4 th Edition ICAR Forum Bucharest Romania World
4 th Edition ICAR Forum Bucharest, Romania World Bank Group 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? World Bank Group
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? World Bank Group
What is parametric weather insurance and how does it work? 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 World Bank Group
What is parametric index-based weather insurance and how does it work? 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. World Bank Group
What is parametric index-based weather insurance and how does it work? Rainfall Index Time Stages Parametric rainfall insurance in agriculture: illustration Sowing Growth 10 Jun-14 Jul 15 Jul-28 Aug 35 days 80 mm 44 days 110 mm World Bank Group Harvest 29 Aug-02 Oct 34 days 80 mm Insurance Payout Loss in yield $ per acre 110 mm 80 mm 85 mm 35 mm 12 mm Output Source: Olivier Mahul, World Bank, 2007
What is parametric index-based weather insurance and how does it work? Probabilistic agricultural risk assessment model § Customized from rapid Historical weather World Bank Group Hazard Module Simulated Weather Generator onset disaster modeling Stochastic normal & drought events framework § Probabilistic drought risk assessment model Crops Soil Mgmt. Vulnerability Module Crop Yield Model § Hazard module Production losses § Vulnerability module § Economic module Planting Area Model Macroeconomic data Economic Module Direct loss model Indirect loss model Direct & indirect economic losses
What is parametric index-based weather insurance and how does it work? Aid Funding in Ethiopia World Bank Group PRESENT APPROACH EVENT ASSESS Aug/ Sept Nov/ Dec EVENT AID APPEAL FUNDING AID Jan/ Feb Mar/ Apr time CONTINGENCY FUNDING APPROACH ASSESS/ APPEAL Aug/ Sept Oct/ Nov Dec Timing gains critical to saving lives and livelihoods (Ethiopia’ 02: ~1 Mil livelihoods lost) Source: Olivier Mahul, World Bank, 2007 time
What is parametric index-based weather insurance and how does it work? 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 World Bank Group
What is parametric index-based weather insurance and how does it work? Ethiopia Drought Index World Bank Group 1984 17 th ten day period 11 -20 June 24 th ten day period 34 th ten day period 21 -31 Aug 2002 2006
What is parametric index-based weather insurance and how does it work? 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 World Bank Group
What is parametric index-based weather insurance and how does it work? Index-based parametric insurance in Malawi 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 World Bank Group
What is parametric index-based weather insurance and how does it work? Index-based parametric insurance in Malawi 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. the bank to pay NASFAM Farmers authorize for the seed S t e p 8 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 Source: Olivier Mahul, World Bank, 2007 World Bank Group Insurance Association of Malawi MET OFFICE Step 7 Step 3 MRFC/ OIBM Step 2 Step 4 CLUB Step 6 NASFAM Step 10 Step 5 Step 11 Step 1 S t e p 9
What is parametric index-based weather insurance and how does it work? Malawi: insurance contract payout structure World Bank Group PAYOUT STRUCTURE FOR LILONGWE PHASE 1 Maximum Payout 5467. 5 MKW 27. 34 MKW per mm 70 mm Trigger Level Source: Olivier Mahul, World Bank, 2007 Groundnut Rainfall Index
What is parametric index-based weather insurance and how does it work? Malawi: insurance contract payout structure Source: Olivier Mahul, World Bank, 2007 World Bank Group
What is parametric index-based weather insurance and how does it work? Tanzania: maize rainfall insurance in Mbulu district Maize cropping calendar World Bank Group 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 Source: Olivier Mahul, World Bank, 2007
What is parametric index-based weather insurance and how does it work? Tanzania: Indicative design for Mbulu rainfall index insurance policy World Bank Group Source: Olivier Mahul, World Bank, 2007
What is parametric index-based weather insurance and how does it work? Weather station network in Tanzania World Bank Group
What is parametric index-based weather insurance and how does it work? Tradable weather risk hedging contracts: key benefits § Contracts cover weatherrelated uncertainty in demand/supply volume and related cash flows (sales income and/or costs) on time scales of months to years. Advantages: smoothing earning volatility n Decreased volatility allows a more efficient use of equity and reduces capital costs n Stakeholders (i. e. government, investors, financial markets) honor more predictable cash flows by increasing the market value of a company Source: Swiss Re, 2007 World Bank Group
What is parametric index-based weather insurance and how does it work? Tradable weather indices World Bank Group
World Bank Group
What is parametric index-based weather insurance and how does it work? World Bank Group
What is parametric index-based weather insurance and how does it work? World Bank Group
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? World Bank Group
What is the relevance of weather insurance for Romania? Climate change as the main driver of current and future losses World Bank Group
World Bank Group
World Bank Group
What is the relevance of weather insurance for Romania? 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. World Bank Group
What is the relevance of weather insurance for Romania? Reducing the impact of weather extremes on agricultural producers - Ecuador World Bank Group
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 business opportunity? World Bank Group
How can weather risk hedging be turned into a 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. World Bank Group
How can weather risk hedging be turned into a business opportunity? Enhancing the traditional insurance business model World Bank Group Weather risk market Tr rr isk s Reinsurance market er ath e t w s ain ag ks r ve ris Co ated rel Local businesses ea at h er sw we ge rs ris k He d sfe the an Insurer Co ve r ag ain st tra dit ion al in su ran ce ris ks Traditional insured
How can weather risk hedging be turned into a business opportunity? 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. World Bank Group
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. World Bank Group
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