Hedging catastrophic risk exposed foreign aid

Several days ago, I posted a comment here that talks about hedging foreign aid.

Most developing countries have very low insurance penetration.  This means, typically, if they suffer a catastrophic loss, their insurance recoveries amount to very little.  Developed economies can and should address this problem.

Reinsurance markets (these are the markets that serve insurance companies, not people) have developed many tools to sidestep what is called "follow the fortunes" doctrine.  This insurance practice says insurance may only pay off on actual losses.  Historically, anything else was referred to as "gambling" and would provide nasty incentives to those gamblers.  However, buyers of "insurance" even if they don't bear the risk of direct loss, are unlikely able to affect the severity of an earthquake, for example.



So, these markets trade as swaps.  As of last week, for example, Swiss Re indicates that you could buy $1 million of California earthquake protection that pays off if California has in excess of $30 billion of realized losses for about $47,500.

Reinsurance pricing depends on where the greatest risks lay.  For example, three or four risks drive most reinsurance pricing: California quake, Florida wind, Japanese quake and European wind.  (Did you know Europe has it's own version of hurricanes?)  For the most part, the bulk of the capital in reinsurance markets faces these risks.

What does this mean?  Everything else, more or less, provides diversification.  "Provides diversification" is a fancy way of saying "We sit on a large pile of capital prepared to pay claims on a massive hurricane in Miami, so we do other stuff with the capital too, because we can.  the risk may be under-priced, because most events don't happen, and they're so small they don't matter, and any incremental premium collected adds to the bottom line, more or less." 

Let's return from Bermuda (reinsurance markets) and get back to Haiti and other developing markets.  The US and other entities and countries make loans to developing economies.  We also grant aid.  These economies often face natural disaster risk.  We also know if these disasters strike, we will likely respond with more aid, etc.  Because these smaller economies have limited insured values, reinsurance companies do not have exposure to them, for the most part.  That makes them "highly diversifying".  Thus, insurers marginal return on capital for taking such risks look attractive.

Also, when making the loans to developing nations, the lenders consider the risk of the loans.  Even though the loans have "altruistic" goals, they should still be made efficiently.  If the loans could be insured against natural disasters, making them less risky, then the cost of the loans fall, making more loans possible.

As a side note, this also addresses some of the problem of the complete inefficiency of emergency response dollars crowding out development aid dollars.  As wonderfully as it plays on CNN, sending extremely expensive search and rescue crews into Haiti to work for days makes people feel good and trains crews, it is an absurdly expensive way to save lives.  Imagine how many vaccines and mosquito nets could be purchased for at risk populations in Africa for the dollars spend in Haiti.