97433 Fiscal Risk Assessment of Contingent Liabilities Associated with Natural Disasters: The Colombian Experience June 2012 Page | 1 List of Acronyms CONPES National Council for Economic and Social Policy COP Colombian Pesos GDCT General Directorate of Public Credit and the National Treasury GDP Gross Domestic Product GFDRR Global Facility for Disaster Reduction and Recovery GoC Government of Colombia IADB Inter-American Development Bank MHCP Ministry of Finance and Public Credit PNPAD National Plan for Disaster Prevention and Assistance SECO State Secretariat for Economic Affairs of Switzerland SNPAD System of Disaster Prevention and Assistance Page | 2 Fiscal risk assessment of contingent liabilities associated with natural disasters: The Colombian experience Considerable progress has been made in the fiscal accounting and management of contingent liabilities as an integral part of fiscal policy in Colombia. This note builds on the report “Contingent Liabilities: The Colombian Experience,” published by the Colombian Ministry of Finance and Public Credit. It focuses on the fiscal assessment of natural disasters- a major source of contingent liabilities in Colombia. The Law 448 of 1998 dictates that the The report titled “Contingent Liabilities: The Colombian National government, territorial Experience,” is the first publication on the management of entities, and other decentralized contingent liabilities in Colombia. Published by the Ministry of entities should include in their public Finance and Public Credit (MHCP), the report highlights technical management the necessary and normative efforts and policy reforms on the management of appropriations to cover possible contingent liabilities implemented by the Colombian Government. losses arising from contingent Policy reforms disclosed in the report pertain to the management of liabilities. contingent liabilities borne by the Government from four different The law also mandates: sources, namely public credit operations, contractual public-private partnerships on infrastructure development, legal actions against  The National Government to the Colombian Government, and contingencies resulting from develop and enforce the natural disasters. Importantly, although natural disasters are the methodology for estimating second most important source of contingent liabilities faced by the contingent liabilities. Colombian Government, most formal policy reforms have been  The General Directorate of Public directed to the institutionalization of managing the first three Credit and the National Treasury sources of contingencies, while legal reforms for the explicit of the MHCP are to have accounting of natural disasters is an ongoing effort in Colombia. oversight over estimation and management of contingencies. Policy reforms laying out the legal platform for a better accounting and management of contingencies comprise a series of  The formation of the “Fund for constitutional laws, sanctions, enactments, acts, and CONPES 1 Contingencies of Government documents aiming at institutionalizing the management of Entities.” contingencies within the country’s fiscal policy framework (See  The Federal Government to Annex 1). The process of identifying, assessing, and managing determine types of risk to be different sources of contingent liabilities in Colombia started with covered by the fund. the formation of the Risk Unit of MHCP in 1998. The law 448 of 1998  accounting of contingencies. establishes that Government entities, state, and local governments should include in their debt service budgets, the necessary funds to 1 The National Council for Economic and Social Policy CONPES is the highest national policy planning body in Colombia. CONPES functions as an advisory agency for the government in economic development and social policies. As such, CONPES coordinates and guides economic policy government ministries and bureaus through the analysis and approval of economic policies. Thus, approved CONPES documents contain authorized economic and/or social policies intended to be developed and/or implemented. Page | 3 cover possible losses experienced from unforeseen events. The “Fund for Contingencies of Government Entities,” was established to manage contingent liabilities and risks faced by local governments, as determined by Government of Colombia (GoC). In 2003, the Republic of Colombia became an example in the region for passing the Law 819, which includes constitutional laws related to budgeting, fiscal discipline and transparency2. Contingent liabilities from public credit operations were first estimated and reported in 2003. A process of technical assistance and training - focused on developing a model to estimate public credit contingencies - was put in place after the 1998 law. This model was used for contingency estimation from 2003 through 2009 and