Reforming the European Union Solidarity Fund

Improving its Solidarity, Robustness and Efficiency from a

Risk-based Perspective

1
Authors: Stefan Hochrainer-Stigler, Joanne Linnerooth-Bayer
International Institute for Applied Systems Analysis, (IIASA)
IIASA, Laxenburg, Austria

1. Introduction
Based on research carried out at IIASA, we show that the European Union Solidarity Fund (EUSF) has fallen short of meeting its objective
of providing solidarity to Member States that experience disasters beyond their capacity to respond. In addition, the EUSF has a significant
risk of insufficient capital to cover potential qualified losses. Finally, as an ex-post financing instrument, the EUSF discourages Member
States from investing in cost-effective preventive measures or risk financing. To address these shortcomings, we extend currently proposed
reforms to include: (1) changing the major hazard criteria to include only losses as a percentage of GNI (eliminating the absolute value
threshold now set at Euro 3 billion). This would advantage small, low-income countries and enhance solidarity; (2) increasing fund capacities
or transferring an upper layer of the EUSF’s risk with commercial reinsurance or directly to the capital markets. This would increase the
robustness of the Fund and help protect it against increasing risk from climate change and multiple catastrophes; and (3) reorienting the
EUSF (at least partially) to capitalize national catastrophe insurance systems. Changing from an ex post to an ex ante instrument would
increase the efficiency of the Fund by leveraging private financing and enhancing incentives to reduce risk. Our proposed reforms, which
2
seek to improve the EUSF’s solidarity, robustness and efficiency, stem from early research that examined the performance of the EUSF
from a risk-based perspective.

2. Does the EUSF promote practical solidarity?

Does the EUSF meet its stated purpose, which is “to show practical solidarity with Member States and candidate countries by granting
exceptional financial aid if these were the victims of disasters of such unusual scale that their own capacity to face up to them reached to
their limits”. Many countries in Eastern Europe are highly vulnerable to natural disasters, and the EUSF is viewed as an instrument to
promote cohesion in the face of disparate coping capacity. Contrary to what might be expected, however, in the past Eastern European
countries received on average less assistance as a percentage of their eligible losses. Furthermore, wealthier countries qualified for EUSF
assistance more frequently than countries less able to cope, due mainly to the fact that they have higher capital stock exposed to natural
hazards. It can be recalled that the criterion for a payout from the Fund is either a direct loss of €3 billion or a loss totaling 0.6 percent GNI.
Taking Austria as an example, based only on the $3 billion loss criterion, the government qualifies for EUSF support for disasters occurring
as frequently as every 30-50 years, even though the Austrian government can easily cope with disasters of this magnitude. This result is
based on IIASA’s Catastrophic Simulation Model (CATSIM), which simulates a government’s post disaster liabilities and financial capacity.
The model shows that Austria can cope financially with flood disasters that occur about every 250-350 years or less frequently. It appears
that the major disaster threshold is set too low for Austria. In contrast, applying the CATSIM analysis to Hungary and Romania shows that
the major disaster criteria roughly reflect the coping capacity of these governments. Note, however, more research is needed to establish the
appropriate major disaster criteria, and this should include all EU member states.

The solidarity of the EUSF might be enhanced by reforming the major hazard criteria to include only losses as a percentage of GNI
(eliminating the absolute value threshold now set at Euro 3 billion). This would advantage small, low-income countries and enhance
solidarity.

3. Is the EUSF financially robust?

Is the EUSF at risk of not being sufficiently capitalized, especially in cases of multi-country disaster events and climate change? Since 2002,
the EUSF has provided €3.6 billion of disaster aid to Member States and accession countries. While the annual disbursement of EUR 1

