Integrating Mitigation with Risk Transfer Instruments

1. Integrating Mitigation with Risk Transfer Instruments Howard Kunreuther Wharton School University of Pennsylvania E-mail: kunreuther@wharton.upenn.edu George Deodatis Dept. of Civil Engineering Columbia University E-mail: deodatis@civil.columbia.edu Andrew Smyth Dept. of Civil Engineering Columbia University E-mail: smyth@civil.columbia.edu Paper Presented at World Bank Conference on Financing the Risks of Natural Disasters: A New Perspective on Country Risk Management June 2-3, 2003 Washington, DC

2. Objectives of Paper Motivating Question What are the financial benefits to national governments by encouraging or requiring property owners to invest in cost-effective mitigation measures? Why is this Interesting? Previous studies have focused on benefits of mitigation to individual property owner. World Bank has a stake in promoting cost-effective mitigation measures to avoid large expenditures after a major catastrophe.

3. Outline of Paper • Defining cost-effective mitigation • Role of risk-transfer instruments • Combining mitigation with risk transfer instruments to governments • Case study of Turkey • How World Bank can promote mitigation using risk transfer instruments • Future Research

4. Defining Cost-Effective Mitigation Cost of Mitigation (C) (e.g. $65,000) Discounted Expected Benefits from Mitigation (B*) Reduction in direct losses Reducing indirect losses Avoiding relocation of residents Avoiding business interruption risk Reducing losses to neighboring structures Reducing financial costs from catastrophic losses Decision Rule:   If B* > C then mitigation is cost-effective If B* < C then mitigation is not cost-effective

5. Building Collapse “Nearly all the fatalities and injuries can be attributed to building collapse.” EERI Report (Oct. 99) From BBC News Photo by Nano Seeber

6. Role of Risk Transfer Instruments Individual: Purchasing insurance • Reward policyholder with lower premiums for adopting mitigation measure • Other factors influencing protective decisions • Underestimation of risk • Myopia (short time horizons) • It will not happen to me • Budget constraints Government Insurer • Provide funds to compensate disaster victims following a catastrophic event. • Increase capacity for providing more coverage to individuals at risk

7. Using Exceedance Probability Curve to Show Benefits of Mitigation

8. Questions government can address using EP curve What types of mitigation measures are most appropriate for dealing with the hazard(s) that the country faces? What types of risk transfer mechanisms are appropriate for reducing the magnitude of claim payments following a major disaster?

9. Case Study: Protection Against Earthquake in Istanbul Chances Istanbul will have strong earthquake in next 30 years = 62% Possible losses to apartment buildings in Istanbul from severe earthquake ·        5,000 complete structural failure ·        40,000 significant structural damage

10. Turkish Insurance Program Turkish Catastrophe Insurance Pool (TCIP) created in September 2000. Current status of insured private property (May 14, 2003) ·       1.9 million insurance policies in Turkey ·       776,755 purchased by Istanbul residents TCIP has purchased excess of loss reinsurance through a consortium of 60 different companies ·       $840 million in place

11. Pilot Study • Located in Caddebostan • Built in 1968, seismic code of 1967 • Z-3 soil (relatively stiff) • Moment resisting reinforced concrete frame with no shear walls • Existing concrete’s yield limit of 16MPa • Retrofitting concrete’s yield limit of 25MPa • Nonlinear (Bilinear model) • Highly representative of residential buildings in and around Istanbul

12. Retrofitting Solution 1 (Braced)

13. Fragility Curves (Braced)

14. EP Curves for 30 Apartment Buildings

15. Reinsurance Cost to Turkish Government With and Without Mitigation 30 Buildings (Based on Actuarial Risk) Without mitigation: $16,179  With mitigation $3,507 30,000 Buildings (Based on Administrative Cost of 1.5 x Actuarial Risk) Without mitigation: $24.3 million  With mitigation $5.3 million Savings to Turkish Government: $19 million.

16. Role of World Bank in Encouraging Mitigation Premium Reductions Linked with Government Mitigation Loans Provide funds for mitigation through some type of long-term loan. Insurance premiums are lowered to reflect benefits of mitigation May have to subsidize low-income residents Issuing Catastrophe Bonds to Governments Can one require cost-effective mitigation as a condition for a cat bond? What are the prices of these new financial instruments likely to be? How can one combine reinsurance with capital market instruments?

17. Future Research Questions • What role can land-use planning play in supplementing mitigation measures for reducing future disaster losses? • What role can government institutions play in aiding low income families? • What role can microcredit institutions (e.g Grameen Bank) play at individual and community level? • What is the role of informal mechanisms (e.g. group-based insurance systems) in spreading coverage over a large area to diversify risk? • How can other mechanisms (e.g. social investment funds and safety nets) help in managing disaster risk?

18. Conclusions and Summary Mitigation measures have many benefits to individuals and countries  • ·        Reducing direct physical damage • ·        Indirect benefits to residents and businesses • ·        Financial benefits to country Risk transfer instruments can aid country in disaster planning Mitigation measures can reduce country’s cost of risk transfer mechanisms World Bank can encourage mitigation and provide risk transfer instruments Need to combine many policy instruments for an effective risk management strategy:  • ·        cost-effective mitigation measures • ·        land-use planning • ·        risk transfer instruments • ·        reconstruction programs