october 2, 2007

World Bank World Bank GroupGroup

4th Edition ICAR ForumBucharest, Romania

Weather risk hedging: the role of insurance and weather risk markets

Eugene N. Gurenko, Ph.D., CPCU, ARe Lead Insurance Specialist

October 2, 2007


Agenda

What is parametric weather insurance and how does it work?

What is the relevance of weather insurance for Romania?

How can weather risk hedging be turned into a profitable

opportunity for the Romanian insurers and businesses?


Why parametric weather insurance?

Crop Insurance Premiums and Indemnities in the United States

All previous attempts to protect farmers through universal indemnity-based multi-peril crop insurance programs have been financially unsustainable



ABCs of parametric index-based weather risk insurance

An alternative to traditional crop insurance.

Payouts linked to the underlying weather risk defined as an index

based on historical data (e.g. for rainfall, temperature, snow, etc)

rather than actual damage, (e.g. crop yield loss and its monetary

equivalent).

Objectivity of loss measurements eliminates moral hazard and

translates into reduced administrative costs.

Helps companies avoid major downfalls in their overall income due to

adverse weather related events.

Improves companies risk profile, enhances access to bank credit and

reduces the cost of borrowing.

The basis risk is an inherent disadvantage of index-based parametric

insurance due to a likely mismatch between payoffs and actual losses.

What is parametric index-based weather insurance and how does it work?



Source: Olivier Mahul, World Bank, 2007

85mm

10Jun-14Jul

15Jul-28Aug

29Aug-02Oct

Sowing Growth Harvest

35 days 44 days 34 days

80mm 110mm 80mm

110mm

Loss in

yield

$ per acre

Insurance Payout

Rain

fall

Ind

ex

Sta

ges

Tim

e

Output

80mm

12mm

35mm

80mm

Parametric rainfall insurance in agriculture: illustration

WB82643

to minimize the basis risk an index needs to be closely correlated with the yield performance of a specific plant. To this the instrument typically would take into account the specific water needs of a plant during each of the 3 critical planting stages, sowing, growth and harvesting. To illustrate the point, I have compiled some numbers from our work in India:


Probabilistic agricultural risk assessment model

Production losses

Stochastic normal & drought events

Historical weather

Hazard Module

Simulated Weather Generator

Vulnerability ModuleCrop Yield

ModelPlanting Area

Model

Economic Module

Direct lossmodel

Indirect lossmodel

CropsSoilMgmt.

Macro-economic data

Direct & indirect economic losses

Customized from rapid

onset disaster modeling

framework

Probabilistic drought

risk assessment model Hazard module Vulnerability module Economic module




Aid Funding in Ethiopia

APPEALASSESS/ EVENT

APPEALASSESSEVENT

AID

FUNDING AID

PRESENT APPROACH

time

time

Aug/Sept

Oct/Nov

Aug/Sept

Dec

Nov/Dec

Jan Jan/Feb

Mar/Apr

Timing gains critical to saving lives and livelihoods (Ethiopia’02: ~1 Mil livelihoods lost)

CONTINGENCY FUNDING APPROACH



Aid funding in Ethiopia: key features of transaction

Insurance contract between UN Food Security Agency and Paris

Re is based on a drought index: $7.1 mm for $0.93 mm premium

Index reflects the envisaged adverse impacts of deficient rainfall

on livelihood of vulnerable population

Premium paid prior to season

Specified variation in index triggers a payout

Payout funds the agency’s emergency response for vulnerable

population

Led to putting in place government contingency funding for up to

316,000 beneficiaries

Encouraged successful MET service capacity building



Ethiopia Drought IndexWhat is parametric index-based weather insurance and how does it work?

$-

$10

$20

$30

$40

$50

$60

$70

$80

$90

0 5 10 15 20 25 30Dekad in Calendar Year

Ind

ex

Va

lue

(M

il U

SD

)

30 year Average Trigger 2006

1984

2002

17th ten day period11-20 June

24th ten day period21-31 Aug

34th ten day period

2006


Index-based parametric insurance in Malawi

Problem:

Groundnut farmers previously used only local seed for production but

were interested in switching to better quality certified groundnut seed

Farmers had little cash and no access to finance

Banks were unwilling to lend primarily because of drought risk




Insurance Pilot:

Contract pays out if the amount of rainfall needed for groundnut production is insufficient

Two banks agreed to lend farmers if farmers buy weather insurance.

