by Panos Varangis

SOURCE: The Climate Report, Vol. 2, No. 4, Fall 2001. Copyright 2002, Climate Risk Solutions, Inc.  For more information contact Maryam Golnaraghi via Email: maryam@climaterisksolutions.com, or Tel. 617.566.0077.

Reducing weather vulnerability in developing countries may very well be the most critical challenge facing development in the new millennium. Natural catastrophes claimed more than 105,000 lives across the globe in 1999, and resulted in losses of around US$100 billion. Developing countries suffer the greatest costs when disaster hits. Losses due to natural disasters are 20 times greater (as a percent of GDP) in developing countries than in industrial countries.

Many emerging economies and companies owe their strength to favorable weather events. Conversely, many have faced significant difficulties when the effects of unexpected and unfavorable weather events could not be protected against. The agricultural, energy, and leisure sectors are examples of industries whose earnings are extremely sensitive to weather. The revenues or costs in these industries are directly tied to seasonal weather conditions. In particular, severe weather events, drought or flood, high winds or low temperatures can have a devastating impact on individual farmers and on the wider population that relies on dependable agricultural production. In recent years, the international community has come to realize that disaster vulnerability, including weather disasters, has everything to do with poverty and development, and vice versa. Measures taken to reduce the impact of weather disasters provide an effective vehicle to make substantial advances in the fight against poverty. Although there is no way of controlling the weather, there is now a solution to the financial effects that weather can have on the incomes of economic agents in developed and emerging economies.

This paper focuses on risks that are related to weather events (excess rain, droughts, freezes, high winds, etc.) that have a severe impact on the livelihoods and incomes of economic agents in developing countries. This paper argues that recent developments in weather derivatives and insurance markets have great relevance for developing countries. Tapping international weather markets can help developing countries not only in coping with disasters but also in creating opportunities for new private insurance products. A case study from Mexico is used to illustrate these points.

Developments in weather derivatives and insurance markets

Weather risk markets are amongst the newest and most dynamic markets for financial risk transfers and include participants from a broad range of economic sectors such as energy, insurance, banking, agriculture, leisure and entertainment. Although the weather risk market is still very much US-based, new participants from Europe, Asia, and Latin America are entering this market.

Although weather risk markets are well advanced in the energy sector, their applications to agriculture, a critical sector for most developing countries, are still limited. For one, this type of market is very new and secondly they have to compete with highly subsidized crop insurance schemes in developed countries. A notable application of weather markets in agriculture is in Canada, in the provinces of Ontario and Alberta. Weather markets were used because of the close correlation between cattle pasture and weather (rainfall).

For developing countries, weather markets create new opportunities for dealing with two fundamental issues. The first is ways to deal with catastrophic or disaster risks and the second is to promote new private-based insurance products for sectors that are highly dependent on weather, such as agriculture.

The traditional market-based instruments for managing weather risks, e.g., insurance, are largely underdeveloped and unavailable in most parts of the world. Given the growing interest in weather insurance markets, there are opportunities for innovation that have, as of yet, not been largely exploited. A number of studies are recognizing that markets may more easily provide weather insurance than traditional crop insurance in many developing countries (Gautum, Hazell and Alderman 1994, Sakurai and Reardon 1997; Skees, Hazell and Miranda 1999; and Skees 2000). Traditional crop insurance based on individual yields and field inspections can be very expensive to administer in most developing countries given the small size of farms. It also has the usual problems of adverse selection and moral hazard that could be much higher in developing countries where individual farm information is scarce. Furthermore, weather-based index insurance covers covariate risk for groups of economic agents through formal and informal risk-sharing arrangement among economic agents that are purchasing these index contracts. This is a potentially important innovation since instruments for systemic risk can complement the approaches for managing idiosyncratic risks found in many developing countries. Several researchers (Black, Hu and Barnett, 1999, Skees and Zeuli, 1999) extend these ideas to the US by arguing that cooperatives could purchase index insurance and become mutual insurers.

In simple terms, weather insurance is based on the occurrence of a weather event rather than on actual losses such as crop failure. The underlying assumption is that certain weather events (such as rainfall above or below a specified amount) are highly correlated with crop losses and are therefore income risks. Drought insurance is one example. Insurance contracts would be written against severe rainfall shortfalls (e.g., 30 percent or more below the norm) that can be measured at a specific weather station. The insurance could be sold in standard units, for example US$10 or $100, and all buyers pay the same premium and receive the same indemnity payment per unit of insurance.

