Disaster Risk Assessment and Risk Financing: A G20/OECD Methodological Framework, Exams of Credit and Risk Management

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EXECUTIVE SUMMARY

Disaster Risk Assessment

and Risk Financing

A G20 / OECD METHODOLOGICAL FRAMEWORK

This G20 / OECD methodological framework on disaster risk assessment and risk financing has been developed as a response to a mandate from G20 Leaders, Finance Ministers and Central Bank Governors in order to foster more effective disaster risk management strategies and financial strategies in particular. This framework has benefited from inputs from the G20 Country Steering Group on disaster risk management, the OECD’s High-Level Advisory Board on the Financial Management of Large-Scale Catastrophes, Insurance and Private Pensions Committee, Committee on Financial Markets and High Level Risk Forum, as well as from the World Bank and the United Nations. The OECD is grateful for a number of tables provided by the World Bank. Cover image: © Shutterstocl/Angela Jones

Finance Ministries and other relevant financial authorities play a pivotal role in DRM strategies given their responsibilities for economic, financial, fiscal and budget policymaking, planning of public investment and coordinating public expenditures. These central responsibilities as confirmed by the framework include:

• Ensuring that financial vulnerabilities within the economy are addressed through private markets, government-backed schemes or other instruments in order to promote financial resilience, and ensuring the availability and efficiency of compensation mechanisms, whether private or public
• Ensuring proper fiscal management of disaster risks by anticipating potential budgetary impacts and planning ahead to ensure adequate financial capacity and rapid release of funds, thus enabling emergency response, reconstruction of public assets and infrastructure, and targeted financial assistance
• Ensuring that clear rules regarding post-disaster financial compensation are established to enable rapid compensation, demonstrate solidarity and clarify the allocation of disaster costs, thereby promoting public confidence in country financial strategies while aligning incentives and reducing moral hazard
• Ensuring the soundness and resilience of the financial sector with respect to disaster risks, including through proper regulation, business continuity planning, and stress testing
• Ensuring the optimal allocation of resources for DRM, including assessment of the cost-effectiveness of major public financial investments in disaster risk reduction projects In regard to financial management strategies, these responsibilities involve key decisions regarding the development and design of schemes enabling post-disaster assistance and disaster insurance and the provision of financial guarantees within these schemes, the management of disaster-related contingent liabilities within the fiscal framework, and the role of the financial sector. These decisions become increasingly critical insofar as country disaster risks are significant and insurance markets are absent or unable to cover these risks, leaving the government with potentially large financial exposures. Methodological framework This methodological framework is intended to help Finance Ministries and other governmental authorities in developing more effective DRM strategies and, in particular, financial strategies, building on strengthened risk assessment and risk financing. While the framework does not specifically explore disaster risk reduction policies, it highlights the strong interconnections between disaster risk assessment, risk reduction and financial management, key building blocks for dynamic and continually evolving DRM strategies. Based on country practices and existing international DRM frameworks, the framework first addresses risk assessment as a key step for promoting risk financing strategies through a series of concrete steps:

The framework balances the need for a flexible, open-ended framework that encapsulates the key issues from a broad, economy-wide perspective and recognises country differences with the need for a framework that provides substantive guidance for decision-making, in particular by financial authorities. It is intended to be non-prescriptive and applied voluntarily by any country seeking to strengthen physical and financial resilience to disasters. Key policy messages for Finance Ministers and other relevant stakeholders Country risk assessment is a critical foundation for disaster risk management and related financial strategies and requires clear rules and governance.

• Risk assessment needs to be comprehensive and well orchestrated both within government and with stakeholders, requiring a robust governance process and framework
• Agreed definitions and rules are needed to ensure consistent and reliable outcomes
• Risk assessment outcomes need to be communicated to decision-makers and the public
• Establishing a solid evidence base through the collection of data on hazards, exposures, vulnerabilities and losses is crucial to this effort and DRM strategies overall