Loans were given to farmer clubs of 15-20 farmers

Farmers used loans to purchase certified groundnut seed

In case of a drought that triggers an insurance payout the money is paid to the bank

If no drought occurs farmers benefit from selling more of better quality groundnut

892 farmers participated in the pilot in 4 groundnut growing areas





CLUB

Insurance Association of

Malawi

MRFC/ OIBM

NASFAM

Step 2

Step 1

Step 3

Step 4 Step 5

Step 6

Step

8

Step 10

Step

9

MET OFFICEStep 7

Step 11CLUB

Insurance Association of

Malawi

MRFC/ OIBM

NASFAM

Step 2

Step 1

Step 3

Step 4 Step 5

Step 6

Step

8

Step 10

Step

9

MET OFFICEStep 7

Step 11

1. Club and NASFAM enter into a sales agreement

2. Club enters contract w/ bank for insurance & loan

3. Insurance purchased on behalf of clubs

4. Farmers -authorize the bank to pay NASFAM

for the seed

5. Seed distribution to clubs

6. Money paid to NASFAM for seed

7. Meteorological information distributed

8. Payout from insurers to MFI

9. Farmer sells output to NASFAM/ NASCOMEX

10.NASFAM pays off loan balance to the bank

11.Payment of any additional revenue from sale of nut to club



Malawi: insurance contract payout structure


PAYOUT STRUCTURE FOR LILONGWE PHASE 1

0

2000

4000

6000

0 10 20 30 40 50 60 70 80 90 100

Payout in

MKW

27.34 MKW per mm

Maximum Payout

5467.5 MKW

70 mmTrigger Level

Groundnut Rainfall IndexSource: Olivier Mahul, World Bank, 2007


Malawi: insurance contract payout structure



LILONGWESucessful Sowing Condition

Sowing Trigger (mm) from 10th November 25Latest Sowing Dekad 6 th i.e. Dekad 6 = 1st-10th JanuaryCompensation for Unsucessful Sowing 5467.45 MKW

Main Production Cycle - DYNAMIC START DATE, starts according to Sowing Trigger

Crop Growing Season Length 140 days

Three-Phase Drought Protection per acre:

Phases LengthAverage (mm)

Trigger (mm)

Tick (MKW)

Limit (mm)

Limit (MKW)

Tick (% of loan)

Limit (% of loan)

Phase 1 - Establishment & Vegetative Growth 30 125 70 27.34 30 5467.5 0.50% 100%Phase 2 - Flowering 50 250 160 16.23 30 5467.5 0.30% 100%Phase 3 - Pod Formation to Maturity 60 184 100 16.23 20 5467.5 0.30% 100%Total 140 330 5467.5

Premium 341MKW per acre 6%


Tanzania: maize rainfall insurance in Mbulu district

Maize cropping calendar

Planting January

*Maize yields are particularly sensitive to rainfall during the tasseling stage and the yield

formation stage – rainfall during the latter phase determines the size of the maize grain

Diagram taken from the FAO’s maize water requirement report*

Sowing and establishment

period is also critical crop survival

*Maize yields are particularly sensitive to rainfall during the tasseling stage and the yield

formation stage – rainfall during the latter phase determines the size of the maize grain

Diagram taken from the FAO’s maize water requirement report*

Sowing and establishment

period is also critical crop survival

Jan-Feb Vegetative Growth March Tassleing & Cob Formation April Ripening

Harvest May



Main contract features:

•Covers 3 growth phases

•Index reflects dependence of maize yields on rainfall from sowing to maturity

•Sum insured = loan principal [cost of improved seed + cost of insurance] + loan interest


Tanzania: Indicative design for Mbulu rainfall index insurance policy

Phases Length (days) Average (mm) Lower trigger (mm)Upper trigger (mm)Tick (Tsh/mm) Limit (Tsh)Phase 1 - Germination 50 155 10 45 1,000 35,000 Phase 2 - Tasseling 30 89 10 30 1,750 35,000 Phase 3 - Maturation 40 146 10 50 875 35,000

