Most economists find it difficult to devise an appropriate policy when they deal with an unpredictable event that affects an economy. Natural disasters are one of the unexpected factors which economics cannot explain, but which may have a significant impact on economic growth as well as on loss of life.
Major catastrophic events from the Wasior flash flood in Papua, to the unprecedented floods in Jakarta, to the volcanic eruption of Mount Merapi in Central Java and finally the tsunami that swept away part of the population of Mentawai have resulted not only in loss of human life and material costs but have also drawn public and global attention.
In its assessment report on disaster risk reduction, the World Bank (2009) placed Indonesia as
a country with 40 percent of the population at risk from frequent multiple hazards such as earthquakes, tsunamis, volcanic eruptions, floods, landslides, droughts and forest fires.
In the case of economic risks, the high frequency of such disasters creates an enormous burden on government expenditure to rebuild public facilities and infrastructure.
The World Bank further analyzed that there are two factors that make our people susceptible to large-scale disasters.
First, economic growth in Indonesia has shown a strong correlation with higher urbanization. By 2008, at least 50 percent of the population was living in the cities and urban areas were increasing at 4.4 percent per year, well above average national population growth.
This puts more than 110 million people in around 60 cities mostly located in coastal areas, increasing the vulnerability of the population.
Second, the high rate of urbanization in Indonesia coupled with limited capacity of urban centers to provide adequate shelter and infrastructure has led to the emergence of many unplanned settlements.
Poor enforcement of land use zoning has in turn led to many hazard-prone locations becoming subject to human settlement.
Thus, the combination of weak governance, widespread new settlement and inadequate infrastructure potentially causes major problems for Indonesia.
We may also take into consideration socio-economic factors like economic development measured by per-capita GDP and institutional factors such as government stability and investment climate in determining a society’s vulnerability against natural hazards.
I believe that all these factors implicitly may provide a level of ex-ante insurance to mitigate risks bearing in mind many disasters in Indonesia have destroyed uninsured public infrastructure and private homes.
Ironically, the government apparently do not have a concise action plan for mitigating disaster including reflecting on the risk profile of Indonesia.
We know that Indonesia is highly vulnerable to earthquakes and volcanic eruptions because we are in the earthquake belt and the Pacific ring-of-fire.
Also, a high rainfall regime in the western area of Indonesia and a dry zone in some eastern provinces potentially can lead to floods and droughts.
Rather, in many cases, the government prefers to choose ex-post disaster financing to cope with the impact of disaster.
So, is ex-post disaster financing through government expenditure and donors better than ex-ante disaster financing through insurance? The University of Yale sociologist, Charles Perrow (2007), shows that public policy should focus on the targets concentrated in coastal areas, and other infrastructures in disaster prone locations.
This suggestion came from the fact that more ex-post assistance generates a “Samaritan’s dilemma”, which increases risk-taking behavior and a reluctance to purchase insurance when aid is likely to be provided, should disaster strike.
But, two economists from the Wharton School of the University of Pennsylvania, Mark Pauly and Howard
Kunreuther (2009), noted that there are some problems associated with exante insurance coverage in the event of large disaster.
First, uncertainty with regard to the magnitude of potential losses. Second, there can be highly bunched risks among the insured.
Third, there could be moral hazards related to excessive risk-taking by the insured.
Last, an adverse selection of insured parties could be caused by imperfect information.
Those problems do not stop if we are pushed to implement disaster insurance.
First, our insurance markets have been insufficiently developed due to risk exposure and weak infrastructure, which often limits the supply of insurance.
Also, high poverty and unemployment rates in the midst of lack of good information contribute to a low demand for insurance.
Finally, weak incentives for political leadership with a short attention span to enter into insurance contracts creates political resistance to purchasing insurance.
Generally, disasters are viewed by policy makers as natural phenomena, and they usually explain events in those terms.
Take the behavior of Jakarta Governor Fauzi Bowo who always blames rain as the cause of floods.
From the above arguments, it can be seen that neither ex-post nor ex-ante disaster financing necessarily provides the best solution. Based on the difficulties of financing large-scale disasters from local resources, I support the view of Howard Kunreuther and Joanne Linnerooth-Bayer (2002) that catastrophe bonds could be included as a risk-transfer mechanism as a substitute for reinsurance contracts in producing a source of contingent capital for disaster relief and recovery in developing countries like Indonesia.
As an instrument for reinsurance companies, this can hedge the risk of insolvency and overcome the limitations of traditional sources of disaster aid.
The nature of risk-transfer has many advantages over ex-post disaster financing, both short-term and long-term, because it provides fast access to capital, and avoids budgetary diversions as well as additional loans.
Another important advantage is that hedging instruments can be designed to deliver incentives for disaster planning and mitigation.
For example, weather derivative contracts are one type of hedging instrument that have begun to emerge in many disaster-prone countries such as the US and Japan, also in under-developed countries with severe weather like Malawi, as a substitute for yield-based crop insurance.
This type of insurance can actually be used to manage weather-related crop risks in Indonesia where indemnity payments are based on rainfall levels and can help hedge against drought or excessive rainfall.
The series of disasters that just happened in Indonesia could provide an important lesson for our government to lessen negative impacts in the future.
To pursue mitigation strategies before such events occur could be the ideal solution.
The writer, a graduate of the University of Adelaide, Australia, is a lecturer at National University, Jakarta, and economic policy researcher at Transparency International Indonesia. The opinions expressed are personal.