Methodological framework for disaster risk assessment and risk

financing

Disasters present a broad range of human, social, financial economic and environmental impacts. In addition to inflicting direct damages to lives, buildings and infrastructure, they can produce indirect damages with the potential for cascading and systemic effects. Disasters can present severe financial challenges to governments. With countries facing more frequent and severe disasters and increasingly constrained public finances, disaster risk management (DRM) strategies have become indispensable for enhancing the resilience of societies against disasters and reducing their social and economic costs. G20 Finance Ministers and Leaders have recognised the importance and priority of adequate DRM strategies and have, in particular, highlighted the key components of disaster risk assessment and risk financing. “We recognize the value of Disaster Risk Management (DRM) tools and strategies to better prevent disasters, protect populations and assets, and financially manage their economic impacts” (Los Cabos, 19 June 2012). Finance Ministries and other relevant financial authorities play a pivotal role in DRM strategies, and especially related financial strategies, given their responsibilities for economic, financial, fiscal and budget policymaking, planning of public investment and coordinating public expenditures. These central responsibilities include:

• Ensuring that financial vulnerabilities within the economy are addressed through private markets, financial schemes, subsidies, and/or other instruments and ensuring the availability and efficiency of compensation mechanisms
• Ensuring proper fiscal management of disasters by anticipating budgetary impacts and ensuring adequate financial capacity and rapid disbursement
• Ensuring that clear rules regarding post-disaster financial compensation are established to enable rapid compensation, demonstrate solidarity and clarify the expected allocation of disaster costs
• Ensuring the soundness and resilience of the financial sector with respect to disaster risks
• Ensuring the optimal allocation of resources for DRM, including assessment of the cost-effectiveness of major public investments in disaster risk reduction projects In regard to financial management strategies, these responsibilities involve key decisions regarding the provision of financial guarantees, the development and design of schemes enabling post-disaster assistance and disaster insurance, the management of contingent liabilities, budget expenditures and role of the financial sector in providing protection against disaster risks. Finance Ministries can also play an instrumental role in promoting and augmenting risk assessment and supporting its coordination, enabling a comprehensive view of disaster risks and permitting the proper calibration of financial management strategies. Executive summary

OECD was invited to develop a voluntary framework to facilitate disaster risk assessment and support the development of financial strategies by Finance Ministries. The framework, summarised below, highlights the need to estimate the likelihood and potential impact of disasters, and their underlying physical and societal drivers, as a basis for elaborating and assessing the full range of DRM strategies. It emphasises the role of Finance Ministries in the development of financial strategies to manage fiscal impacts, reduce financial vulnerability within the economy and enhance overall resilience. This methodological framework is intended to be non-prescriptive and applied voluntarily by countries. Building on national, regional, and international frameworks, it ultimately seeks to strengthen physical and financial resilience to disasters. Key components of the methodological framework

Disaster risk assessment is best able to capture the full range of losses if it adopts a comprehensive, all-hazards approach, covering all major natural and man-made types of hazards or threats. An all- hazards approach permits an integrated assessment of disaster risks, facilitating the identification of commonalities and interlinkages between hazards, the possible sequencing of events and follow-on impacts. As risk assessment may be conducted for different purposes, the objectives for risk assessment need to be established before it is conducted, as the intended purpose may determine the nature of data required, the most suitable methodology to use and appropriate risk communication tools to develop. Furthermore, developing a common understanding of core terminology and agreeing on a methodology promotes consistent approaches to risk assessment across sectors and facilitates comparability of outcomes. While risk is inherently difficult to measure, the purpose of risk assessment is to obtain at least orders of magnitude of potential risks in order to facilitate prevention, preparation and mitigation efforts and consider proper financial strategies.

Risk assessment

Risk assessment provides governments with the basis for decision-making regarding all phases of DRM, including decisions on the appropriate allocation of resources, in a manner tailored to local conditions, needs and preferences. Risk assessment, which includes risk assessment from a financial perspective, is an essential pre-condition for elaborating financial strategies (see figure below). Its main elements are: Governance – establishing agreed procedures and methodologies, transparency and accountability and structured interaction with stakeholders Risk analysis – identifying and analysing the hazards, exposures, and vulnerabilities and then the evaluating risks Risk communication and awareness – communicating the results of risk analysis widely to decision-makers and the general public Post-disaster impact analysis – evaluating the impacts of disasters Policy implications of risk assessment outcomes – leveraging the results of risk analysis for the full range of DRM actions, including financial strategies Adopt an all- hazards approach, identify objectives, and agree on terms and methodology