improved by the MHCP Deputy Directorate of Risk for the estimation of contingencies in 2010 and 20113. As of April 2011, the Government of Colombia faced an exposure of COP$ 4.13 trillion (US$ 2 billion) due to credit guarantees offered in public credit operations. Taking into account the probability of default of payment (the probability that indebted institutions do not repay their debt), estimated contingent liabilities from public credit operations total COP$ 1.22 trillion (US$ 0.6 billion) for a medium-term fiscal period (2011-2021). On average, the Government of Colombia faces annual expected contingent liabilities from credit operations of around COP$ 122 billion (US$ 56 million) for the next 10 years4, representing a modest 0.02% of the country’s GDP (See Table 2). The methodology to assess contingent liabilities arising from infrastructure development projects under PPP was developed and improved from 1998 through 2010. For the first time in 2010 the Deputy Directorate of Risk of the MHCP assessed the liabilities. A methodology based on the identification, assessment, management and oversight of the risk factors that can affect economic results of infrastructure development projects is used to estimate related contingent liabilities. Estimated contingent liabilities to infrastructure projects total COP$ 575 billion (US$ 289 million) for the medium-term fiscal period (2011-2021). Estimated annual expected liabilities arising from this source of contingency amount to COP$ 57 billion (US$ 26 million), less than 0.01% of the country’s GDP in 2010 (See Table 2). The first estimation of contingent liabilities related to legal actions was completed in 2004. But it was not until 2009 and 2010 that these contingencies were estimated and reported. The estimation of these contingencies was only possible after the establishment of LITIGOB, a unique data collection and information system managing data and documentation related to national and international legal processes involving the GoC. Contingent liabilities to legal actions against the Colombian Government totaled COP$ 408.1 trillion (US$ 205 billion) for the fiscal period 2011-2021. Annual expected liabilities to legal actions are estimated at around COP$ 37 trillion (US$ 18 billion) for the next 10 years. This 2 It is important to point out that neither Law 448 of 1998, nor Law 819 of 2003 define natural disasters as explicit sources of contingent liabilities. 3 Following U.S. methodology, one billion is a thousand millions and one trillion is a million of millions (1 billion = 1,000 million; 1 trillion = 1,000,000 million). 4 Total contingent expected liabilities were estimated for a medium-term fiscal period of 10 years (2011-2021). In this case, estimated contingent liabilities represent total expected losses faced by the Colombian government over the medium-term fiscal period 2011-2021. Annual figures representing annual expected contingent liabilities are computed by dividing total expected liabilities for the period by the number of years. Page | 4 represents 7.46% of the country’s GDP, which places legal actions against the GoC as the most important source of contingent liabilities (See Table 2). Policy Reform for a Sovereign Disaster Risk Financing Strategy The fiscal risk management strategy against natural disasters is currently under development. The Government of Colombia has institutionalized the management of contingent liabilities arising from public credit operations, contractual public-private partnerships on infrastructure development, and contingent liabilities resulting from legal actions against the Colombian Government. Important advances have been undertaken towards the formulation of an ex-ante natural disaster risk financing strategy in Colombia. Focusing on sovereign disaster risk financing, the contingent liability of the Government associated with natural disasters has been assessed and an integrated disaster risk financing strategy, relying on risk retention and risk transfer mechanisms, is being developed. Estimated direct economic losses caused by natural disasters in Colombia totaled US$4.5 billion for the period 1970-2000. During that period, Colombia was affected by high-intensity, low frequency natural events such as earthquakes, tsunamis, volcano eruption, seismic activity, and landslides, resulting in 28,258 deaths, 395,347 people affected, and US$2.3 billion in economic damages. Likewise, high-frequency, low-to-medium impact natural disasters, such as floods and landslides, among others, have had a toll of 9,954 deaths, 14.8 million affected people, and estimated economic losses of US$2.2 billion (See Table 1) The development of a disaster risk management strategy in Colombia starts with Popayán‘s earthquake of 1983, and its necessity is reinforced by the Nevado del Ruiz’s volcanic eruption of 1985. After the 