Can Cat Bonds Improve Catastrophe Preparedness?
Unclear financial responsibility for catastrophic events may be an explanation for inadequate catastrophe preparedness in Swedish municipalities.
In the past year (2013/14), extreme rainfall and storms have caused indemnities in Sweden of some 3 bn SEK (Dagens Nyheter: More rainfalls have cost billions, in Swedish only, October 16, 2014). In an international context, that is not alarming – the flooding in Copenhagen three years ago caused about 8 bn SEK of indemnities. But the cost for extreme weather events is on the rise, due both to more occurrences and to the fact that increasing living standards mean greater values at risk.
Another reason for increasing costs is the lack of adequate catastrophe preparedness in municipalities that in Sweden are responsible for preemptive measures. While private enterprises prepare for extreme events, municipal preparations lag behind. Examples could be under dimensioned sewer systems and a lack of risk analysis in the local zoning process. The problem is probably emphasized by the somewhat unclear division of responsibilities between municipalities and the national government. In principle, it’s easy: Municipalities are responsible for preparations and the national government has the overall responsibility for costs to society incurred by catastrophes. However, reimbursements to municipalities are subject to discretionary decisions by the government.
In general it’s not a good idea to separate responsibilities for making preparations from the responsibility to carry the consequences of an event. This was true during the subprime crisis in 2008-09 and it’s true on the insurance market today.
A concrete example is that municipalities have strong incitements to permit new housing in attractive locations, such on beaches and riverbanks, to attract people to settle in the municipality. However, the increased household risk is normally carried by all insurance policy holders, which has led a number of insurance companies to limit new policies in exposed areas. And the increased risk to society (such as infrastructure) is carried by all local citizens, and, in many cases, by citizens in other parts of the country, due to the national economic responsibility.
A simple way to adjust the situation would, of course, simply be to delegate the responsibility for the consequences as well to municipalities. This would, on the other hand, be punitive to municipalites in more exposed areas.
Another normal option would be to introduce a ceiling for the local responsibility. On the other hand, this would not change the incitements to prepare for extreme and very costly events.
Perhaps a better solution would be a full national responsibility to cover the costs of “normal” catastrophic events, while demanding that municipalities carry the excess risk through insurance solutions, such as municipal cat bonds? By doing so, municipalities would immediately be forced to consider the costs of neglecting preparations as premiums would rise. But they would also see the benefits of mitigating investments in lower premiums. The beauty of introducing financial instruments for disaster preparedness is precisely that we also get a tool to measure the value of mitigating efforts and the cost of neglect.