World Bank Group 4 th Edition ICAR Forum Bucharest, 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

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 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 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 What is parametric weather insurance and how does it work?

World Bank Group 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?

World Bank Group What is parametric index-based weather insurance and how does it work? Source: Olivier Mahul, World Bank, mm 10Jun-14Jul 15Jul-28Aug29Aug-02Oct Sowing Growth Harvest 35 days44 days34 days 80mm110mm80mm 110mm Loss in yield $ per acre Insurance Payout Rainfall Index Stages Time Output 80mm 12mm 35mm 80mm Parametric rainfall insurance in agriculture: illustration

World Bank Group Probabilistic agricultural risk assessment model Production losses Stochastic normal & drought events Historical weather Hazard Module Simulated Weather Generator Vulnerability Module Crop Yield Model Planting Area Model Economic Module Direct loss model Indirect loss model Crops Soil Mgmt. 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 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? Aid Funding in Ethiopia APPEALASSESS/EVENT APPEALASSESSEVENT AID FUNDINGAID PRESENT APPROACH 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 Source: Olivier Mahul, World Bank, 2007

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

World Bank Group Ethiopia Drought Index What is parametric index-based weather insurance and how does it work? th ten day period June 24 th ten day period Aug 34 th ten day period 2006

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

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

World Bank Group Index-based parametric insurance in Malawi What is parametric index-based weather insurance and how does it work? CLUB Insurance Association of Malawi MRFC/ OIBM NASFAM Step 2 Step 1 Step 3 Step 4 Step 5 Step 6 S t e p 8 Step 10 S t e p 9 MET OFFICE Step 7 Step 11 CLUB Insurance Association of Malawi MRFC/ OIBM NASFAM Step 2 Step 1 Step 3 Step 4 Step 5 Step 6 S t e p 8 Step 10 S t e p 9 MET OFFICE Step 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 Source: Olivier Mahul, World Bank, 2007

World Bank Group Malawi: insurance contract payout structure What is parametric index-based weather insurance and how does it work? PAYOUT STRUCTURE FOR LILONGWE PHASE MKW per mm Maximum Payout MKW 70 mm Trigger Level Groundnut Rainfall Index Source: Olivier Mahul, World Bank, 2007

World Bank Group Malawi: insurance contract payout structure What is parametric index-based weather insurance and how does it work? Source: Olivier Mahul, World Bank, 2007

World Bank Group Tanzania: maize rainfall insurance in Mbulu district Maize cropping calendar What is parametric index-based weather insurance and how does it work? Source: Olivier Mahul, World Bank, 2007 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

World Bank Group Tanzania: Indicative design for Mbulu rainfall index insurance policy What is parametric index-based weather insurance and how does it work? Source: Olivier Mahul, World Bank, 2007

World Bank Group Weather station network in Tanzania What is parametric index-based weather insurance and how does it work?

World Bank Group 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. smoothing earning volatility Advantages: 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 What is parametric index-based weather insurance and how does it work?

World Bank Group Tradable weather indices 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 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 Climate change as the main driver of current and future losses What is the relevance of weather insurance for Romania?

World Bank Group

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. What is the relevance of weather insurance for Romania?

World Bank Group Reducing the impact of weather extremes on agricultural producers - Ecuador What is the relevance of weather insurance for Romania?

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 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?

World Bank Group Enhancing the traditional insurance business model Insurer Local businesses Cover against weather related risks Traditional insured Cover against traditional insurance risks Reinsurance market Weather risk market Transfers weather risk Hedges weather risks How can weather risk hedging be turned into a business opportunity?

World Bank Group 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. How can weather risk hedging be turned into a business opportunity?

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.