By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB
A series of tragic events (US and elsewhere – Katrina & Sandy) in recent years has rekindled interest in the economic consequences of natural catastrophes. There is growing debate whether disasters are harmful or conducive to economic activity. While the immediate destruction they cause triggers a range of adverse socio- economic consequences, natural disasters may also have growth-enhancing effects since investment for reconstruction is part of measured GDP (a flow), whereas the destruction of physical capital (a stock) is not. Replacing dated capital with more recent vintages might also raise long-term growth. Weighing against this optimistic view are the disarray and loss of productive capacity depressing output in the immediate aftermath of a major catastrophe.
This is a question that G. von Peter, S. von Dahlen & S. Saxena of the BIS examine in a recent working paper (BIS WP 394) Unmitigated disasters? New evidence on the macroeconomic cost of natural catastrophes (Dec. 2012). The authors note existing studies differ widely on their results and reach no firm conclusions on disaster-related growth effects.
This study measures the response of growth to major natural catastrophes, and examines the extent to which risk transfer to insurance markets may facilitate economic recovery. The study makes the link between natural catastrophes and economic growth conditional on risk transfer. This nuances the transmission channels, thereby helping to resolve the conflicting findings on catastrophe-related growth.
The findings suggest that risk transfer to insurance markets has a macroeconomic value. This value may be particularly high for smaller nations that lack the capacity to (re)insure themselves against major natural disasters. The analysis thus contributes to the policy debate on different forms of post-disaster spending, as well as the balance between prevention ex ante and compensation ex post. The study notes that catastrophes have permanent output effects are also relevant for a growing literature that explains asset pricing puzzles through rare disasters. The extent to which risk transfer mitigates the macroeconomic cost of disasters is pertinent to the literature on finance and growth, which focuses on banks and stock markets but not on insurance. Considering the macroeconomic value of risk transfer could also enrich the macro prudential approach to the regulation and supervision of insurance companies.
The main result is that it is the uninsured part of catastrophe-related losses that drives macroeconomic costs, whereas well insured catastrophes can be inconsequential or even positive for economic activity. The strongest growth-enhancing effects from insured losses appear in the three years following a catastrophe, in line with the average timing of insurance payouts. This suggests that insurance facilitates the financing of the reconstruction effort that contributes to measure GDP. Distinguishing the effects by physical type of catastrophe shows that insurance coverage at best neutralizes the contractionary effects of earthquakes and volcanic eruptions, while the growth effects of storms, flooding and climatological events can be weakly positive when insured.
Insurance can therefore play an important role in mitigating the macroeconomic costs arising from major natural catastrophes. This form of risk transfer can be useful at any stage of development. Splitting the sample by land area and income group shows that small and low- to middle-income countries suffer more when uninsured but also recover faster when insured against catastrophes. Hence the mitigating role of insurance appears to be more pronounced for this group, especially in the year after a disaster when reconstruction takes place. Whether it is desirable for countries to seek high coverage depends, of course, on the frequency of disasters and on the terms and cost of insurance.
Major natural catastrophes have large and significant negative effects on economic activity, both on impact and over the longer run. However, it is mainly the uninsured losses that drive the subsequent macroeconomic cost, whereas sufficiently insured events are inconsequential in terms of foregone output. This result helps to disentangle conflicting findings in the literature, and puts the focus on risk transfer mechanisms to help mitigate the macroeconomic costs of natural catastrophes.
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