Presentation on theme: "Dr. Jerry Skees HB Price Professor, U of KY"— Presentation transcript:
1 Drawing from Lessons Learned on Index Insurance to Consider Financing Famine Relief Efforts Dr. Jerry SkeesHB Price Professor, U of KYPresident, GlobalAgRisk, Inc
2 Defining the ProblemFamine & Hunger are complex social problems created by numerous interrelated factorsLow incomesBad governmentsChronic vs TransitoryCrop failures (weather driven)High prices due to local shortages
3 Defining the Problem The solutions today can help with: Crop failures (weather driven)High prices due to local shortagesTransitory shortagesLess clear that they can help with:Low incomesBad governmentsChronic shortages
4 The most common response Emerging food aid has limitationsStorage problemTransport problemDependency problemTiming problemBad government problemPolitical issue among the developed countries
5 Proposition:Getting cash to market participants before a transitory food shortage problem emerges is a superior food assistance programCash is fungible it can be used for any food stuffs to mitigate the problem
6 Searching for Solutions that get cash into the country “Food Insecurity in the Least Developed Countries and the International Response”By Michael Trueblood and Shahla ShapouriThis paper compares 3 alternativesGrain optionsRevolving import compensation fundImport insuranceConclusion: All would cost significantly less$300-$600 million per year vs $2.9 Billion
7 ‘Insurance’ based solutions from Trueblood and Shapouri All involve protecting the cost of imports at some levelEach is focused on the price sideWe consider insurance that protects the supply side
8 Insuring crop/pasture failures Issues:Traditional crop insurance is a failureCrop failures represent correlated losses; in a classic sense they are not insurableFinancial innovations are creating new opportunitiesTechnological innovations enhance those opportunities
9 Traditional Crop Insurance A failureMoral hazard/ adverse selection / high monitoring and administrative costNo successful crop insurance in the world when one measures the total cost of the program versus the transfersHave we targeted the wrong level?
11 Consider Drought Insurance A frequent event (1 in 5 / 1 in 7) with high correlated losses.. Everyone can have a wreck at the same timeLoss function has a thick tail to the right with frequent-heavy losses much more likely than with earthquakesClassically NOT an insurable risk!Cause of loss is not easy to verify as a combination of events can cause a crop loss
13 Financial and Technological Innovations Pave the Way Financial InnovationsWeather marketsIndex based insuranceCatastrophe bondsBlending capital markets with reinsurance marketsTechnological InnovationsSatellites are measuring weatherSatellites images on vegetative coverGround level real-time weatherComputer models to give early warning (LEWS)
14 Recent Market Innovations for Catastrophes Catastrophic Bonds in the equity marketsCatastrophic Insurance options on the CBOTCrop Insurance Yield contracts on CBOTOver the Counter index tradesTemperature Contracts on the CMEWeather markets and agriculture
15 Catastrophic Bonds Debt instrument or Equity instrument? Those at risk have a contingent claim on the Bond if the catastrophe occursYou give me your capital .. I give you a high rate of return unless the catastrophe hits… then I either reduce your return or take your capitalSince over $10 Billion in dealsFund managers like CAT Bonds as they are not correlated to other equity markets
16 Area Yield Insurance Essentially, an option on county yield. Indemnity does not depend on farm-level yield!No moral hazard.No adverse selection.Low transactions costs.Geographic basis risk!
17 Area Yield Insurance Need: Don’t need: County yield history. Independent party to measure county yield for insured crop year.Don’t need:Farm yield history.Farm yield for insured crop year.Compliance officers.Loss adjusters to measure farm-level losses.
18 US Group Risk PlanPayments are strictly based on estimates of county yields
20 Paying on Index Contracts Expected county yield =100Payment is based on percentage below a trigger yieldEX: Payments begin yields of 90 or lessActual yield = 70Percentage = (90-70)/90 = 22.2%Payment = Liability Selected x .222%Premium= Premium rate x Liability
24 Romanian Rain (drought or excess rain) Strike for drought at 100 mm or belowStrike for excess rain 100 mm or aboveSimple contractWe will pay for every 1 mm of rainfall below 100 mm. You decide where to stop payment and the maximum level of insurance value
25 PremiumPremium rates are driven by the PDF and actuarial procedures for loading ratesPremium payment = Liability x Premium rateQuestion: How does one determine how much liability to purchase? What is at risk?
26 Index-Based Insurance Products Example:Farmer purchases an insurance policy that will pay an indemnity if cumulative precipitation measured at a given location is below a specified level over a period of time.Indemnities are not based on farmer’s yield; they are paid on an independent source of information
27 Index-Based Insurance Products Advantages:No moral hazard.No adverse selection.Low administrative costs (no individual farm loss adjustments).Easy to understand.Protects against correlated risk
28 Weather Index Insurance Need:Reliable historical weather data for a given weather station.Secure and objective source of current weather measurements.Don’t need:Farm yield history.Farm yield for insured crop year.Compliance officers.Loss adjusters to measure farm-level losses.