1983 earthquake, the Government of Colombia realized the importance of creating a system for the management of natural disaster risks. Risk mitigation strategies were formulated and adopted through the development and enforcement of a seismic-resistant construction code. The National Disaster Fund (Fondo Nacional de Calamidades) was enacted in 1984 as a starting point for a disaster risk management strategy. The System of Disaster Prevention and Assistance (SNPAD) was created in 1989, together with the legislation of a territorial zoning plan (POT) and sector development plans (PDS) as part of a disaster risk mitigation mechanism. The National Plan for Disaster Prevention and Assistance (PNPAD) was enacted in 1998 . The PNPAD comprised four strategic lines: 1) risk identification and monitoring, 2) risk reduction, 3) institutional strengthening, and 4) outreach and training of natural disaster risk mitigation and assistance efforts. In 2001, constitutional laws directing resources to the prevention and assistance of natural disasters were adopted. As a result, municipalities and departments were able to prevent and assist natural disasters occurring in their jurisdiction, provide risk mitigation training for urban and rural high-risk areas, as well as to relocate communities in times of emergency. Page | 5 Table 1. Natural Disaster Risk Statistics (1970-2000) Number of Number of Number of structures Economic Intensity/Impact Disaster affected deaths destroyed or damage* people affected 3,081 (D) Tsunami at the 672 1,011 17 Nariñense coast (1979) 2,119 (A) 2,470 (D) Seismic activity in 20,000 Popayan (1983) 300 11,722 (A) 378 Del Ruiz's Volcanic 4,700(D) 23,500- eruption and Armero 200,000 246 28,000 High-Impact Landslide (1985) 5,150(A) events Seismic activity and N/A landslide in Cauca - 1,100 8,000 150 Páez river (194) N/A 35,949 (D) Earthquake in the 166,336 1,558 coffee-belt (1999) 1,186 43,422 (A) 89,337 (D) Subtotal 28,258 395,347 2,349 62, 143 (A) Cumulative landslides, 89,337 (D) Low-to-medium 14.8 floods, and other 9,954 2,227 impact events million events (1970-2000) 185, 365 (A) 135,537 (D) Total Low, medium and high 38,212 impact events 247,777 (A) 15,195,347 4,576 Source: National System for Disaster Prevention and Assistance Note: A: Affected. D: Destroyed. * Damages in US$ millions Interest on disaster risk assessment and management, as well as a paradigm shift from ex-post disaster assistance to an ex-ante disaster risk management gained momentum among Colombia’s authorities. A series of studies on ex-post government responsibilities, economic assessment of natural disasters, risk transfer mechanisms, insurance of public goods and fiscal discipline were contracted by the Government. The 2004 study titled, “Natural disasters in Colombia: Loss assessment, ex-post government responsibilities: The Colombian Case and International Experience,” concludes that the institutional setting in Colombia was designed for ex-post assistance of natural disasters, and not for ex- Page | 6 ante disaster risk management. As a result, a paradigm shift focused on understanding risk and risk management, gains momentum in Colombia’s governmental system. In 2004, a CONPES document facilitated resources for the implementation of a project to reduce fiscal vulnerability to natural disasters. An external credit line with multilateral banks was authorized for an amount of US$260 million to partially finance a program for the reduction of fiscal vulnerability to natural disasters over a period of 10 years, starting in 2005. As part of the program to mitigate fiscal vulnerability, the risk transfer and retention component seeks to design public policies that promote the development of insurance markets against natural disasters. To that end, this component aims to develop three important areas: 1) policies to transfer the government’s medium and high layers of risk; 2) support for ministries and municipalities in the development of insurance mechanisms, and 3) development of a possible “pool” of reserves for the reinsurance of catastrophic risks. Government responsibilities in the aftermath of disasters have been identified, fiscal exposure to natural disasters has been assessed, and risk transfer mechanisms for higher levels of risks have been analyzed in different consulting reports for the Government of Colombia. Public asset losses arising from natural disasters are the governments’ direct responsibility. Further, based on historical events, losses arising from private dwellings of low income households (strata 1 and 2 as per the property tax system) are assumed by the National Government given the incapacity of territorial entities (municipal, departmental) to cover such losses, and the government’s social responsibility. The expected direct loss from adverse natural events in Colombia is estimated at US$ 