Catastrophe bonds to fund disaster recovery and reconstruction

Supplement fiscal resources for disaster recovery and reconstruction with funds mobilized through risk transfer mechanisms, tapping the risk appetite of investors with large and diverse portfolios

Catastrophe bonds for recovery and reconstructtion

Supplement fiscal resources for disaster recovery and reconstruction with funds mobilized through risk transfer mechanisms, tapping the risk appetite of investors with large and diverse portfolios, who stand to gain by allocating tiny fractions of their corpus to high-risk but high-reward instruments

The Union government has asked state governments to create a separate category of funds within the State Disaster Response Fund, to cover recovery and reconstruction. The SDRF has limited resources, and the outlay on recovery and reconstruction would far exceed the funds available in the Fund. The sensible way to finance reconstruction is to buy insurance or institute risk transfer mechanisms of our own. The Catastrophe Bonds that insurance and reinsurance companies have been taking resort to, in order to cover the damage caused by hurricanes in the Americas and other such major disasters, offer a good model. Rather than rely exclusively on fiscal resources for recovery and reconstruction following a natural disaster, India should mobilise resources for post-disaster recovery and reconstruction from the wider world, while distributing the risk of a disaster to as many agents as are willing to bear it.

India’s current institutional framework for managing natural disasters is for the central and state governments to mobilise the funds needed for different aspects of disaster management. The tasks involved are one, response and relief, two, recovery and reconstruction, three, preparedness and capacity building, and, four, mitigation. So far, the Centre and the states have been providing for three of these four classes of functions, out of their own budgets. The unfunded task of recovery and reconstruction has generally been left to be funded out of multilateral loans, repaid over an extended period from state resources, or special central development assistance. The Fifteenth Finance Commission recommended that a separate facility for recovery and reconstruction be created, within the State Disaster Response Fund, as well as in the National Disaster Response Fund.

State governments create separate State Disaster Response Funds and State Disaster Mitigation Funds. Mitigation relates to action to reduce the risk from disasters, such as relocating habitats further away from rivers, reinforcing buildings, roads and bridges, amending building codes to withstand additional pressure, and such other measures. The State Disaster Response Fund used to finance two functions, response and relief, on the one hand, and preparedness and capacity building, on the other.

Recently, the Home Ministry wrote to state chief secretaries, asking them to implement the recommendation of the Fifteenth Finance Commission and restructure their disaster funding on the following lines. States would allocate 20% of their disaster management funds to the State Disaster Mitigation Fund. The State Disaster Response Fund would allocate the remaining 80% of the disaster response funds in the following proportions: 40% of the total to response and relief, 30% to recovery and reconstruction, and 10% to preparedness and capacity building.

There is a strong case for augmenting the recovery and reconstruction funds with extra-fiscal finance, funds mobilized through risk transfer mechanisms similar to insurance, tapping the risk appetite of investors with large and diverse portfolios of investments, who stand to gain by allocating tiny fractions of their corpus to high-risk but high-reward instruments.

Any investment involves a trade-off between risk and reward. Low-risk instruments, such as government bonds, typically deliver low returns, but these would be stable returns with low likelihood of default. High-risk instruments such as equity could generate high returns, via a combination of dividends, capital gains, and, in case of merger/acquisition, premia for enabling corporate control. Dividends could grow thin, if company prospects worsen, and technological change or a superior rival somewhere in the world could sink the company.

Catastrophe bonds are debt, but carry higher than normal risk. In case disaster does strike, both interest payments and principal repayment could be delayed or written off, in full or in part. To compensate for this risk, the bonds offer higher-than-normal rates of interest. These bonds have short maturity periods, improving the risk profile. Further, natural disasters are rarely correlated with business cycles, giving Cat bonds an additional sheen of appeal. If the disasters are large enough to trigger a national recession, of course, things would be different.

The proceeds of the bond issuance would go to the issuer of the Cat bonds only if the specified catastrophe does strike. Otherwise, the monies are kept in a fund, which can be prudently managed to earn safe returns that go towards payment of interest. The interest earned during the life of the bond from deploying the bond proceeds in safe instruments would be lower than the promised interest payout. The difference would have to be paid by the bond issuer, and it serves just like an insurance premium. If the corpus has funds left over after making recovery and reconstruction payouts, it should be repaid to investors.

Who should issue the Cat bonds, State disaster agencies or the National agency? Ideally, the National Disaster Management Authority should issue the bonds. The sovereign would be able to issue debt with lower rates than individual state agencies, and the Centre would retain its monopoly over raising international debt. Separate bonds should be issued for disasters in separate states. Since some state or the other is likely to experience a natural disaster every year, a Cat bond that covers the entire country would be unattractive to investors.

Cat bonds should supplement, not substitute, fiscal outlays for disaster management. The corpus for preparedness and capacity building, and the corpus for mitigation should be rigorously used, to minimize the outgo under response and relief, and recovery and reconstruction.

With climate change proceeding apace, extreme weather events turn more frequent, carrying with them the potential for death and destruction. Disaster management turns ever more important, every passing day, and the government system has to think outside the conventional framework.