1. Governance Comprehensive approach and agreed objectives and methodology

The risk assessment process may involve interaction and collaboration among key groups of stakeholders, including those who use its results to develop policies, those who are responsible for managing impacts and stakeholders whose lives, assets or resources are exposed to hazards. Designating a lead national government authority to coordinate a risk assessment across central government ministries can facilitate the development of an integrated view on the most significant risks facing the country. Its responsibilities may include co-ordinating input from ministries and developing guidelines to ensure consistent and systematic approaches to risk assessment across sub-national levels of government. Risk assessment can benefit from close coordination with sub- national levels of government and from instituting partnerships and regular consultations with the private sector, relevant centres of scientific research and civil society. Adequate resources and expertise are required to ensure an ongoing, well-developed risk assessment process. Risk assessment needs to be as objective and transparent as possible to ensure credibility of the output. Transparency promotes accountability and furthers rigorous results. Transparency can be supported, where appropriate, by identifying and documenting the sources of data and any limitations, as well as making them accessible. Access to data on exposures and vulnerabilities can be used to improve risk modelling, identify risk reduction measures, support the development of preparedness plans and reduce the cost of financial risk transfer tools. Reporting and accountability mechanisms create sound incentives for high-quality risk assessment and promote the communication of risks. Accountability can be fostered by clearly assigning responsibility for the risk assessment process and is facilitated by the establishment of oversight requirements and periodic review. Promote transparency, disclose sources of information, and establish reporting and accountability mechanisms Transparency and accountability Involve key groups of stakeholders, assign a lead national government authority, and provide adequate resources Multi-level governance, multi-actor participation

Populations, assets or environmental resources that are exposed to hazards and consequently susceptible to death, injury or damage need to be identified. The nature of these exposures, including physical, social, economic, and environmental, can be assessed and their magnitude or importance evaluated. Self-protection capabilities and coping capacities that can limit exposure at the outset, mitigate impacts and/or enable recovery, such as early warning systems, emergency response capacity and financial tools, are relevant in analysing vulnerability. Describing the impacts of disasters pays due attention to such factors as the expected sequence or chain of events that may ensue from a hazard event or set of events, possible amplifiers that can accelerate, intensify, or spread destructive impacts, possible interdependencies and spillovers, for instance due to damaged networks or infrastructure or environmental damage, and the distribution of impacts across the population and economy, including by major segments such as government, households, the financial sector and corporate sector and their nature and scale. Data inventories are useful to catalogue elements at risk and enable an assessment of exposures and vulnerabilities. Inventories may include location-based information on the characteristics and vulnerability of assets (e.g., value, use, age, building materials) and on prevention infrastructures (e.g., flood defences). Location-based data permits the layering of information to obtain an integrated view within a defined geographical area. Other data linked to exposures and vulnerability can be collected such as data on investments for risk reduction and on insurance coverage. Steps in risk analysis Vulnerability and impact analysis Identify exposures, and analyse factors that create vulnerability, and estimate potential impacts Establish location- based inventories of exposures and prevention infrastructures

Risk is determined through the investigation of hazards, exposures, and vulnerability and can be expressed as a function of probability and likely impacts within a given time horizon. Where there is sufficient data, a probabilistic risk modelling framework can provide useful results. Verifying and keeping track of the risk evaluation outcomes is valuable for comparing and monitoring risks over time. In national risk assessments, experts estimate the relative impact and likelihood of different scenarios based on common criteria and rank the risks. The results may be visualised within a matrix, in which each risk factor, determined by its “likelihood” and “impact”, is shown as a point. For disaster risk financing and transfer strategies, the relevant risk measure depends on the precise context but it is linked to anticipated losses that, absent financial tools, cannot easily be managed within existing resources. Based on hazard, exposure and vulnerability analyses, evaluate risk and document outcomes With risks emerging and threats evolving, risk assessment requires ongoing monitoring and efforts to update of data linked to hazards, exposures, vulnerabilities, and damages. Incorporating a forward- looking element, whereby a long-term horizon is adopted, can help to identify future risks. Continuous risk assessment and periodic review of the risk assessment process itself help to ensure that it remains useful. Risk evaluation Risk monitoring Monitor current and emerging risks The outcomes of risk analysis can be communicated to enable top-level DRM decision-making through a dedicated structure or leadership position within government. Risk matrixes, risk maps and plotted risk curves can facilitate the communication of results. Outcomes can also be communicated, in simplified fashion, to the broader public, coupled with relevant information on risk reduction actions realistic to local conditions. Wide communication of risk assessment results can deliver benefits. Communication can for instance help build public trust, easing the acceptance of any crisis measures. Wide communication can also help in embedding risk reduction knowledge into policies, spatial planning strategies, regulations and standards, such as zoning and building codes.