The key advantages to this kind of insurance are that the trigger events (e.g. rainfall shortages) can be independently verified, and therefore not subject to the possibilities of manipulation which are present when insurance pay-outs are linked to actual farm losses. And, since the contracts and indemnity payments are the same for all buyers per unit of insurance, the usual problems of moral hazard and adverse selection associated with traditional crop insurance are lessened.

The insurance can be relatively inexpensive to administer, since there are no individual contracts to write, no on-farm inspections and no individual loss assessments. This can help make the insurance affordable to a broad range of people, including agricultural traders, agro-processors, shopkeepers and landless workers whose incomes are also affected by the insured weather events.

This type of insurance is relatively easy to market. For example, it could be sold through banks, farm cooperatives, input suppliers and micro-finance organizations, and perhaps even sold directly to farmers. Weather insurance is not only for producers and rural people. Banks and rural finance institutions could also purchase such insurance to protect their portfolios against defaults caused by severe weather events. Similarly, input suppliers could be the purchasers of such insurance. Once financial institutions can offset the risk with this type of index insurance contracts, they may be in better position to expand credit at perhaps improved terms. This is a critical issue for many developing countries as credit availability to agriculture is constrained, partly because of weather risks. Finding solutions to protect borrowers against adverse weather events could contribute to improving credit markets in developing countries.

Key challenges for developing weather risk management markets in developing countries

There are some important challenges in bringing weather risk management to developing countries. First, it is crucial that reliable and verifiable data are available on weather patterns. There are two aspects to this. First, there is a need for reliable historical data covering a period of at least 30 to 40 years (daily observations). The availability and cost for obtaining such data may be an important issue in several developing countries. Second, tamper-proof weather stations must be established to ensure reliable readings on insured events. New hardware systems, such as optical precipitation sensors, can eliminate any direct human involvement in the recording process. Readings can also be verified by comparing with adjacent stations or with remote sensing data taken from satellite images. Satellite instruments could provide estimates of rainfall and perhaps, in the longer run, these instruments could become the main means of providing rainfall measurements for insured areas. At present, an important constraint with satellite measurements of rainfall is that there is little history compared to conventional measurements.

Second, rainfall can vary spatially. For example, it is possible to have sufficient rain registered in a weather station on which a rainfall contract is written and not have rain falling on a farmer's nearby field thus preventing the farmer from collecting insurance. In addition, it is important to determine the correlation of rainfall measurements within a certain region; in other words, how representative of the region is the measurement of rainfall in a certain weather station? Low correlation indicates high rainfall basis risk. The basis risk has an analogy with the price hedging where local prices may differ from the price observed in, say, CBOT or any other futures exchange. It may be possible to address this risk by averaging measurements over a longer period of time (monthly or even quarterly) and over a larger region. Low spatial correlation may be more of a problem for individual farmers but less so for producer associations, financial institutions, and agro-industries, because they operate over a much broader geographical region(s). Whether the basis risk overwhelms the significant benefits of weather insurance is an empirical question, depending largely upon the spatial correlations of rainfall events over time. For example, in areas with microclimates, the spatial correlation may be too weak and the basis risk too high.

Third, in dealing with severe weather events it may be difficult to find someone with an offsetting exposure, that is finding someone that would benefit if droughts or floods occur. The cost efficiency of derivatives markets increases by bringing together parties with opposite exposures.

Fourth, the actuarial soundness of the insurance could be undermined by weather cycles that change the probability of the insured events. It may be necessary to adjust the cost of the insurance whenever a specific weather event is confirmed, though this would require sufficient lead time between knowledge of the pending event and the time of selling insurance. However, this should happen only when the occurrence of an event amounts to a shift in the weather patterns rather than a movement along the existing distribution of weather patterns. An example of this is if, say, rainfall levels have a negative trend and droughts occur with more frequency over time.

Fifth, insurance regulations in most developing countries do not envisage the use of weather derivatives as insurance instruments. There is a need to enact changes in these regulations that would allow the use of financial insurance instruments, including weather derivatives, in addition to traditional insurance.