Risk loaded Premium (%SI) 9.40%

Germination phase: Insurance payout by rainfall amount (Dekads 1-5)

0

10

20

30

40

50

60

70

80

90

100

110

120

130

140

150

0 5000 10000 15000 20000 25000 30000 35000 40000

Money

Rai

nfa

ll (

mm

)

Tasseling phase: Insurance payout by rainfall amount (Dekads 6-8)

0

10

20

30

40

50

60

70

80

90

100

110

120

130

140

150

0 5000 10000 15000 20000 25000 30000 35000 40000

Money

Rai

nfa

ll (

mm

)

Maturation phase: Insurance payout by rainfall amount (Dekads 9-12)

0

10

20

30

40

50

60

70

80

90

100

110

120

130

140

150

0 5000 10000 15000 20000 25000 30000 35000 40000

Money

Rai

nfa

ll (

mm

)




Weather station network in Tanzania



Tradable weather risk hedging contracts: key benefits

Contracts cover weather-

related uncertainty in

demand/supply volume and

related cash flows (sales

income and/or costs) on time

scales of months to years.

$200

$300

$400

$500

$600

$700

$800

smoothing smoothing earning volatilityearning volatilityAdvantages:

Decreased volatility allows a more efficient use of equity and reduces capital costs

Stakeholders (i.e. government, investors, financial markets) honor more predictable cash flows by increasing the market value of a company

Source: Swiss Re, 2007



Tradable weather indices



Agenda




opportunity for the Romanian insurers and businesses?


Climate change as the main driver of current and future losses

0

20

40

60

80

100

120

140

160

180

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Great Weather Related Disasters 1950 – 2005Economic and insured losses

© 2006 NatCatSERVICE, Geo Risk Research, Munich Re

Economic losses (2005 values)

Insured losses (2005 values)

Trend of economic losses

Trend of insured losses

US

$bn



Relevance of index-based parametric weather insurance for Romania

Availability of financially sustainable weather risk insurance will

increase the productivity and international competitiveness of

the Romanian agricultural producers, processors, exporters,

and other businesses exposed to the risk of weather.

Can assist the country to prepare fiscally for income shocks

caused by major floods and droughts.

Can assist countries to identify segments of population

vulnerable to climate change and put in place effective climate

adaptation plans.



Reducing the impact of weather extremes on agricultural producers - Ecuador

Covered and uncovered production of coffee (detrended, '00 tons)

0

500

1000

1500

2000

2500

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

uncovered covered strike



Agenda




business opportunity?


Preconditions for a vibrant weather risk market

Availability of quality weather data A country-wide network of weather measurement stations Weather radars Fraud-and-tempering-proof system of weather data reporting by

the responsible weather services Accessibility of weather databases

Creation of weather tradable weather indices

Development of customer base for such new risk transfer

instruments.

How can weather risk hedging be turned into a business opportunity?


Enhancing the traditional insurance business model

Insurer

Local businesses

Cover against w

eather

related risks

Traditional insured

Cover against traditional insurance risks

Reinsurancemarket

Weather riskmarket

Transfers weather risk Hed

ges

wea

ther

risks



A possible way forward for a Romanian P&C insurer?

Step I: Enters into a reinsurance agreement with a large

specialized global weather underwriter (Swiss Re, Paris Re,

etc.) by which it would cede up to 90+% of risk written to the

treaty or buys weather risk hedges in international weather risk

market, when these become available for Romania.

Step II: Hires several underwriters that would focus exclusively

on writing weather risk (initially operating more like trained

agents).

Step III: As the company develops its internal underwriting

expertise in weather risk, it may increase its own risk retention.



The World Bank Regional Climate Adaptation and Hazard Risk Management Program for SEE countries

Offers know-how to countries of SEE in areas of catastrophe

risk insurance and weather risk hedging through commodities

and capital markets.

Assists countries with the creation of weather risk market

infrastructure

Facilitates the development of the regional weather risk

market.

october 2, 2007

Documents

parametric weather insurance

parametric insurance

relevance of weather

weather risk marketseugene

underlying weather risk

role of insurance

insurance specialistoctober

crop insurance premiums