490 million per year. According to ERN (2011), the total value of public assets and low-income housing exposed is equivalent to US$ 173.2 billion. This includes estimated exposure of public assets at the national, departmental, and municipal levels, as well as private dwellings of low income households in Colombia. The fiscal value at risk is then computed by adjusting the value at risk with the probability of a disaster event. Table 2 presents annual expected liabilities arising from natural disaster, infrastructure development projects, legal actions, and public credit operations. Probable maximum losses (PMLs) measuring the likely loss for various return periods are also presented5. Three points are important to consider when comparing liabilities from natural disasters with other contingent liabilities.  Fiscal shocks caused by natural disasters are highly variable. Hence the AEL may not be the right risk metric to reflect the possible fiscal shocks caused by natural disasters. Probable maximum losses should also be considered; 5 Figures are based on study prepared by Natural Risk Evaluation (ERN) in 2011, which contains probabilistic modeling of natural hazards for Colombia and Mexico. Page | 7  Fiscal loss estimates should also capture indirect impacts. Natural disaster loss estimates reported in Table 2 only capture the physical damage. Indirect losses, such as loss in tax revenues, should also be captured, as they will create additional fiscal burden.  Immediate liquidity is required in the aftermath of a disaster. The immediate financial response capacity of the government in the aftermath of a disaster is critical to meet the emergency needs of the affected population and the quick recovery and reconstruction of lifeline assets. Table 2. Estimated Annual Expected Contingent Liability by Category and Probable Maximum Loss from Natural Disasters Contingent Liability* COP $ Millions US$ Millions % of GDP Annual Expected Liability Infrastructure Projects 57,460 26 0.01 Legal Actions 40,812,000 18,642 7.46 Public Credit Operations 122,000 56 0.02 Natural Disasters 1,072,725 490 0.20 Natural Disasters Probable Maximum Loss** PML 100-yr 6,515,158 2,976 1.19 PML 250-yr 9,669,843 4,417 1.77 PML 500-yr 12,380,114 5,655 2.26 Source: MHCP (2011) and ERN (2011) *World Bank estimates based on MHCP (2011) and ERN (2011). Contingent liabilities from infrastructure development, legal actions, and public credit operations are reported for a medium-term fiscal period of 10 years, and represent the period expected loss of the stock of contingencies in the present. Annualized expected liabilities for these sources of risk are estimated by dividing total expected loss by the number of years. AEL from natural disasters is the “Hybrid AEL” reported in ERN 2011.Real 2010 GDP base of COP$ 546,951,000 million and exchange rate as of December 2010 is used to compute figures. **Probable Maximum Losses were retrieved from ERN 2011’s probabilistic risk assessment of seismic risks in Colombia. While reported AEL reflects expected losses arising from high-frequency, low impact events (e.g. landslides, volcanic activity, etc), PMLs correspond to maximum losses associated to low-frequency, high-impact earthquakes. The Government of Colombia may not have sufficient economic resilience to meet contingent liabilities to natural disasters. The fiscal deficit index for natural disasters, DDI, for Colombia is 1.28 for a 100-year loss, 2.07 for a 1000-year loss and 2.53 for a 1,500 year-loss. The DDI is computed as the ratio between a given return period PML and the sum of internal capacity and external funds available to the government to face disasters (its economic resilience); the Colombian Government’s DDI higher than one indicates its insufficient economic resilience to adequately respond to disasters (See Box 1) . Page | 8 Box 1. Disaster Deficit Index (DDI) The Inter-American Development Bank (IADB) Disaster Deficit Index (DDI) captures the relationship between the demand for economic resources to cover losses that a government would have to assume and the nation’s economic resilience, that is, its ability to generate internal and external funds to replace the affected infrastructure and goods. A DDI greater than 1.0 reflects the country’s inability to cope with major disasters, even by going into as much debt as possible. The greater the DDI is, the greater the gap between losses and the country’s ability to face them. Government responsibility was restricted to the sum of losses associated with public sector buildings and housing for the lowest income population. The left side of the figure below shows the DDI calculated in 2000 for a Maximum Considered event (MCE) with 100 years of return period (five percent probability of occurrence in ten years). The right side of the figure shows the maximum loss, L, for the