Finally, the systemic nature of weather risk needs to be addressed. If a severe weather event, such as a drought or a flood, does occur, all those covered by the policies have to be compensated at the same time. This can pose an intolerable level of risk exposure for the local insurance provider. Mechanisms to spread these financial risks internationally are therefore required. Until recently, the only viable way for national insurance companies to manage this kind of risk was to obtain international reinsurance. These markets work, but the insurance companies involved have limited capacity to absorb large amounts of covariate risks-risks that affect many people simultaneously-as opposed to independent risk such as car accidents, heart attacks, etc. Recent developments in financial markets (such as weather derivatives, catastrophe or "cat" bonds-bonds whose coupon and principle payments depend on the performance of an index or pool of natural catastrophe risk) offer new opportunities to pool large volumes of covariate risks on a global scale (Cole and Chiarenza 1999, Lamn 1997, Skees 1999). For example, "catastrophe" bonds issued against rainfall events in developing countries could be very appealing to international investors because their risk would be uncorrelated with the risks of most other financial investments. If these instruments could be successfully harnessed through contracts with governments, banks or large insurance companies, the covariate part of catastrophic risks could be reduced to a manageable amount at the country level. There are already successful examples of using cat bonds in Japan and the U.S. to spread the risks of earthquake insurance. Expansion of this approach offers a unique opportunity to link world financiers and emerging economies in a partnership that is mutually beneficial.

Mexico: a case study

Given some recent innovations targeted at helping economic agents cope with catastrophic weather events, we use Mexico as a case study to support some of the general concepts developed above. Mexico has two institutional innovations that could be combined with well-crafted weather-based index risk management products. Not only could such indexes be developed to offer insurance to the rural people, but the same indexes can be crafted to allow improvised governments opportunities to hedge budgetary exposure when they provide free disaster aid.

In 1996 the Mexican government established a Fund for Natural Disasters (FONDEN) for post-disaster financing for reconstruction of public infrastructure, and compensation to low-income producers for crop and livestock losses arising from natural disasters. FONDEN targets the beneficiaries and has limits to amounts it disburses per beneficiary. The intent is not to compete with private insurance. FONDEN payments are triggered only when droughts, frost or other weather perils affect most people in a region-that is, FONDEN pays out against systemic risks. In addition, more recently, FONDEN has started to adopt objective rules for declaring catastrophic events. For example FONDEN rules that livestock owners are eligible for drought payouts when cumulative rainfall is below either 50% of its historical average or historical minimum for two consecutive months. Similarly, frost is declared when temperatures fall below a certain level depending on the crop. For example, for sorghum is -9°C, for wheat -6°C, for oranges -2°C, for melons -1°C. Using parametric rules for triggering payments removes an ad hoc dimension in the declaration of catastrophes and reduces the political interference in FONDEN's operations. The government of Mexico is currently looking into the feasibility of obtaining financial re-insurance for FONDEN to cover its exposure from weather risks affecting the agricultural sector.

Catastrophic insurance coverage has encouraged the formation of mutual insurance funds amongst farmer organization. These farmer organizations are called fondos de aseguramiento (fondos for short), and were formed to provide mutual crop insurance to their members. The fondos collect premiums creating reserves to pay indemnities and cover operational costs. However, in the event of catastrophic weather events the collected premiums and reserves are not sufficient to cover the losses. This is because a catastrophe affects all farmers at the same time and the mutual insurance needs to make payments to all of them at the same time. World Bank researchers (Skees, Varangis and Larson, 2001) identified drought, excess humidity and frost as the main weather perils that cause catastrophic risks for the fondos. These risks depend on the geographic location of the fondos, so each fondo is exposed to mainly one or two weather risks. That is, fondos run out of collected premiums and reserves to pay for losses mainly due to these severe weather events. Thus, obtaining catastrophic insurance for these perils is crucial for the financial viability of mutual insurance arrangements.

World Bank researcher (Skees, Varangis and Larson 2001) examined the development of weather contracts based on rainfall to insure against drought in four states: Durango, Jalisco, Tamaulipas and Zacatecas. The feasibility study had two main components. First, it examined the correlation between rainfall and yields to determine the loss due to lack of rain. Second, it designed a prototype rainfall contract and examined how this contract affects the variance of revenues from these crops. The study finds that weather contracts are feasible in about 40% of the planted area in these four states where the correlation between rainfall and yields is around 60-80%. Furthermore, rainfall contracts could reduce the relatively risk by up to 30%. These findings suggest that rainfall contracts have potential in Mexico.

