Spreading the risks of catastrophes presents special difficulties in developing countries, particularly rural areas. In general, there is very limited use of commercial insurance because of long histories of economic instability, fluctuating and prohibitive insurance costs as related to agricultural prices, lack of enforcement of building codes and land-use regulations, subjective evaluation of risk by consumers ("it won't happen to me"), and non-monitored economies. In some developing countries, government-organized crop and disaster insurance exists on paper, but with large debt loads and weak economies, many such programs are inactive. In many cases, governments are unable to respond to public expectations.

A World Bank/UN Development Programme (UNDP) workshop reports that disaster mitigation is evolving from the phases of relief and contingency planning, technical preparedness, and structural solutions to a phase in which there is a greater emphasis on reducing social and economic vulnerabilities and investing in long-term mitigation activities. However, formal sector mechanisms may completely bypass the poorest households. Therefore, the need to develop informal and flexible financial instruments such as microfinance for disaster mitigation has become extremely important (World Bank, 2000).

Although targeted microfinance programs have been able to meet the financial needs of individual households, the same attributes of microfinance also could be applied to deal with natural disaster reduction. There is a potential for microfinance to provide explicit and implicit insurance to households (World Bank, 2000). However, limitations of microfinance as a risk-reduction mechanism arise from issues of moral hazard (see Section 8.3.4), inadequate monitoring of credit programs after large spatial shocks, and reduction in informal insurance arrangements provided by social networks. There also is the possibility of governments committing much less to relief programs in the wake of a disaster if affected communities are served by microfinance institutions. Small microfinance programs without access to reinsurance may collapse in a natural disaster. For nationwide disasters, even the largest microfinance programs may require international arrangements (World Bank, 2000).

Several microfinance organizations in Bangladesh have been seriously affected by the floods in 1998 in terms of maintaining savings mobilization, credit repayment, and cash availability. Larger microfinance organizations with greater capitalization and preparedness cope better with disasters than small microfinance organizations, many of which get completely wiped out. There is now a recognition of the need for providing a financial cushion for the unexpected. It could be provided through a Central Reserve Fund/Emergency Fund and bigger microfinance organizations such as Grameen Bank setting aside part of their funds to meet the contingencies of natural disasters (World Bank, 2000).

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