Working Paper: NBER ID: w21674
Authors: Eduardo Borensztein; Eduardo Cavallo; Olivier Jeanne
Abstract: This paper uses a dynamic optimization model to estimate the welfare gains that a small open economy can derive from insuring against natural disasters with catastrophe (CAT) bonds. We calibrate the model by reference to the risk of earthquakes, floods and storms in developing countries. We find that the countries most vulnerable to these risks would find it optimal to use CAT bonds for insurance only if the cost of issuing these bonds were significantly smaller than it is in the data. The welfare gains from CAT bonds range from small to substantial depending on how insurance affects the country's external borrowing constraint. The option of using CAT bonds may bring a welfare gain of several percentage points of annual consumption by improving external debt sustainability. These large gains disappear if the country can opportunistically default on its external debt.
Keywords: macroinsurance; natural disasters; cat bonds; welfare gains
JEL Codes: F36; G15; G22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Issuance of cat bonds (G22) | Improve external debt sustainability (F34) |
| Improve external debt sustainability (F34) | Enhance welfare (I30) |
| Cost of issuing cat bonds significantly lower than observed (G19) | Optimal use of cat bonds for insurance (G52) |
| Welfare gains from cat bonds (G52) | Ranges from small to substantial (L25) |
| Welfare gains from cat bonds (G52) | Improve country's borrowing capacity (F34) |
| Improvement in borrowing capacity (G51) | Increase external borrowing from 30% of GDP to over 60% of GDP (F65) |
| Welfare gains diminish (D69) | If the country can opportunistically default on its external debt (F34) |
| Smoothing of income (D15) | Relatively small welfare gains (D69) |