government during the same period. The table shows that access to external resources would be critical for eight of the fourteen countries studied. Peru, with a DDI of 3.5, is in the most critical situation, with the loss of a 1‐in‐100 year event estimated at more than US$4 billion. Source: Ghesquiere and Mahul (2010) and IADB (2000). Natural disasters are the second most important source of contingent liabilities for the Government of Colombia. Contingent liabilities associated with legal actions are the largest by far, with an annual expected value of US$ 18.6 billion for the medium-term fiscal period 2011-2021, or 7.46 percent of Colombia’s GDP (See Table 2).6. Annual expected losses arising from natural disasters, at COP$ 1.07 trillion (US$ 490 million), 0.20% of 2010 GDP, represent the second largest contingent liability in Colombia. Estimated maximum losses from low-frequency high-impact seismic events for 100-year and 6 The majority of these legal contingencies (82.75%) is accounted for by a single legal action against INCORA, the Colombian Institute for Agrarian Reform, due to the presumptuous impossibility of exploiting coalfields in the Venecia municipality, Antioquia. The case is currently handled by the Ministry of Agriculture and Rural development. Page | 9 500-year return periods are US$2.9 and US$5.6 billion, which represent as much as 1.17% and 2.26% of GDP, respectively. In contrast, annual expected contingencies as a result of infrastructure development projects and public credit operations represent less than 0.01% and 0.02% of GDP, respectively. A challenge for the assessment of contingent liabilities is the collection and management of data necessary to estimate the value of contingencies. Another important challenge is the dynamic nature of risks, and the possible benefits that could arise from accounting for the correlation of risks across different sources of contingency. In spite of these challenges, the Government of Colombia has made significant progress for the fiscal accounting of contingencies. Future Steps towards a Sovereign Disaster Risk Financing and Insurance Strategy The design of a risk financing strategy to reduce fiscal vulnerability to natural disasters is a priority for Colombia’s MHCP. The Government of Colombia, with technical assistance from the World Bank in partnership with Switzerland’s State Secretariat for Economic Affairs (SECO) and the Global Facility for Disaster Reduction and Recovery (GFDRR), has developed a formal agenda towards the formulation of a sovereign disaster risk and insurance strategy. This strategy relies on four main activities:  Further assess the contingent liability of GoC using catastrophe risk modeling tools, particularly for public assets and low-income housing;  Design of a sovereign disaster risk financing strategy, relying on risk retention and risk transfer, to stabilize the budget against natural disasters;  Develop a catastrophe risk insurance program for public assets;  Promote the development of property catastrophe risk insurance for private dwellings. The outputs of this partnership are summarized in the table below. Table 3. Agenda for a Sovereign Disaster Risk and Insurance Strategy in Colombia Expected outputs Timeline Draft national disaster risk financing policy note By end 2011 Financial and actuarial risk assessment tool By mid 2012 Fiscal risk assessment of natural disasters Feasibility study of index-based risk transfer solutions By mid 2012 Possible Implementation of a Pilot Standard terms and conditions of property cat insurance policy of By mid 2012 public buildings Inventory of Infrastructure By end 2012 Risk assessment of major infrastructure Design of property cat insurance policies of major infrastructure By end 2012 Page | 10 Placement of group insurance policies of key infrastructure By end 2013 Risk pooling mechanism of public assets By end 2014 Expansion of the risk pooling mechanism to private assets By end 2015 Annex 1. Legal Framework for Contingent Liabilities Legal Framework for Contingent Liabilities Contingent Liability Laws Enactments Acts CONPES Others Report 3045 of 1999, 3107 of 2001, Infrastructure 3133 of 2080 of development 2001, 3186 Analysis 2008, 6128 projects of 2002, and of 2008, through PPP 3249 of valuation 446 of 2010 schemes 2003, 3413 423 of 2001 of 2006, 185 of 1995, 3535 of 448 of 1998, 2008 819 of 2003 2818 of 2005, 3045 Analysis Public credit of 2006, and operations 4291 of valuation 2007 Presidential Analysis 3250 of Directorate, Legal actions and 2003 January, valuation 2004 919 of 3146 of Natural 448 of 1998, 1989, 93 of 2001, 3318 Disasters 715 of 2001 1998 of 2004 References: ERN (2011). Global Assessment Report on Disaster Risk Reduction, Probabilistic Modeling of Natural Risks at the Global Level, Phase 1A, Development of Methodology and Case Studies. Page | 11