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Saturday, 01 November 2014

IMF/World Bank 2007: Rough weather

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The World Bank should be able to combine weather insurance and risk management products to complement its aid solutions. But pilot projects for the bank’s push into encouraging weather risk management when working with governments on assistance packages to developing countries have had mixed results. Jean Haggerty reports.

Weather risk management consulting now has a formal role in World Bank activity, but the complexity of the initiative makes its future as unpredictable as the weather itself. Interest in finding a role for weather risk management in global social protection and climate change projects continues to grow, however.

The idea that weather risk management can be used as part of aid organisation-led initiatives in developing countries dates back to the 1980s.

It was not until 1999, when Rodney Lester led the first World Bank feasibility study on weather index based insurance in developing countries, that testing of the idea began in earnest.

The project involved using weather risk management techniques to address developing countries’ weather-linked volatility in agricultural production and income.

“The challenge for us is drawing lessons from the pilots. Each pilot is unique and thus you have to look at the pilots on a case-by-case basis," said Olivier Mahul, programme manager for insurance for the poor at World Bank headquarters in Washington.

In the first pilot, the International Finance Corporation (IFC), the private sector arm of the World Bank, planned to use weather derivatives as a risk management tool for developing economies. The pilot involved helping to set up a joint-venture insurance company that would act as an intermediary between local agricultural banks or insurers and end-users and the international entities interested in taking on weather risk.

Morocco was selected as the testing ground for the idea. At the time, the correlation between Morocco’s GDP growth and rainfall was close to 60%, making it one of the most weather-exposed countries in the world. The population depends on rain, as Morocco is a cereal-dependent country. The index that the contracts would have been based on was intended to represent rainfall over a set period and to set thresholds linked to the growing season of specific goods, such as sunflowers.

Under the plan, which foundered not long after it was launched in 2001, local bank and insurance companies in Morocco would have offered affordable index-based weather insurance to farmers and other weather-exposed parties in select regions. The new joint-venture insurance company would have pooled the weather exposure and placed most of it in the open market, while a portion of the exposure would have been retained by the IFC.

The project’s short lifespan was due in part to the failure of its international joint venture partner, Aquila, which was dragged down in the wake of Enron’s collapse. On top of this, the Moroccan government proved to be unwilling to push the idea. Subsidies can be hard to compete against, those who watched the pilot plan unravel said.

Other factors also pose challenges when introducing projects to provide farmers in developing economies with direct access to weather risk management tools.

The absence of the technical capacity to develop weather risk products or even a lack of a local market concept of weather or crop insurance, can create technical problems that hinder a broad roll-out of weather risk-based programmes by the World Bank.

Operational obstacles to delivering a programme to farmers present another issue. A main reason why crop insurance can be so expensive in some developing countries is because is can be hard to deliver.

Legal challenges have also emerged as a hurdle. "In terms of the regulatory and legal framework, the local insurance law usually does not allow for index-based insurance, or more precisely does not mention whether index-based financial products are considered as insurance products," Mahul said.

For the World Bank, the vision driving its pilots is to popularise the concept of weather risk management, rather than to set up large programmes within countries.

In theory, a programme offering direct access to weather risk management tools could replace or compete with the World Bank’s business of delivering emergency loans, one official noted.

The World Bank dismisses this conflict of interest claim, however. For the past five years it has been moving away from the post-disaster strategies that characterised its approach in the past towards an approach that includes pre-emptive risk financing.

“You need both,” Mahul said, adding that the World Bank’s recent efforts in the Caribbean highlight this point.

After Hurricane Ivan devastated a huge portion of the Caribbean in 2004, several Caribbean countries experienced the limitations of post-disaster relief and asked the World Bank about risk financing solutions that could serve as an alternative.

"It can be a timing issue . . . Most post-disaster loans and grants are earmarked for rehabilitation and reconstruction, but governments may face other needs like paying their civil servants," Mahul said.

The World Bank accordingly designed an insurance pool for 16 Caribbean countries that is based on a parametric weather fund. If a hurricane of a pre-determined force hits one island, liquidity to cover emergency needs can be directed to that island quickly. Rather than replace the donor market, this type of insurance-based solution is meant to complement it.

The World Bank also met success with a pilot initiated in 2003 for that year’s monsoon season in India. Over four years after the pilot’s inception, weather insurance is viewed as a mainstream product in India.

India was an obvious choice for a pilot because the country is big enough to interest reinsurers, has enormous weather exposure and has banks, micro-finance operations and local insurance companies that are interested in innovative solutions to weather risks. Additionally, agriculture contributes roughly 23% of India’s GDP, and supports about 65% of India’s population in terms of providing a livelihood.

According to officials, the Indian pilot was also helped by the country’s high population density. In many African countries, by contrast, delivering a comparable pilot might prove tricky, they said.

Although it was large compared with other pilots, the Indian initiative has not been too expansive given the size of the country. More than half a million Indian farmers have taken weather insurance under the programme, but by some estimates, there are about 100m farmers, or potential weather risk management clients, in India.

"It is still small scale in the Indian context. If you ask me if this can be done on a large scale, I do not know, because scaling up these pilots and making them financially viable in the long term is challenging," Mahul said.

Practical challenges, such as tackling the financial difficulties associated with securing insurance or reinsurance capacity in the global market in the event of a pilot expansion, must be considered when creating or expanding projects, he noted. The World Bank’s Indian weather risk insurance pilot will be examined as part of a review of index-based insurance products worldwide that is due later this year.

