Natural disasters pose daunting barriers to development in poor countries. The human and material losses resulting from droughts, floods, storms and earthquakes further impoverish already poor populations. The year 2005 was a case in point. Victims of already longstanding disasters continued to suffer in places like southern Sudan, the Democratic Republic of the Congo and Ethiopia. Recent disasters like the Indian Ocean tsunami, the food crisis in Niger, the earthquake in Pakistan, the hurricanes in Central America and the drought in Malawi struck already vulnerable populations in poor countries.
In order to maximize its value to the world's most vulnerable populations, often the victims of these disasters, the international aid community must endeavor to create an effective and equitable international emergency aid system. To reach this dual goal requires a conceptual shift from a reactive emergency aid business model to a proactive risk-management investment model. Vulnerable populations almost continuously suffer some losses as a result of localized, frequent natural calamities and manmade hazards. To treat these events as emergencies obscures the fact that some populations have become so poor that they can no longer support themselves even in normal natural conditions. From a financial perspective, providing assistance to vulnerable populations to enable them to survive normal one-in-two- or one-in-three-year fluctuations in weather and other expected events is an investment proposition. Aiding populations to cope with extreme events is an insurance proposition. The first needs a predictable, steady flow of investment funds; the second requires contingency funds to cope with probable but uncertain events. The second is the focus of this article.
The dilemma facing any aid agency with contingency funds is how to ensure effective and equitable use of a limited amount of funds within a specific emergency and across all disasters in a specific region during a fiscal year. (1) There are three obvious possibilities. First, one could use the contingency funds to create a fund of last resort, in which case one would wait to see how other donors respond to an emergency and fill in the gaps. However, this is hardly a prescription for timely funding. Second, one could fund as much as possible of the response to the first disaster that happens to strike and risk being unable to help victims of disasters which occur later in the fiscal year. Third, one could limit assistance to a dollar amount or a percentage of costs of each disaster, hoping other funds will come in later to fund the full operation. As a provider of last resort the aid agency would forfeit the gains of timely intervention. As a provider of first resort an agency could only pro vide aid based on a first-come, first-served basis or an arbitrarily limited basis. None of these approaches ensures efficient and equitable use of funds nor do they enable aid agencies to plan and manage effective operations.
A more equitable and effective system requires managing contingency funding against a portfolio of risks. Risk, in this context, is defined as the potential loss of lives and livelihoods, ultimately requiring a humanitarian aid response, which vulnerable populations face as a result of natural or other disasters in the developing world. Equity, in the sense of fairness, requires forward-looking risk management. Fairness requires anticipation of the magnitude and probabilities of disasters that may occur over the course of a budget period. To be fair, financial allocations over the course of this time must reflect our best understanding of this portfolio of risks--the sum of the spatial and temporal distribution of the risks associated with loss of lives and livelihoods faced by vulnerable populations. Allocating resources, such as a fund or anticipated contributions against this portfolio of risks ensures the equitable distribution of funds across emergencies and over time.
Financial efficiency first requires understanding the correlations between potential disasters. Efficient sizing and allocation of relief funds must take advantage of the portfolio effects of noncorrelated or countercorrelated risks in order to understand how limited capital should be allocated to distinct risks and regions over time. Second, an optimally designed disaster aid finance system must also make use of risk transfer opportunities in order to take advantage of the potential financial efficiencies gained by including vulnerable population risk in commercial risk portfolios held by international reinsurers and hedge funds, as well as to leverage existing capital and risk-taking capacity. This new approach to disaster aid finance promises several advantages. These include more timely and predictable aid in times of crisis, risk price information for sound development portfolio decisions and greater dignity for the beneficiaries. It may also include greater political support for aid by bringing the financial advantages if diversifying developing country natural disaster risk into the international risk markets. This article discusses how one would build such a system.
MANAGING DISASTER RISK PORTFOLIOS
Similar to traditional risk-taking entities, actors in the international aid community have important roles as insurers. Indeed, the World Food Programme (WFP) plays a de facto role as insurer of last resort for vulnerable populations facing food shortages in the developing world. But unlike a traditional insurance company, beneficiaries of this protection do not pay a premium. Furthermore, the WFP raises aid funds from donors after the disaster--the loss--has occurred. Despite these differences, there is still an inherent "insurance" obligation in the WFP's work. The WFP honors a promise to provide assistance, mainly in the form of food, in times of loss. But more importantly, the WFP has the extra responsibility of providing life-saving aid. Whereas in the developed world, waiting a few months for a car insurance claim settlement or the payment of a hospital bill is not a matter of mortal peril, the timing of humanitarian assistance in the developing world has critical consequences.
Similar to other (re)insurance companies or financial institutions, the WFP and other actors in the international aid community hold a portfolio of risks. They hold portfolios of contingent liabilities--inherent to their mission of aiding vulnerable populations in times of crisis--that are triggered not by movements in the financial markets, but, like any other agriculture or property/casualty (re)insurer, by drought, earthquakes, floods and conflict. These financial liabilities manifest themselves not in cash claim settlements, but in the mobilization of aid workers, shelter, water, food, clothes, health care and all the other aspects associated with emergency relief.
Thus, acknowledging the insurance nature of humanitarian aid and the critical role of financing requires more than establishing a fund to make cash readily available for emergency relief operations; it requires that the international aid community fully harness the tools and methodologies developed in the financial and risk markets over the past three hundred years to improve their performance.
THE RISK MANAGER'S TOOLKIT
Implementing such a risk management transformation will require the humanitarian aid community to address important questions regarding the risks we hold on behalf of vulnerable populations. Questions include the following:
* How large are the contingent liabilities--the droughts, floods and potential conflicts--in our portfolio, and how do they relate to one another?
* How likely is it that a catastrophic drought will happen in, say, Ethiopia this year, and how much money will we need to adequately assist affected populations if it does?
* How much of the contingency funds available should be set aside for Ethiopia given the other emergencies that are likely to occur?
* How likely is it that we will need more than $x million to cover all the emergency relief operations we will need to run in the next twelve months?
These questions, which would be mandatory in analogous situations in the financial and corporate world, are not generally asked, let alone answered, by those whose responsibility it is to assist vulnerable populations through emergency operations.
Financial institutions monitor and manage risk on a daily basis, calculating measures that describe different aspects of the risk in their financial portfolios every day for every market variable to which they are exposed. These hundreds of calculations are synthesized for senior management each day into a single figure, a portfolio's Value-at-Risk (VaR), an attempt to summarize the total financial risk an institution is bearing. (2) The aim is to make a statement along the following lines: "We are 99 percent confident that we will not lose more than x dollars in the next n days," where x represents the VaR over the given time horizon. (3) VaR has become a risk measure commonly used by financial institutions--bank regulators use it to determine the capital a bank is obligated to keep to reflect the market risk it carries--as well as by chief financial officers and fund managers. (4)
Equally, rating agencies require insurance and reinsurance companies to hold capital, known as a capital charge, against the potential losses they face--measured by VaR or a similar risk metric--in order for a company to maintain its investment grade rating. (5) However, despite the obvious links between risk, its consequences for vulnerable populations and humanitarian aid, the international aid community has been surprisingly slow in converting an uncertain future into an opportunity and capitalizing on the benefits that risk management offers.
Before beginning to manage risk the first step is to understand and quantify it. This mandates recognizing and identifying the frequency and potential...