1
The authors take full responsibility for all views expressed in this document, which do not necessarily reflect the views of IIASA.
Contact address: hochrain@iiasa.ac.at; bayer@iiasa.ac.at
2
Hochrainer-Stigler, S, Linnerooth-Bayer, J, and Mechler, R. (2010), (2014).
billion EUR has not been exceeded, there remains a risk that the Fund cannot support all countries experiencing a major disaster. By design,
the EUSF has no obligation to grant funding for applications once the capital of the Fund is depleted. Yet, politically it will be difficult to
turn down qualified applications. Making use of state-of-the-art catastrophe modeling. IIASA in cooperation with IVM and JRC, estimates
the annual probability of Fund depletion, without taking into account disasters that affect more than one country, is approximately eight
percent, meaning that the EUSF has an expected shortfall every 12 years. Flood events frequently affect several countries at once, as in the
3
2002 and 2013 flood events, putting more pressure on the EUSF . In addition, the International Panel on Climate Change expects more
extreme climate events in the future. Consequently, the Fund seems to be underfunded especially in cases where it would be needed the most,
i.e. for very extreme events.

Under the new Financial Framework the EUR 1 billion annual capitalization will be reduced, if confirmed by the European Parliament, but
with the possibility to carry over unspent allocations from the preceding year for the first time. If this carryover does not sufficiently increase
the fund size, transferring an upper layer of the EUSF’s risk through commercial reinsurance or directly to the capital markets, e.g., with
catastrophe bonds, might be considered. This would increase the robustness of the Fund and help protect it against increasing risk from
climate change and multiple catastrophes.

4. Is the EUSF efficient?

The Commission recognizes the danger that EU responsibility for disaster losses will create disincentives for governments to take preventive
actions, what is referred to as moral hazard or “charity hazard”. The revised Solidarity Fund Regulation actively encourages Member States
to implement disaster prevention and risk management strategies through a requirement to report before and after applications. The
Commission may consider reducing or refusing a grant if a Member State repeatedly infringes its obligation to implement EU law, such as
the Floods directive (FD). While this reform is an important step forward, we question whether it will be effective given that EU legislation,
is limited in its requirements for cost-effective risk reduction (e.g. the FD requires mainly flood risk mapping). Risk reduction (or efficiency)
could be enhanced by ex ante insurance instruments that incentivize investments in risk mitigation. An assumption underlying the EUSF is
that public infrastructure (roads, dams, etc.) is not insurable; however, sovereign (government) insurance is available and is becoming more
affordable for governments through regional insurance pools, such as the South-East Europe Catastrophe Insurance Facility, which allows
governments to .access international catastrophe reinsurance markets on competitive terms. Another assumption underlying the EUSF is that
private capital is insurable; yet, private insurers are increasingly reluctant to cover high-risk loss events without government backing.

The European Commission could pursue its objectives (solidarity and risk reduction) by reorienting all or part of the EUSF from a post-
disaster response instrument to a pre-disaster, risk-based solidarity instrument by supporting public and private insurance systems in
Europe, e.g., providing assistance to national or regional sovereign insurance pools and making available needed capitalization. There are
many advantages, including: the provision of EU-scale reinsurance helps make insurance premiums affordable to low-income property
owners and in this way promotes solidarity; since private and public insurers are reluctant to provide cover for very rare, extremely high
consequence events, EU backing ensures more availability of insurance; placing even partial responsibility on governments and property
owners as an alternative to post-disaster assistance will increase the costs of locating in hazardous areas and engaging in other types of
hazardous behavior; finally, EU backing has advantages over national government reinsurance in that it spreads or diversifies risks across the
larger European economy.

5. Summary
The European Commission has put forth important reforms to the EUSF that will improve its responsiveness and financial viability. In this
communication, we have proposed possible alternative or additional reforms that, we argue, would improve the EUSF’s solidarity,
robustness and efficiency. These include:
 Restricting the major hazard criteria to include only losses as a percentage of GNI (eliminating the absolute value threshold now
set at Euro 3 billion). This would advantage small, low-income countries and enhance solidarity;
 Increasing fund capacities or transferring an upper layer of the EUSF’s risk through commercial reinsurance or directly to the
capital markets, e.g., with catastrophe bonds. This would increase the robustness of the Fund and help protect it against increasing
risk from climate change and multiple catastrophes;
 Reorienting the EUSF from a post-disaster to a pre-disaster instrument by using its capital to support public and private insurance
systems, particularly those of highly exposed and highly vulnerable European countries.

3
Jongman, B., Hochrainer-Stigler, S. et al. (2014).