandplanning• Administrationactivities• Commercialmanagement• Communityeducationandsensitizationwork.

8.1.1.3 Water supply network sectorizationFor better service provision, Aguas de Manizales S.A. E.S.P has been performing the sectorization of existing hydraulic circuits for them to coincide with the reading cycles for invoicing; to date, it has attained a total of 42 circuits, out of which 21 have a macro-measuring system using mechanical, electromagnetic, and/or ultrasound means.

Moreover, the company has a telemetrics system in 16 city tanks out of the 51 in operation. That system enables real-time behavior information.

The program is part of the Unaccounted-for water control activities; it allows determining water loss by circuit and its causes.

8.1.1.3.1 InfrastructureAguas de Manizales has been protecting natural and planted woodlands, thus conserving the hydric infrastructure for raw water and protecting the natural resources in the basins. Currently, there are 11 water intakes, 13.4 kilometers of raw water adducts, 5 weather stations, 5,255 hectares out of which 3,617 hectares are located in the Blanco River basin and 1,638 hectares in the Chinchiná River basin.

It has three water supply treatment plants. The Luis Prieto I plant and the Luis Prieto II plant have a treatment capacity


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of 1,466 liters per second and an average treated flow of 706 liters per second. The third plant is the Niza plant; it has a capacity of 600 liters per second and an average treated flow of 245 liters per second.

The water supply network in the urban area of the city of Manizales is 612.69 kilometers long and in the rural area it is 238.06 kilometers long, for a total length of water supply pipe length of 850.75 kilometers. The sanitation service network is 488.73 kilometers long in the urban area and it has 924 septic tanks installed and operating in the rural area.

From 2007 to 2008 the Luis Prieto Plant underwent structural refitting.

8.1.1.3.2 Aguas de Manizales’s insurance programThe insurance brokers are a joint venture of Delima Marsh and Willis de Colombia; the insurance company is Agrícola de seguros (Suramericana).

The current brokers worked on the implementation of the corporate risk management system (RAS) for the company. For quite a while now they have made their knowledge and experience available to the company through training on everything related to Colombian Technical Standard NTC 5254 for risk management; training has been forwarded with the process leaders as well as with the personnel involved in the processes. They have also actively participated in designing the Aguas de Manizales S.A.E.S.P. risk management process and in facilitating training for it.

The company has been applying the methodology designed by the current brokers to such an extent that sources of risk and areas of impact have been identified. Likewise, the risk identification form has been designed and is being prepared.

Also, insurance brokers have been linked with this company since it was founded in 1996; that makes them knowledgeable

not only about its administrative, operational, and financial structure but also about the risks that it faces and about the insurance program that guarantees proper coverage against such risks.

The insurance company that had insured the company since 1996 was Agrícola de seguros; it was bought out by Suramericana de seguros.

In 2001 Company engineers and the insurance brokers worked jointly to update the insured amounts.

Then, in 2005 risk engineering work was done using a firm called SUMA.

The policies taken out to cover the company are:

• Allriskmaterialdamages• Automobile• Automobileexcesscivilliability• Allriskequipmentandmachinery• Extra-contractualcivilliability• CivilLiabilityforDirectorsandAdministrators• Disloyaltyandfinancialrisks• Handling• Merchandisetransportation• Off-the-jobaccidents• GroupLife

The insured amounts at 2008 are shown in Table 8-1:

The combined material damages policy that includes the value of the treatment plants comprised material damages $188.135.580.210; Business Interruption $18.035.000.000; a six-month Indemnity period; all risk material damages and business interruption coverage.

The deductibles for that policy are shown in Table 8-2:


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The inventory that covers the Aguas de Manizales insurance program comprises high-turnover small-sized elements, such as elbows and bends, water meters, meter casings, screws, miscellaneous meter parts, gaskets, hand tools, containment keys, manholes, manhole accessories, hydrants, packings, pipes up to 6 inches in diameter, and valves.

It is worth mentioning that the Company has supply contracts with hardware stores and companies and in

Table 8.1: aGUaS De ManizaleS inSUreD aMOUnTS

(aT 2008)

insurance area insured amount (in US$)

Combined material damages 9,564,5948.3

Company cars 296,512.456

Excess civil liability for company cars

2,074,224.71

All risk equipment and machinery 468,169.72

Extra-contractual civil liability 2,000,000

civil liability for directors and administrators

- Option No. 1 1,016,776.82

- Option No. 2: 1,525,165.23

Disloyalty and financial risks

- Option No. 1: 610,066.09

- Option No. 2: 1,270,971.02

Handling

- Option No. 1: 25,419.4204

- Option No. 2: 50,838.8409

- Merchandise transportation 25,419.4204

Off-the-job accidents

- Option No. 1: 5,083.88409

- Option No. 2: 10,167.7682

- Option No. 3: 15,251.6523

Group life

- Option No. 2: 10,167.7682

Total Option no. 2: 101,377,585

general with suppliers that guarantee the supply of elements whenever it needs them. One-time payment elements are supplied, such as, for example:

