Managing the Unexpected: Impact of Disasters on Sovereign Asset and Liabilities Management

Disasters by their nature present a shock but nonetheless their occurrence can be estimated, as has been done by the insurance industry for years. That is to say the consequences are not so unexpected. However, when trying to account for the implicit contingent liabilities, such as those generated by natural disasters, the impact of the shocks are often not quantified in the government balance sheet. Yet, when they materialize, they place pressure on government finances that may raise interest expenditures and financial risks.

Understanding the impacts of disaster risk on sovereign assets and liabilities plays a key part in understanding how to manage the unexpected. The importance of accounting for disaster impacts across public sector balance sheets, and the implementation of Sovereign Asset and Liability Management (SALM) can help build understanding of the impacts of disaster risk. This can then be used to provide key practical recommendations for understanding risk in its multiple dimensions (economic, fiscal, and financial).  It can demonstrate the value of sovereign disaster risk finance strategies which allow governments to reduce the costs and risks of disasters using prearranged financial instruments.

In practice, it can be difficult to identify the total direct cost of a disaster with any precision and reconstruction may continue for several years after the event. There might be reallocation within existing budget baselines that is difficult to track, and replacement assets might be of a higher standard. Accrual accounting and cash based accounting both recognize reconstruction as an investment, however, one identified advantage of accrual accounting over cash based accounting is that it allows better identification of when and how reconstruction occurs, and hence of the associated costs and benefits, which can be used to inform measures to build financial resilience against disasters. The complexity of applying SALM is further discussed in this blog; Zooming out for better clarity: sovereign asset and liability management.

The application of SALM can increase countries’ resilience to financial shocks posed by disaster risk through improved understanding of the impacts of disaster risk on both sides of the sovereign balance sheet. Going forward it could even be used to define a country’s risk tolerance to disaster risk, monitor changes in this position and help to inform policy design on disaster risk and where needed support the introduction of financial instruments to manage disaster risk.

A recent report by the World Bank proposes applying the Sovereign Asset and Liability Management (SALM) framework as a new and comprehensive way of looking at the potential impacts of a disaster on the public sector balance sheet through assets and liabilities. The paper introduces a theoretical framework (see figure 1) to understand the potential impact of natural disasters on countries’ economy and public finances. To evaluate this impact, existing alternatives for modeling and stress testing and the challenges that arise from lack of data are discussed. The theoretical framework is applied in three case studies, Peru, Serbia and New Zealand to derive lessons about the potential impact of natural disasters on the sovereign balance sheet and highlight the importance of accounting for disaster impacts across public sector balance sheets.

Figure 1: Framework for impacts of disasters on the public sector balance sheet

Source: World Bank

Note: PS = public sector

The case studies demonstrate that estimating the potential impact of disasters on the national economy and the sovereign balance sheet is complex requiring significant data and modeling. However, they demonstrate that viable mechanisms to assist timely post disaster response and reconstruction can have very high payoffs, especially when assisted by an appropriate SALM framework, moreover, that the lack of these may be very costly. For example, reserve funds were found to mitigate the need to borrow after the event, as demonstrated by both the Peru and New Zealand cases. In the case of New Zealand, the Natural Disaster Fund, in essence the capital of a government-run insurance scheme for households, covers the first tier of losses for most natural disasters. In Peru, the Stabilization Fund may be accessed to finance severe economic and disaster shocks. However, the amount of finance to be kept in reserve should be carefully considered against the opportunity cost of holding these funds as discussed in this blog which sets out the rationale for holding funds in reserve.

Disasters create an opportunity to embark upon a more systematic approach to disaster risk management. Following the floods in Serbia, the government developed a disaster risk financing strategy and established a dedicated fiscal risk management unit. Embedded within the strategy was the inclusion of a contingent credit, a World Bank Catastrophe Deferred Draw Down Option (CAT-DDO) to strengthen the financial response capacity to natural disasters by having a pre-agreed line of credit that can be used following an event.

Reinsurance can play a major role in reducing the economic impact of disaster. The New Zealand case study included the use of the global reinsurance market, both by the government scheme and private sector insurers; it showed that claims on foreign reinsurers improved the net international investment position of New Zealand by around eight percentage points of GDP. Without this, the government would have been required to borrow more, as the NDF was exhausted (for the first time in 70 years).

Countries that are only starting to consider SALM should start with simple analysis (e.g., debt analysis). Countries using cash accounting and with no complete data set on government assets, face challenges in adopting and implementing the SALM approach. However, not all aspects need to be included at once, and having some basic level of understanding on how disaster risk can impact the structure of your debt portfolio would benefit many countries, perhaps now more than ever in the wake of the COVID-19 pandemic.

The application of SALM can increase countries’ resilience to financial shocks posed by disaster risk through improved understanding of the impacts of disaster risk on both sides of the sovereign balance sheet. Going forward it could even be used to define a country’s risk tolerance to disaster risk, monitor changes in this position and help to inform policy design on disaster risk and where needed support the introduction of financial instruments to manage disaster risk.

Photo credit: Adwo / Shutterstock

Financial Resilience Around the World | Blog Series 

1. Financial Resilience Around the World: Global Risk Financing Facility
2. Three Ways Lesotho's Past Experience with Disasters Strengthen COVID-19 Response
3. Three Steps to Help Albania Withstand the Financial Impacts of Disasters and Crises
4. How the Pandemic Has Highlighted the Need for the Next Generation of Natural Catastrophe Impact Modeling
5. How Burkina Faso is Leveraging a Credit Guarantee Scheme to Help SMEs Weather the COVID-19 Economic Crisis
6. Using Satellite Data for Climate, Crisis and Disaster Risk Finance
7. Learning from COVID-19 and Climate Change: Managing the Financial Risks of Compound Shocks
8. Developing Disaster Risk Finance in Morocco: Leveraging Private Markets for Sovereign Risk Transfer
9. Rural Resilience: It's Not Only About Insurance
10. Leveraging Space Technology for Climate Risk Finance
11. Resilient Finance: Closing the Protection Gap Against Disaster Risk
12. Piloting the Next Generation Analytics for Climate-Related Financial Resilience of Critical Infrastructure in Southeast Asia
13. How Much Did It Cost to Make Budget Cuts for Fighting the COVID-19 Pandemic?