3. Risk communication and awareness Communicate the results and inform key decision- makers and the broader public

The financial impacts of disasters need to be understood and assessed by Finance Ministries as a basis for developing financial and fiscal management strategies, for which they have central responsibility. These impacts can be mitigated ex ante through financial management tools along with physical risk reduction measures. Financial tools reduce financial vulnerability by ensuring that resources are available for rapid reconstruction and recovery, thus averting financial distress and potentially devastating drops in welfare. Risk financing strategies usefully consider: Risk exposure and risk-bearing capacity – identifying the nature and distribution of exposures within the economy, risk-bearing capacities and, thereby, financing gaps (or financial vulnerability) Risk financing and risk transfer – evaluating the availability, adequacy and efficiency of risk financing and risk transfer tools to address financial vulnerabilities Institutional arrangements – assessing the need for government intervention in risk financing and risk transfer markets and, if there is a role for government, identifying appropriate schemes Effective disaster risk financing and risk transfer strategies at the country level require a good understanding of risk exposures within the economy and risk-bearing capacities, which together indicate levels of financial vulnerability, or the extent to which a financing gap might emerge as a result of a disaster. As a first step, those who are exposed to disaster risk and thus expected to sustain losses following a disaster need to be identified and their level of financial exposure assessed. Assessing the exposures facing the major segments of the economy, namely households, the corporate sector, the financial sector, and government, helps to identify economic and social disruptions that might be caused by disasters. Specific sectors or populations can be examined in light of economic, social, environmental and other considerations. Risk assessment developed in the first part of the methodological framework can provide input into this analysis.

Risk financing

1. Financial exposure and capacity Identify risk exposures, assess risk-bearing capacities, and identify actual or potential gaps in financial capacity (‘financing gap’)

As a second step, the risk-bearing capacity of those exposed to disaster risks needs to be assessed. Risk-bearing capacity refers to the capacity to absorb and recover from losses, based on own resources, income, and self-financing capabilities. Similar to analysing financial exposures, assessing risk-bearing capacity can cover the major segments of the economy and those populations and sectors of the economy whose inability to absorb disaster risks might have important consequences. Those unable or potentially unable to absorb losses given their risk exposures face a “financing gap”. Absent financial tools or further risk reduction measures, such gaps translate into financial vulnerability. Financial vulnerability provides a reference point for assessing the costs and benefits of ex ante financial tools: some may be able to cope with the financial impacts of disasters without using financial tools; however, others may clearly benefit from such tools despite their costs. Risk financing and risk transfer instruments, in combination with risk reduction measures, reduce financial vulnerability by addressing expected financing gaps. These instruments may also reduce the economic costs of disasters by enabling the reprofiling or the transfer of risks, improving government financial planning, and the management of contingent liabilities and possibly providing incentives for risk reduction: Risk financing involves retaining risk but adopting an explicit financing strategy to ensure that adequate funds are available to meet financial needs should a disaster occur. Such financing can be obtained internally through the accumulation of funds or externally through pre-arranged credit facilities. Risk transfer involves shifting of risks to others who, in exchange for a premium, provide compensation when a disaster occurs, ensuring that any financing gap that might emerge is partially or fully bridged. Risk transfer may be obtained through such mechanisms as mutualisation, insurance policies or capital market instruments. Where risk financing and risk transfer markets are domestically well- developed, those facing disaster risks need to evaluate whether, given their financial vulnerability, to retain risks and fund them solely on an ex post basis within existing financial capacities, or whether to manage risks ex ante through risk financing, risk transfer, or additional risk reduction measures, based on their benefits and costs.