29 Potential Applications Weather index insurance can be:Sold to households at riskSold to importersSold to governments for disaster aidSold to groups of householdsSold to agribusinessesUsed for commercial risk and for emergency assistance
30 Mexico Same infrastructure can be used To sell direct to farmers To reinsure the crop insurance programSold to collective groups (Fondos)Used for natural disaster relief (Funden)Wider Press ChapterCan Financial Markets be Tapped to Help Poor People Cope with Weather Risks?
31 Mexico Case StudyDecember 2001, Agroasemex was the first emerging economy ever to use weather derivatives to reinsure the Mexican crop insurance programMotivation: Obtain a price for the upper layer of reinsurance (the biggest risk) was lower than other alternatives in the marketMuch more activity in Mexico now to use weather measures for disaster payments and insurance
32 Countries Argentina (use area yield for disaster pay) Morocco (rainfall insurance this fall)Mexico (first reinsurance with weather)Canada (Alberta & Ontario use rain)Mongolia (to use mortality rate of animals)Ukraine (progress toward using rain)Romania (recommended area yield)
33 Linking Rainfall Insurance and Water Markets Rain feeds the system of reservoirsRainfall insurance sold to the Irrigation Authority (IA) offers new opportunitiesIA could sell quota rights to water with 3 characteristics: 1) ownership and right to use water; 2) right to lease water; and 3) a guarantee that replaces lost water with insurance payments
34 Linking Rainfall Insurance and Water Markets How does a quota with these characteristics change the political economy of water markets?IA sells these quotas to obtain the capital needed to make infrastructure improvementsBurden is on IA to ‘fix things’ and make certain that they can deliver water to quota ownersThe IA reinsures the indemnity payments with the rainfall insurance
35 Moving to a Proposal for Famine Use the early warning systems to index emerging problems and offer index insuranceIssuesWho will pay premium?Who should purchase?How might such a system be implemented?
36 Livestock Early Warning System for East Africa. Global Livestock CRSP - LEWSLivestock Early Warning System for East Africa.…..blending monitoring/modeling and spatial technologiesto improve food security of pastoral communitiesin East AfricaLead Institution:Texas A&M University SystemDr. Jerry Stuth, PI
37 Biophysical Models, Technologies and Spatial Analysis Tools Currently Used in the LEWS Project ProcessPHYGROW - hydrologic based, spatially explicit multiple-species plant growth/hydrology/animal grazing model.NUTBAL - nutritional balance analyzer used to assess nutrient requirements, nutrient intake, milk production, and performance in cattle, sheep, goats and horses with least cost mediation solutions..Near Infrared reflectance spectroscopy of (NIRS) – Allows fecal profiling of livestock to determine the quality the forage recently consumed prior to defecating.Spatial Characterization and GIS tools - GPS units, ACT, ArcView, GS+Satellite Imagery - NOAA RFE weather and EROS NDVI data
38 Systems can focus on local problems Grid of 12 x 12 km
40 Using Early Warning Systems for Insurance Contracts These systems index the deviations from normalThese systems give early warning (up to 90 days)Insurance model could be indexed with deviations from normal and the early warning informationInsurance would likely have layered payment structure (1 early payment with another payment should certain excess conditions be meet)
41 Who Could Purchase? Governments NGOs who want resources when there is a serious problemImporters within the country (remember.. If they are concerned about price increases they should purchase more liability)Microfinance entities within the country for local problemsVillages / households
42 Who will pay?Some level of payment could come from the G-8 (for the worst catastrophes)Some level should come from the end-usersSome payments could be in the form of food stampsSome payments could come from NGOsCharity Catastrophe Bonds
43 Who will supply these index contracts? A consortium of international reinsurersInvestment banks via famine CAT BondsCharity CAT BondsKeeping some market base is important!Relative risk pricing..Proper design of contractsPooling of global risk to make undiversifiable risk diversifiable
44 Is this doable?Yes.. I have visited with some key market makers: there is an interestDeveloping such a system helps them spread global risk / helps them with an enhanced social imageWhat is needed?
45 Rules for Successful Indexes Easy to understandReplicationFrequency of PublicationRepresentative of True Economic ValueBreak-down of alternative hedging(Drs. Richard Sandor and Joseph Cole)
46 BenefitsGets cash to important stakeholders in the developing country: BEFORE the problem gets too seriousPaves the way for more risk management instruments by providing the important infrastructure for a variety of commercial and social risk problemsEnhances the opportunity to spread global risk