• Cement• Largediameterpipes• Valves

Therefore, the inventories are not very representative of the true situation. Clearly the Company Emergency Plan has all of the suppliers of materials, large diameter pipes or special structures identified with contact data so, at the time of an event, the Company knows exactly where to go for its previously prepared designs and thus, immediately know when and how the supply will be delivered.

The components included in the risk management program Aguas de Manizales take into account several issues regarding disaster risks such as the financial aspects to know how and where resources will be obtained before, during, and after an event. Likewise, the Company operating aspects were analyzed bearing in mind that it is responsible for providing a domiciliary public utility service and that

Table 8.2: aGUaS De ManizaleS cOMBineD MaTerial DaMaGeS pOlicY DeDUcTiBleS

earthquake 2% of the insurable amount. Minimum 2% of the insured amount of the affected risk. Minimum US$ 2,000

natural disasters 10% of the loss value. Minimum US$ 2,500

Third-party intentional damage and Strike, mutiny, coup, civil commotion

10% of the loss. Minimum 2% of the insurable amount of the affected risk not lower than US$ 7,500

Theft with violent entry 10% of the loss. Minimum 2 ELMMS

electronic equipment 10% of the loss. Minimum 3 ELMMS

Machinery breakdown 10% of the loss. Minimum 3 ELMMS

Other events 10% of the loss. Minimum 2 ELMMS

Business interruption Mutiny, Third-party intentional damage and Earthquake: 5 days

Other events: 3 days


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it must respond to the city in an urgent manner giving an immediate response. Considering this panorama the Company started designing its Emergency Plan that basically sought to be concordant with the Emergency Plan designed for the city but also to understand that it is merely one piece of the pie and as such that it must harmonize all of its activities for the greater good.

The most important steps when preparing the Plan were:

• Identifyingandclassifyingthehazards• Analyzingthevulnerabilityandlevelofrisk• ImplementingtheEmergencyPlan• CarryingoutaPlanforEducationalActivities• PreparingthePlanforOperationalActivities• FormingtheSafetyBrigade• FormingtheCommitteeforEmergencies• Doingsimulations.

The insurance companies that have insured the Company have always sought reinsurance because the city has many problems due to its topography and to heavy winter storms and above all because after any situation occurs in the city the inhabitants immediately would go make claims to the Company. However, in the great majority of the cases it could demonstrate that it had not been responsible for the problem. Once again it is worth mentioning that the policies solely included pipes with a diameter of under six inches. The company has always believed that a seismic risk exists that may provoke a significant insurance claim.

The other problems relate to pipe damages that generate flooding in certain neighborhoods or landslides produced by ruptured pipes, which mix with runoff water that generates insurance claims. Every year the insurance companies have contracted reinsurance.

8.1.1.4 empresa de acueducto and alcantarillado de Bogotá (eaaB)The water supply and sanitation service company for Bogotá called EAAB periodically conducts risk studies that apply

to the different insurance schemes that it has. Among the studies that EAAB has conducted are the following:

• Calculationoftheprobablemaximumloss(PML)for the networks supplied by different aggregates. Specific cases for San Rafael and Tibitoc

• Consequential damages (business interruption) inthe system due to seismic events

• Calculation of damages to themainwater supplydistribution network due to seismic events, expressed as damages per kilometer of pipes

• Vulnerability studies and retrofitting design fortreatment plants and storage tanks.

Although it is known that EAAB has its different assets insured, information on the financial protection scheme, the insured amounts, business interruption values, and variation in user rates due to the implementation of insurance is all confidential and despite many queries access to such information was not granted. It is known that the Company is insured against earthquakes and that insurance companies are selected through bid award.

As to the impact of the insurance scheme on the user rates charged, it is known that this type of public utility company handles a rate model that reflects all company costs and expenses, so it may be assumed that the model is reviewed every five years and that the model is run in which there are fixed components for the fixed costs that are divided among all of the users and that is called the fixed charge. The other costs and projected investments are represented in the cost for a cubic meter of water.