2. Risk financing and risk transfer Evaluate how financial tools might be used to retain or transfer disaster risks, in possible combination with risk reduction

Where insurance markets are not well developed, but also in more developed markets, insurance products may be unavailable or unaffordable. In such contexts, financial vulnerabilities, which may be significant, might remain unaddressed, particularly for poorer segments of the population. Governments would need to consider ways to ensure that basic compensation or post-disaster risk financing is made available to reduce hardship, for instance through the development of innovative financial tools such as micro-insurance, and parametric insurance products, or through the establishment of government compensation programs. Absent such arrangements, the government may be called upon to provide financial aid in an ad hoc manner, potentially increasing outlays. For their part, governments and Finance Ministries in particular need to assess carefully the potential role of risk financing and risk transfer instruments in their fiscal management strategy. This assessment is best be made within a disciplined framework that is based on a sound risk assessment process and risk financing approach that seeks to identify any financing gaps. For countries with significant populations or sectors that are financially vulnerable and, for whatever reason, uninsured, governments and their Finance Ministries especially need to factor implicit government contingent liabilities into financial planning given expected funding pressures. A similar consideration applies to any explicit contingent liabilities created by governmental involvement in an institutional scheme for risk financing or risk transfer, whose establishment will reflect a financial strategy elaborated by Finance Ministries and other relevant financial authorities. Fortunately, governments are well placed to affect their own exposures not only due to their role in risk reduction strategies, but also given their ability to foster the development of risk transfer markets, which can serve to reduce exposures. Clarifying the allocation of disaster costs – among different levels of government and between the public and private sectors -- can align incentives with risk reduction and proper financial management. Such an understanding and internalisation of risk allocation may incentivise those facing risks to consider relevant mitigation actions. Among governments, clarity is required regarding responsibilities for public investments in disaster risk reduction. Insurance markets can help to provide signals on risks, which may serve to incentivise risk reduction. Where these markets exist, pricing of coverage may provide signals regarding existing and emerging risks and their costs, which may encourage privately initiated risk reduction measures and help governments in identifying critical risk reduction measures, evaluating their costs and benefits, and measuring the extent to which disaster costs are being reduced through time. Devise strategies to address vulnerable populations or sectors lacking financial tools Evaluate the potential role of financial tools in fiscal management Clarify the allocation of disaster costs to align incentives with risk reduction

Institutional arrangements may be established to promote efficient risk financing and transfer capabilities within an economy as well as promote effective mechanisms for the provision of governmental financial assistance. These arrangements may be established by industry or government or, typically, both. For arrangements involving the government, Finance Ministries have key decision-making responsibilities in terms of: i) assessing the need for these arrangements; ii) designing them and in this context determining the appropriate type of financial commitment to provide, for instance ex post financial assistance or a financial guarantee, given the nature and objective of these arrangements (e.g., public scheme to support the disbursement of post-disaster aid, scheme to support private risk financing and transfer); iii) ensuring clarification of responsibilities and financial commitments to ensure that incentives are aligned, policy objectives are met, and unwanted risks to the fiscal framework are minimised; and iv) ensuring that ex ante public arrangements for financial assistance and private financial mechanisms are well-coordinated and complementary. Institutional arrangements may serve to ensure the general availability or affordability of financial tools, provide adequate compensation for identified segments of the population or economy (which may include supporting private-sector development of products and/ or developing government financial assistance arrangements and programs for targeted segments), strengthen rapidity in financial responses, and provide greater certainty regarding the allocation of disaster costs. These arrangements may be complemented by special subsidies or forms of tax relief. Institutional arrangements may bring other benefits, such as better coordination and synergies with industry and clarification of disaster-related contingent liabilities. A critical decision is whether the government needs to play a role in private risk financing or risk transfer markets, which generally involves the creation of institutional arrangements in concert with the private sector. This decision requires Finance Ministries to conduct a careful evaluation (see text box below for key elements for consideration). The government may also, for similar reasons, directly provide compensation and recovery financing. Such arrangements may be financed ex ante through a reserve fund or ex post based through pre- established funding rules. Well-designed schemes help to secure timely release of funds for emergency response, recovery and reconstruction, strengthen incentives for financial self-protection and avoid crowding- out effects of private markets. There is a need for a rigorous balancing of the respective roles of government and market-based or insurance- based solutions in promoting financial resilience, depending on the maturity of insurance markets and the nature of financial vulnerabilities within the country economy.

3. Institutional arrangements Assess whether the government should play a role in providing risk financing or risk transfer of private losses