Chapter 3. Mitigating disaster-related contingent liabilities and financing residual risks: Policy lessons
This chapter looks at how governments can reduce their expected disaster-related contingent liabilities through effective mitigating and financing strategies. It underlines the importance of setting clear and explicit disaster assistance rules, especially as they relate to the central governments’ financial support to subnational counterparts. It also emphasises the need to take moral hazard risk into account in determining rules for financial assistance to private stakeholders. This helps ensure that public disaster assistance does not undermine disaster risk reduction investments, but instead encourages them. The chapter concludes with a discussion of financing residual risks.
While Chapter 2 focused on the identification and quantification of disaster-related contingent liabilities with a view to better managing them as part of governments’ budgets and fiscal risk frameworks, this chapter focuses on strategies that help governments reduce their expected disaster-related contingent liabilities. Governments can reduce liabilities through two main lines of action: by clarifying and controlling explicit - and to the extent possible implicit - contingent liabilities and by managing moral hazard risks. Thus the mitigation strategies for governments could include all or a mix of the following:
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definition of clear cost-sharing mechanisms across levels of government;
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establishment of incentives for both subnational governments and non-governmental stakeholders to reduce disaster risks ahead of disasters;
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consideration of a ceiling on disaster recovery costs the government will assume;
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development of financial strategies to cover residual risks.
Since governments’ mitigating actions are intrinsically linked with their approach to managing disaster-related contingent liabilities, the findings of this report provide relevant policy lessons, discussed below.
Cost-sharing mechanisms between central and subnational governments
A significant part of central government disaster-related contingent liabilities stems from reimbursing costs incurred by subnational governments for their recovery and rehabilitation efforts. As seen earlier, a large share of these costs originates in the damage to public assets managed or operated by subnational governments. The process of providing post-disaster financial assistance creates a natural opportunity for central governments to encourage their subnational counterparts to engage in appropriate risk management. Particularly in economies where central governments offer wide-reaching assistance for damage to subnationally owned assets, cost-sharing arrangements should encourage subnational governments to invest in risk reduction and assess the cost-effectiveness of risk transfer. One important component is to encourage “building back better” in reconstruction, i.e. using the funds for recovery to invest in risk reduction in order to avoid the same damages the next time a disaster occurs.
Table 3.1 shows that many governments, independent of their administrative set-up, have specific cost-sharing arrangements between their levels of government to reimburse the costs incurred by a disaster. Most governments demonstrate a sense of solidarity in sharing and distributing those costs to help those subnational governments most affected by disasters.
The explicit commitments central governments have made to their subnational counterparts are sometimes exceeded under exceptional circumstances. In the aftermath of the major earthquakes experienced in New Zealand in 2010, 2011 and 2016 the central government assumed costs incurred by subnational governments that far exceeded its formal obligations. Central government support calledI into question the established definition of “essential infrastructure” – that is, the infrastructure it had committed to replace for subnational governments. This experience sparked reform discussions and a renewed interest by the central government in reducing disaster-related government liabilities through more effective and centrally monitored disaster risk reduction measures (e.g. building code and land use code enforcement).
Some governments do not clearly define the maximum levels of central governments’ disaster recovery support to subnational governments. In France, for example, disaster recovery assistance for subnational governments is available through the solidarity provisions for local authorities when damages exceed EUR 150 000 (USD 180 000), but a maximum amount of financing is not defined.
A number of central governments have started to re-designtheir cost-sharing mechanisms to improve compliance with existing rules during disasters. In Australia state governments compile an overview of the insurance arrangements in place for the assets that they own.This information is provided to the attorney-general, who has the authority to review the arrangements, make recommendations for changes and penalise states that do not comply with those recommendations, including through reductions in the rate of reimbursement for reconstruction costs. In Mexico, the FONDEN mechanism encourages subnational entities to reduce their disaster risk by limiting reimbursement for assets damaged in a second or subsequent disaster.
Several lessons are emerging. Central governments must be clear and explicit in their commitments for reimbursing disaster-related costs incurred by subnational levels. Ceilings that limit central government contributions to subnational counterparts could be a helpful enforcement tool. Finally, governments can better leverage cost-sharing mechanisms to reduce future liabilitie. Governments could consider rewards for subnational governments that invest in risk reduction measurs, risk transfer products or enforcement of non-structural measures.
Cost-sharing mechanisms between government and private actors
Another source of a central government’s disaster-related contingent liabilities is costs it covers for damages incurred by private stakeholders. This government support is often provided directly by central government agencies to the affected stakeholders, but is sometimes also channelled through and complemented by subnational governments (Table 3.2).