The costs and expenses are sent each year to the Colombian Water Supply and Sanitation Service Regulatory Commission (CRA) for it to verify that they correspond to the company’s actual costs and expenses and that they are the ones that were included in the rate models. The insurance program is included in the rate and, as of the time when calculations are made for a five-year period, that factor is included and is periodically charged. If the program is contracted at a value higher than the value included in the rate model, the company bears the greater cost in its profits but if the program


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is contracted at a value lower than the cost included in the rate model, the company gains in efficiency. The above means that the cost of the program is already quite standardized and the CRA has a lot of influence on it. It is worth mentioning that the Colombian Energy and Gas Regulatory Commission (CREG) manages an efficiency model in which it creates a virtual company with the characteristics of a group of companies and based on the virtual company approves or disapproved the costs submitted at the time of calculating the rates.

8.1.1.5 Public utility networksMost public utility lines (natural gas, electricity, etc...) are not insured. It is common practice to insure them during the installation process pursuant to the provisions set forth in 1993 Law 80 and in 2007 Law 1150. During the installation, usually all-risk coverage is taken out to cover natural disasters and also damages caused to third parties during that process.

Machinery may also be insured by an equipment policy that protects them if they are affected by any event. In summary, it looks like this:

Table 8.3: inSUreD aMOUnTS DUrinG The inSTallaTiOn prOceSS

insured amount installation cost

DeductibleAs of the first lossA percentage of the insured amountOn the loss

Currently ten medium-sized and large SP exist in Chile; they are listed in Table 8-4 with their respective market share.

8.1.2.1 Water supply system and sanitation system risk management There are no norms relating to risk mitigation or reduction measures for water supply and sanitation services in Chile. The figure that may have most influence over such matters is the laws and regulations regarding safety measures during the construction of such installations, to be able to guarantee service continuity under any circumstance and thus allow the service providers to avoid possible sanctions due to supply interruption. To conclude, risk management is solely centralized in the topic of installation but does not globally address the system as a whole.

Using the concession system, the service providers are bound to permanently guarantee service continuity

Table 8.4: MeDiUM-SizeD anD larGe chilean Sp. MarKeT Share

Sp Sales in $Thousand

customer sales /month in 2004

$

2004 2004

large companies 158.871.290 9.749

Aguas Andinas 158.871.290 9.749

Medium-sized companies 207.768.975 9.250

ESSBÍO 63.898.509 9.450

ESVAL 57.826.453 10.012

Aguas Nuevo Sur Maule 16.507.984 7.704

SMAPA 15.939.106 7.810

Aguas Araucanía 14.884.108 7.355

Aguas del Valle 16.804.010 8.947

ESSAL 21.908.805 11.921

Aguas Los Domínicos 1.869.045 50.553

COOPAGUA 647.429 17.954

Source: Sanitation Services Superintendence

8.1.2 The experience in chileIn Chile water supply and sanitation service companies are regulated by the Sanitation Services Superintendence. Any situation that may affect the normal performance of their activities by diminishing or interrupting the service that the various companies provide must be evaluated by the Superintendence.

Sector norms are issued by the National Norm Standardization Institute but the verification of the compliance of such norms are the labor of the Ministries and their corresponding public agencies.


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other countries in the area. Accordingly, the earthquake that hit Chile on February 27, 2010 is generally considered the second most costly earthquake worldwide for this sector, after the earthquake in Kobe, Japan. The cost of the insurance claim for this disaster will be from US$ 4 billion to US$ 6 billion. The insurance market in Chile produces around US$ 2.3 billion per year corresponding to damages, which means that the losses represented two times the annual insurance capacity, thus generating a critical situation for the sector.

The insured losses due to the Chilean earthquake exceeded US$ 2 billion. The Chilean Insurance Company Association (AACH) estimates the cost that the insurance companies must bear to indemnify the damages provoked by the January 2010 earthquake in Chile to be at least US$ 2.5 billion to 2.6 billion (EUR 1,842 million to 1,920 million). That calculation is based on the insurance claims indemnified after the earthquake that ranked 8 on the Richter scale, which affected the country in 1985. On that occasion, the insurance companies paid 7.2% of total damages in the country.

8.1.2.2 the February 2010 earthquakeThe seismic event in Chile in February 2010 hit the region of Bio-Bio in the State of Concepción; total losses in water supply and sanitation systems are estimated at US$ 100 million. That amount was mostly covered by the insurance companies that covered the risk for the sector. Partial service reconnection arrived on the fourth day after the occurrence of the seismic event in some areas and the total reconnection took place on the fourth day for all of the population. For that population as well as for the population in the capital city Santiago, total service reestablishment took the companies around two weeks.