Other global aid agencies and actors are also getting involved in offering weather risk solutions, and some are taking the idea beyond crop insurance.

The World Food Programme (WFP), for example, has picked up the theme and added weather risk management to its safety net operation for Ethiopia. So far, the work that has evolved out of the WFP’s thinking has focused on how to better respond to drought, which is by far the largest and most frequent shock that Ethiopia suffers.

Replacing the current emergency system with an early response to livelihood stress saves developmental money later and also reduces emergency and safety net costs, according to Ulrich Hess, chief of business risk planning at the WFP in Rome. Education gains, because children are left in school, are also possible, he added. By his estimate, risk management savings amount to a five-to-one cost benefit ratio.

The growing body of literature on poverty traps demonstrates that repeated shocks followed by traditionally late or inadequate responses can lead to loss of livelihoods and increase the number of people living at risk to food shortages. For example, studies show that Ethiopian households that suffered substantially during the 1984-85 drought, which resulted in widespread famine, continued to experience 2-3% less annual per capita income growth during the 1990s, compared to households that were not hit as hard. (See graph)

The WFP’s debut project involved the creation and use of the Ethiopia Drought Index (EDI).

“The opportunity to index risks allows government and donors to develop timely, objective, transparent and sustainable triggers that can be used to determine when and to what extent assistance may be required,” according to a discussion paper on deploying weather risk management solutions in Ethiopia that was presented to the WFP late last year.

An index-based insurance approach has limits, however. The main limitation of the approach is basis risk, which must be managed in terms of designing the index and in explaining the product to the user, Hess said.

In the first section of the two-part pilot, a weather derivative indexed to the EDI was used to demonstrate the feasibility of establishing contingency funding for an effective aid response in the event of contractually specified severe and catastrophic shortfalls in rain during the 2006 Ethiopian agricultural season.

The weather derivative used to secure contingency funding in 2006 was structured as an insurance-like contract with a trigger level set at about one standard deviation above the EDI average, corresponding to an estimated US$55m in drought-related agricultural livelihood losses. The WFP obtained an insurance contract based on the Ethiopian drought index through Axa Re.

The World Bank's Africa region social protection unit participated in the second part of the pilot. Its work involved lining up donors to provide coverage through contingent credit, contingent funds and insurance. Under this umbrella, the World Bank's Africa social protection unit put up a contingent grant of US$25m. Other aid agencies are considering participating.

According to Hess, the Ethiopian drought insurance pilot demonstrates that it is feasible to use market mechanics to finance management of drought risk in Ethiopia. The current emergency appeal system for responding to humanitarian risk in Ethiopia leaves a critical gap in the government strategy for promoting sustainable livelihoods and protecting people from sliding or falling back into chronic poverty, he added.

Each of the aid agencies that are in various stages of exploring or using weather indexed-based solutions brings strengths and weaknesses to the table. The WFP has competencies in understanding disasters, but its reputation was damaged by problems with past food aid practices, for example. The World Bank is not a disaster relief organisation and is viewed by some as politically-biased towards the US.

The UN, through the International Fund for Agricultural Development or through its International Strategy for Disaster Relief Reduction, has credibility, knows about disaster management and could take the lead on coordinating joint aid agency efforts, but no such initiatives are currently in the pipeline.

Without hard proof that weather risk management solutions work, scaling up initiatives and getting various bodies, including the private sector, on board could be tricky. The private sector is interested, however. The Gates Foundation, for example, has shown an interest in micro finance. Some officials say that institutions like the World Bank could act as a facilitator for use of creative capital provided by the private sector.

Combating climate change is also seen by some as another potential future area for weather risk management, and various global agencies have had preliminary discussions on whether weather insurance programmes could be the right solution.

The Catch-22 remains the same: weather insurance cannot cover all risks and it is not always the right solution. Additionally, even in some developed countries weather insurance markets are advanced, as the infrastructure to support new programmes is not always available, and data sources can be limited.

"Weather insurance complements other risk management activities, and it can be a solution. But it is not a panacea," Mahul said. "It is not a one-size fits all type of product. Each country, each crop and each hazard must be carefully identified before we can figure out if weather insurance might be the right solution.”

For example, in 2004, a World Bank-assisted pilot for livestock insurance was launched in Mongolia. Initially, a weather-based livestock mortality contract was envisioned.

In the end, this was not pursued because preliminary work showed that the impact of adverse weather events – such as a dry summer followed by a harsh winter – on livestock mortality could not be properly captured through weather indices.

The World Bank opted instead to design an index based directly on aggregate livestock mortality rates.

“Weather index insurance offers promise, but mainly for selected hazards like deficient rainfall or excess rainfall. Weather index insurance is only effective when basis risk can be minimised,” Mahul said, noting that a second focus could be for specific crop types and specific time windows during the growth cycles of vulnerable crops.

As the Mongolian pilot showed, it can be difficult to design an effective weather index insurance product if losses are caused by a complex interaction between multiple weather variables.

An irony of this conclusion is that climate change is increasingly accepted as a factor that is influencing and adding to the complexity of global weather patterns. These forces may in turn lead to the displacement of people and of livelihoods, particularly in countries where gross domestic product performance is heavily dependent on agriculture, and thus weather.

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