Debt Sustainability Under Catastrophic Risk: The Case for Government Budget Insurance

• Author: Patricio Valenzuela,Eduardo Cavallo,Eduardo Borensztein
• Date: 01 September 2009
• Published date: 01 September 2009
• DOI: http://doi.org/10.1111/j.1540-6296.2009.01168.x

C

Risk Management and Insurance Review, 2009, Vol.12, No. 2, 273-294

EDUCATIONAL INSIGHTS

DEBT SUSTAINABILITY UNDER CATASTROPHIC RISK:

THE CASE FOR GOVERNMENT BUDGET INSURANCE

Eduardo Borensztein

Eduardo Cavallo

Patricio Valenzuela

ABSTRACT

Natural disasters are an important source of vulnerability in the Caribbean re-

gion. Despite being one of the more disaster-prone areas of the world, it has the

lowest levels of insurance coverage. This article examines the vulnerability of

Belize’s public finance to the occurrence of hurricanes and the potential impact

of insurance instruments in reducing that vulnerability. The article finds that

catastrophic risk insurance significantly improves Belize’s debt sustainability.

In addition, the methodology employed makes it possible to estimate the appro-

priate level of insurance, which for the case of Belize is a maximum coverage of

US$120 million per year. International organizationscan play a role in assisting

countries to overcome distortions in insurance markets, as well as in helping to

relax internal political resistance to the purchase of insurance policies.

INTRODUCTION

This article analyzes the vulnerability of Belize’s public finances to the occurrence of

large natural disasters and the possible use of insurance instruments to reduce that

vulnerability. Natural disasters cause an abrupt increase in government spending, both

for relief activities and to restore infrastructure and facilities that have been damaged

or destroyed. Although international aid usually helps to defray those costs to some

Eduardo Borensztein is with Inter-American Development Bank, 1300 New York Ave., N.W.,

Washington, DC 20577; phone: 202-623-2717; fax: 202-623-2268; e-mail: borensztein@iadb.org.

Eduardo Cavallo is with Inter-American Development Bank, 1300 New York Ave., N.W.,

Washington, DC 20577; phone: 202-623-2817; fax: 202-623-2481; e-mail: cavalloe@iadb.org.Patri-

cio Valenzuela is with the European University Institute, Villa San Paolo, Via della Piaz-

zuola 43, Florence 50133, Italy; phone: 39 333-856-5527; fax : 39 055-4685-928; e-mail: patricio.

valenzuela@eui.eu. The views expressed here are strictly the views of the authors and do not

necessarily represent the views of the International Monetary Fund (IMF), the Inter-American

Development Bank (IDB), the boards of these institutions or the countries they represent, or

any other institution. The authors thank Pelin Berkmen, Andre Faria, Francis Ghesquiere, Diego

Vil ´

an, Federico Mandelman, and Romina Bandura for their help with the data and useful sug-

gestions, and two anonymous referees for their suggestions. Fidel Jaramillo and Matteo Bobba

kindly provided us with their data. All errors are ours. This article was subject to double-blind

peer review.

273

274 RISK MANAGEMENT AND INSURANCE REVIEW

extent, the experience of Belize and other frequently affected developing countries is

that disasters result in an increase in government debt and a higher risk that debt

may reach an unsustainable level. With the development of insurance and reinsurance

markets for natural disasters, and the initiatives sponsored by the WorldBank and other

institutions to facilitate access to those markets by Caribbean economies, countries like

Belize now have an opportunity to reduce their public finance vulnerability to disasters.

This article attempts to evaluate the reduction in debt vulnerability that can be achieved

through disaster insurance and computes the optimal level of insurance from the point

of view of debt sustainability.

In two recent papers, Robert Barro (2006a, b) has shown that the occurrence of infrequent

economic disasters has much larger welfare costs than continuous economic fluctuations

of less amplitude. Barro estimated that for the typical advanced economy, the welfare

cost associated with large economic disasters such as those experienced in the 20th

century (wars, economic depressions, financial crises) amounted to about 20 percent of

annual gross domestic product (GDP), whereas normal business cycle volatility only

amounted to about 1.5 percent of GDP. For developing countries, which usually suffer

from a larger propensity to disasters of all types, and of even larger magnitude than

in advanced economies, these events have an even greater effect on the welfare of the

average citizen. Of the more than 6,000 natural disasters recorded during 1970–2002,

three-fourths of the events and 99 percent of the people affected were in developing

countries (Rasmussen, 2004). At the macro level, Rasmussen (2004) finds that the 12

large natural disasters in the Eastern Caribbean Currency Union (ECCU) produced a

median reduction in same-year GDP growth of 2.2 percentage points and a median

increase in the current account deficit equal to 10.8 percent of GDP. In addition to their

direct costs, large catastrophic risks pose a major challenge for public finances, and for

debt sustainability in particular. And reaching a position of unsustainable public debt

usually results in further financial and economic distress for the country.

In the case of case of Belize, a Central American country of 300,000 people and a GDP of

approximately US$1 billion, natural disasters are the source of relatively frequentevents

of catastrophic proportions. For example, the last two hurricanes that hit Belize, Keith in

2000 and Iris in 2001, caused some of the worst damage ever in the country. According

to available estimates, the costs amounted to 33 percent of GDP (US$280 million) and

30 percent of GDP (US$250 million), respectively.1The increase in government expen-

ditures associated with these two storms reached US$50 million and spread over three

fiscal cycles. As the country’s fiscal position worsened, its debt dynamics became in-

creasingly unsustainable, and Belize eventually required a restructuring operation for

public debt in 2006. Although not all the fiscal imbalances that have developed since the

late 1990s may be directly associated with the storms, the government argues that the

spending increases that led to the large deficits and debt accumulation were necessary

to pay for reconstruction in the aftermath of the hurricanes.2

1The economic impact of a disaster usually consists of direct costs, such as damage to infras-

tructure, crops, and housing, and indirect economic losses, such as drops in tax revenues, un-

employment, and market instability. See EM-DAT, “The OFDA/CRED International Disaster

Database” (2006).

2See Government of Belize (2006).