8.1.3 The experience in MexicoIn spite of Mexico being the leader, along with Japan and the United States, in seismic risk studies, the population is unprotected against such natural disasters. According to information furnished by Axa Seguros, only 5% of Mexican homes and constructions are insured against earthquakes.

with compliance of all quality standards. In the event of non-compliance, the Superintendence must perform its functions and is empowered to sanction the defaulting SP. The sanctions are mostly economic penalties but, depending on the seriousness of the service failure, forfeiture of the concession may be declared. However, situations exist related to surface sources of water supply, which are considered cases of force majeure (defined as the occurrence of an unforeseen event that cannot be resisted, which makes it difficult to properly provide the service), where, at the discretion of the Superintendence, it may release the SP of its responsibility. That assessment is normally based on the background, the assessment of similar prior events, and historical events. The types of events that would be considered a case of force majeure are not legally defined; therefore, the assessment of the causes for service suspension must be handled on a case by case basis.

Regarding such matters, the Superintendence states that “…the law does not set forth a priori scenarios in which a level of service inferior to the one defined by law may be accepted. Therefore, it must be considered that, in the event of a disaster, it is very difficult to establish a priori what infrastructure will be damaged and to what magnitude. Consequently, if we intend to establish attention levels by type of event, we may fall prey to a scenario in which an event hits with a greater magnitude than the ones previously recorded but, despite that fact, it does not cause a significant impact on all of the facilities. Such a situation could generate a case in which, although the SP could reestablish service in a reasonably immediate manner, it would be released from the obligation of guaranteeing service continuity and quality.

In addition to the above, it would be necessary to have a description of all of the risks to which the sanitation systems have been exposed, considering a detailed quantification of the magnitude of each one of them, and such historical information is not always available”.

Insurance in Chile represents around 4% of its Gross Domestic Product, a relatively high index as compared to


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That equals an insurance penetration in Mexico that does not go beyond 1.8% of the GDP. Also, the latest official statistics reported by the National Insurance and Bonding Commission (CNSF) show that the earthquake insurance area in Mexico only has 744,000 contracts. That represents a total insured amount of MXN 8,460,296,000.

One of the factors influencing that low market penetration is the cost of said policies, which the insured perceive as high; another factor is the lack of a widespread insurance culture, a problem that is common to most Latin American countries. The costs of such coverage in Mexico are a product of calculations made using models specifically designed for that country. That is to say that the costs are adjusted to the risks proper to the territory, which determines the probable maximum loss that an agency will have during a catastrophe of that nature and the average annual loss, indicators that ultimately define the commercial cost of the insurance policies. Due to the earthquake insurance premium cost assessment system in Mexico, in general it is expected that said costs will remain more or less stable and that there will not be significant variations after the occurrence of important catastrophic events such as the seismic events in Chile and in Haiti in 2010, unless important adjustments are made in reinsurance rates, which would clearly influence the local insurance rates in Mexico.

As concerns the water supply and sanitation service SP in Mexico, although their insurance information is not made public, the usual practice consists of taking out insurance either as a result of a public bid award, of an invitation to bid or by incorporating themselves into the insurance policies for government agency equity assets coordinated by the Finance and Public Credit Secretariat (SHCP). If the insurance companies do not have sufficient capacity for risk retention, reinsurance companies can be used (including reinsurance companies registered with the SHCP).

Below is a general structure of the insurance scheme for this type of infrastructure.

8.1.3.1 assets covered The assets covered by the insurance policies generally include all property, buildings, and goods belonging to the hydraulic infrastructure. Here reference is made to goods that are under the water level as well as the main system constructions. Among them are the following:

• Electronicequipment• Tunnelboringmachines,boringequipment• Motorsandengines• Furnitureandfixtures• Pumpingequipment• Wells• Drainageequipment• Dams• Waterintakeworks• Dikesandcanals• Tunnels• Sewersandtraps• Controlstations• Pumpingstations• Ductsandpipes• Storagetanks,dischargetanks,andregulatingtanks• Treatmentplantsanddrinkingwaterplants.

8.1.3.2 Covered risksUsually the insurance policies state all-risk coverage, understood as any damage or material loss caused to the infrastructure. It is common that risks that affect electrical equipment, electronic equipment, and machinery in general are taken into account.

Earthquake, hurricane, and flooding are among the risks generally included.

8.1.3.3 excluded risksThe policies usually exclude the following risks: insured asset design change or enhancement, manufacturing faults in the assets, normal wear and tear, and normal movement or settling.


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8.1.3.4 general policy conditions The insurance policy determines what the insurance company pays on losses caused up to a defined limit of the insured amount and it also defines deductibles and co-insurance.

Deductibles are usually determined according to the type of risk, that is to say, different percentages and limits are defined for the covered risks, using for each type of risk criteria that adjust to the idiosyncrasies of the event.

