# **1. Introduction**

It has been increasingly recognized that economic agents attempt to smooth consumption by managing risks associated with natural and social hazards in low-income countries through both formal mechanisms and informal arrangements (e.g., Townsend, 1994; Rosenzweig, 1988; Binswanger and Rosenzweig, 1986). In many low-income settings, since formal insurance and government supports are limited, they tend to rely on informal insurance such as remittances from relatives to secure their livelihoods. For example, marriage arrangements with households in other villages would diversify income risks among relatives (Rosenzweig and Stark, 1989). These mechanisms can be quite effective to smooth the impacts of idiosyncratic shocks but if the risks are aggregate or correlated across agents (e.g, large-scale natural hazards), these strategies cannot be so useful since the risks cannot be pooled to offset each others.<sup>3</sup> When agents perceive the high likelihood of large-scale hazards in the near future, they have to employ strategies that differ from the informal arrangements described above since cross-sectional diversification and pooling of such risks are difficult. That is, the scope of insurance arrangements (whether they are formal or informal) against large-scale natural disasters is quite limited (see also the review by Dercon, 2002; Morduch, 1999; Skoufias, 2003). Instead of pooling risk across individuals or households, agents need to reallocate resources intertemporaly.<sup>4</sup> The relationship between natural hazards and investment behavior provides interesting insights. Most of natural disasters damage physical capital. For instance, climatic disasters such as floods and droughts damage crops on farm land. Earthquakes suddenly destroy buildings and landscapes. The immediate loss of human capital is typically much smaller than that of physical capital, though the loss largely depends on not only the nature and magnitude of events but also the suddenness and unexpectedness of the events. Impacts on human capital seems more gradual due to potential repercussions from physical destructions as well as economic impacts.

The above observations suggest the possibility of a poverty trap. Once a disaster destroys productive assets and public goods (such as schools), the expected income in subsequent periods will be lower than that in the past. For example, when an earthquake destroys schools, human capital investments (and its quality) drop, decreasing the expected income in the future. This point clearly distinguishes between disasters and income fluctuations.

Recent macroeconomic studies report that high likelihood of natural hazards can increase economic growth in the long run (e.g., Skidmore and Toya, 2002; Tol and Leek, 1999). However, more careful studies on developing countries recently show that technology inflow, positively related with growth, increases with natural disasters only among wealthier countries (Crespo Curaresma et al., 2008). Disasters also have

> 3In informal insurance arrangements, not only the correlation structure of risks but imperfect information on actual realizations of shocks limit the effectiveness. The latter creates a limited commitment (self-enforcing) problem unless agents can reduce monitoring cost through strong personal ties (Ligon, 1998; Coate and Ravallion, 1993; Ligon, Thomas and Worrall, 1997). In correlated risks such as large-scale natural hazards, this problem is mitigated as agents can easily observe states facing other agents, as it is opposed to indiosyncratic risks. In the case of highly correlated risks, however, they cannot pool and cancel the shocks.

> 4Agents could also diversify against risk spatially, through migration of entire households or of individual household members, as pointed out above. But spatial diversification against risk is limited in the case of large-scale natural disasters.

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