Conclusions and policy implications

Weather markets provide new opportunities for developing countries in dealing with weather risks whether for catastrophic or more frequent weather events. Policy makers could use these markets to design effective weather disaster assistance programs and support the development of private markets within their countries.
The goal of government intervention after a natural disaster is to provide the most cost-effective form of government aid that will help economic agents. This aid should be provided in an objective fashion with ex ante rules for when and how much assistance to provide. Further, the assistance should not unduly distort economic incentives. In particular, care should be taken to assure that aid does not spur unsustainable new economic activity in areas that are more risky or vulnerable to natural disaster risks. Doing so will likely result in more losses and suffering when the next disaster strikes.

The government should define disaster and catastrophe within the context of frequency as well as severity. For example, it would be a mistake and very expensive to have government intervention too frequently. The infrequent events that create serious problems may require some level of government intervention, such as free disaster aid. Those events that are more frequent but still cause serious losses may be more appropriately left to private sector insurance markets if the transaction costs of such insurance can be contained. Solutions should involve segmenting and layering the weather risks so that the most catastrophic risk is handled with government aid and the less catastrophic risk is left to private market mechanisms. Private insurance companies can develop insurance products that deal with individual risks after the more systemic and catastrophic weather risks are covered.

A critical element for encouraging the use of weather risk markets in developing countries is for governments to provide access to their meteorological data and make the necessary investments in their weather stations in order to ensure accurate and tamper-proof measurements. International weather trading companies stand to benefit from including developing countries into their activities because they achieve diversification of the weather risks they cover on a global level. This may contribute to reducing the overall risk of their weather portfolio and reduce the overall costs of covering weather risks.

Relevant Readings

Black, J.R., B.J. Barnett, and Y. Hu, 1999: "Cooperatives and Capital Markets: The Case of Minnesota-Dakota Sugar Cooperatives." American Journal of Agricultural Economics, 81, 1240-1246.

Cole, J.B. and A. Chiarenza, 1999: "Convergence in the Markets for Insurance Risk and Capital." Risk Magazine.

Dischel, R., 1998: "The Fledgling Weather Market Takes Off" Applied Derivatives Trading. Web site: http://www.adtrading.com 

Gautum, M., P. Hazell and H. Alderman, 1994: Rural Demand for Drought Insurance. Policy Research Working Paper no. 1383.

Lamm, R.M. Jr., 1997: "The Catastrophe Reinsurance Market: Gyrations and Innovations amid Major Structural Transformation." Bankers Trust Research. Bankers Trust Company, New York, NY., 1-13.

Nagarajan, G., 1998: Microfinance in the Wake of Natural Disasters: Challenges and Opportunities. Development Alternatives, Inc.

Risk, "Weather Risk", Risk Special Report, the Risk Waters Group, August 2001.

Sakurai, T and T. Reardon, 1997: Potential Demand for Drought Insurance in Burkina Faso and its Determinants. AJAE, 79, 1193 - 1207.

Skees, J.R., P. Hazell, and M. Miranda, 1999: "New Approaches to Crop Insurance in Developing Countries". EPTD Discussion Paper No. 55. International Food Policy Research Institute, Washington, D.C. November.

Skees, J.R., 2000: "A Role for Capital Markets in Natural Disasters: A Piece of the Food Security Puzzle." Food Policy, 25, 365-378.

Skees, J.R, (1999a): "Opportunities for Improved Efficiency in Risk-Sharing Using Capital Markets." American Journal of Agricultural Economics, 81, 1228-1233.

Skees, J.R. and B.J. Barnett. (1999b): "Conceptual and Practical Considerations for Sharing Catastrophic/Systemic Risks." Review of Agricultural Economics. 21, 424-441.

Skees, J.R., P. Varangis and D. Larson, 2001: "Can Financial Markets be Tapped to Help Poor People Cope with Weather Risks?", paper presented at the UNU/WIDER conference on Insurance against Poverty, Helsinki, June 15-16.

Zeuli, K., 1999: "New Risk Management Strategies for Agricultural Cooperatives." American Journal of Agricultural Economics, 81 , 1234-1239.