Co-insurance is charged after applying the deductible and the same as with the deductibles, they are fixed percentages differentiated by type of risk.

8.1.4 The experience in costa rica8.1.4.1 San Jose de Costa ricaCosta Rica also has de financial protection schemes; it insures its water supply and sanitation systems. For the capital city of San José, the SP has catastrophe insurance that includes earthquake risks. It also has all risk fire insurance.

The insurance includes a deductible for flooding and earthquake risks equal to 5% of the loss with a US$ 250,000 minimum per event. The deductible for landslides is US$ 100,000 for each loss. The insurance also has a maximum liability limit for the insurance company; the limit is estimated using a first relative risk that is estimated by the insured party according to the capacity of risk retention that it has and the degree of exposure to which it is subject. For San José, the maximum limit has been estimated at US$ 63,000,000.

Insurance for this sector is El relatively new and it started operating approximately two years ago. In that time frame only one catastrophic event occurred due to flooding in November 2010. The loss amount for that particular event has not yet been calculated nor has it been established if such loss will be covered by the insurance company.

The Company does not have a fund to cover deductibles or losses caused by minor events; said losses are borne through risk administration. Nor does the Company have contingent loans.

Lastly, earthquake–resistant standard compliance plays a fundamental role in the insurance and reinsurance areas. Indeed, for the infrastructure to be able to be insured, it must comply with the local earth-quake resistant design code, and based on that status, vulnerability after different natural hazards is assessed.

The above information was obtained through personal communications with specialists in the topic of insurance and reinsurance; it is not the result of any study or case study in particular. Nor are the statistics official or officially supported because all such official information is confidential in nature.

8.1.5 comments on other mass insurance mechanismsDiverse catastrophe fund and insurance program experiences exist, some have boasted successful results, others have failed, and yet others have been problematic. An example of a problem was insuring poor communities in Brazil where cases of moral risk arose to the extent that the program had to be canceled. A large number of poor proprietors burned their homes after they found out that they would receive an indemnity in the event of a disaster. Another known case that led to many claims and conflicts occurred as a result of Hurricane Katrina in New Orleans because hurricane insurance did not include flooding because in the United States flood insurance is only offered by the federal government (through FEMA) and most of the damage was due to flooding caused by some lake and the Mississippi River overflowing as they are located on higher ground than many of the places in the city and, more specifically, some flooding was due to the containment dikes breaking. Most of the persons who had hurricane insurance were not insured by FEMA against floods.


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It is important to discuss some government instruments that, similar to the Turkish Catastrophe Insurance Pool (TCIP) (the only existing one in a developing country), have been implemented in developed countries with a more advanced insurance culture. Worth mentioning are the Florida Hurricane Catastrophe Fund (FHCF), the Hawaii Hurricane Relief Fund (HHRF), the California Earthquake Commission (CEA), the New Zealand Earthquake Commission (EQC), the CAtNat in France, the Taiwan Residential Earthquake Insurance Pool (TREIP), the Japanese Earthquake Reinsurance Company (JER), the Norsk Naturskadepool in Norway, and the Insurance Compensation Consortium in Spain. None of the above covers public assets or finances emergencies. Most of these facilities have the following in common:

1. They tend to provide coverage against specific natural hazards;

2. They tend to have a regional focus;3. They provide coverage mainly for homes and their

contents;4. They have premium rates that tend to reflect the

characteristics of the risk with an element of solidarity involved;

5. As a rule of thumb, they do not receive direct subsidies from the government;

6. To different degrees, they promote retrofitting and safe construction practices offering discounts on the premiums; mitigation is not typically their main focus; and

7. They rely on the distribution and service capabilities of private insurance companies and their agents.

8.2 Case analysis conclusionsAs may be appreciated, different mechanisms exist that enable the financial protection of assets by insuring different assets at risk. In the particular case of the water supply and sanitation service sector, the city of Manizales in Colombia boasts a complete protection scheme for its assets and has conducted recent studies to update exposure, hazard, and vulnerability information.

The above case shows that it is possible to design and implement financial protection strategies in the water supply and sanitation service sector although, generally speaking on an international level this sector is not commonly insured. The above case does not imply that the same financial protection mechanism designed for Manizales can be applied to any other water supply and sanitation system in the world; the design of such an instrument is specific to each case and depends on the risk assessment results considering the local conditions regarding the different natural hazards, how said hazards interact (for example, the occurrence of landslides after a seismic event), the different companies’ financial situation, the measures taken to reduce or mitigate the risk such as building or plant retrofitting, and the location of system safety valves and emergency valves, among others.

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