The expectation of ex post financial assistance can discourage private stakeholders from investing in risk reduction measures, including disaster insurance. France’s overseas territories have much lower hazard insurance coverage (52%) than mainland France (close to 100%). The lower rate in the overseas territories is explained by the prevalence of traditional buildings that do not meet the building code and thus cannot be insured. Unlike in mainland France, post-disaster assistance by the central government in the overseas territories is not limited to basic needs, but may also include financial assistance for the reconstruction of uninsured private assets. With the exact eligibility criteria adapted after each disaster, private actors may have reason to assume that the government will step in to provide disaster recovery and reconstruction assistance (Grislain-Letrémy and Peinturier, 2012).
Governments’ assistance for households varies across economies. While some governments focus their support on low-income households, others provide support to all affected persons, independent of their income levels. Post-disaster assistance for individual households is generally independent of any preventative measure taken by households. In line with this, the level of disaster insurance coverage for households is extremely low (as shown in Table 3.2),.
Governments recognise that assisting businesses with disaster-related costs is a key factor in limiting the overall economic impact of a disaster. Ex post assistance for disaster-affected businesses has focused on limiting the liquidity constraints created by an interruption of business operations, including through low-interest-rate credits or the reduction of taxes due in the year of the disaster. Like household assistance, assistance to businesses has most often not been tied to previous preventative actions taken.
The design of ex post government assistance for households and businesses should include incentives to invest in physical risk reduction measures. Rewards can be given to those households and businesses that adhered to existing rules on disaster risk prevention or for those that adapted voluntary protection measures, such as disaster insurance.
Managing remaining fiscal risk through multi-pronged financial protection strategies
Even after disaster-related contingent liabilities have been mitigated, some fiscal risk remains. Financial protection strategies help governments to manage these remaining contingent liabilities in a way that meets cost and liquidity objectives. In the past, the remaining fiscal risk was often met on an ad hoc basis after the disaster event (Bevan and Cook, 2015). However, governments are beginning to consider multi-pronged financial protection strategies based on more proactive planning to secure optimal access to post-disaster financing ex ante, before a disaster occurs (Table 3.3).
A dedicated reserve fund is a common ex ante budgeting mechanism for disaster-related contingent liabilities (explicit or implicit). It enables governments to respond immediately to disasters without having to cut other spending programmes or seek additional legislative authority. In many cases, such mechanisms have been established in response to particularly severe disaster events. Mexico’s disaster fund (FONDEN), whose mandatory allocation is no less than 0.4% of the annual budget, is an example of a dedicated disaster reserve fund. In case of disaster, FONDEN provides the 32 Mexican states and the federal agencies with the necessary resources to cover losses and damages, whose magnitude exceeds their financial capacity.
In addition to reserve funds, governments commonly use supplementary budgets, financed e.g. by new debt or taxation. In economies where the expected frequency and severity of disaster events is lower, governments may opt for a general contingency budget line, although such an instrument is rarely earmarked only for disasters. Depending on other contingent financing requirements, – it often has only small and uncertain amounts available to meet the cost of disaster-related contingent liabilities. The national budget in South Africa, for example, includes a contingency reserve that can be used in case of disasters, specified in the Annual Division of Revenue Act. In Japan, a general contingency reserve in the general account budget supplements the annual contingency budget line for disaster recovery.
Contingent credit facilities, which also allow an immediate disbursement once a disaster hits, may be more efficient than dedicated reserves for governments that face high-damage/low-probability disaster events. This option is particularly popular in Latin American economies. The government of Costa Rica has two such contingent credit loans: the Catastrophe Deferred Drawdown Option (CAT DDO) loan signed with the World Bank in 2008 and a contingent loan signed with the Inter-American Development Bank in 2012. In 2009, after the Cinchona earthquake and severe floods, Costa Rica used the CAT DDO twice to obtain a total of USD 24 million (World Bank Group, 2014).
Ministries of finance have an important role to play in ensuring appropriate scrutiny of decisions on financing residual fiscal risks and their incorporation in routine budget and public financial management processes. The balance between ex ante and ex post instruments to disaster risk financing is a key strategic issue. Isuch as tax incentives, extra-budgetary funds, public insurance and public-private partnerships can themselves, introduce new sources of fiscal risks or exacerbate fiscal risk if not well designed. Ministries of finance should advocate to integrate these decisions in governments’ budgetary processes.
References
Bevan, D. and S. Cook (2015), “Public expenditure following disasters”, Policy Research Working Paper, No. 7355, World Bank, Washington, DC, https://openknowledge.worldbank.org/handle/10986/22240.
Grislain-Letrémy, C. and C. Peinturier (2012), “L'indemnisation des risques naturels en France: implication de l'Etat, enjeux et perspectives ” [Compensation of natural disasters in France: State involvement, problems and prospects], in Gestion des risques naturels : Leçons de la tempête Xynthia [Disaster risk management: Lessons from the storm Xynthia], Chapter 10, https://ssrn.com/abstract=2646518.
World Bank Group (2014), “Managing disaster risks for resilient development”, World Bank, Washington, DC, http://www.worldbank.org/en/results/2013/04/12/managing-disaster-risks-resilient-development.