Increasing countries financial resilience through global catastrophe risk pooling

TL;DR

This paper proposes a novel method for forming global catastrophe risk pools that maximize risk diversification, aiming to improve financial resilience for countries affected by extreme weather events.

Contribution

It introduces a new pooling method that optimizes risk diversification by selecting countries with low correlations, and demonstrates the benefits of global over regional pooling.

Findings

Global pooling increases risk diversification.

It reduces individual country shares in pool risk.

More countries benefit from risk pooling.

Abstract

Extreme weather events can have severe impacts on national economies, leading the recovery of low- to middle-income countries to become reliant on foreign financial aid. Foreign aid, however, is slow and uncertain. Therefore, the Sendai Framework and the Paris Agreement advocate for more resilient financial instruments like sovereign catastrophe risk pools. Existing pools, however, might not fully exploit financial resilience potentials because they were not designed with the goal of maximizing risk diversification and they pool risk only regionally. To address this, we introduce a method that forms pools maximizing risk diversification and which selects countries with low bilateral correlations or low shares in the pool risk. We apply the method to explore the benefits of global pooling with respect to regional pooling. We find that global pooling increases risk diversification, it lowers countries shares in the pool risk and it increases the number of countries profiting from risk pooling.