A role for capital markets in natural disasters

Summary of a published Paper

Market-based means of managing natural disaster risk are emerging according to a recent article in Food Policy¹. While multiple peril crop insurance programmes in developing economies have in the past largely failed, it may now be possible to create an index based insurance contract for when there is a rainfall shortage. Furthermore, there may be a role for government in developing the market for natural disaster risk-sharing.

The authors of the article argue that if farmers do not have the means to manage catastrophic risk from natural disaster bankers will be forced to internalise the risks. When bankers recognise that loan defaults are tied to natural disasters, they will either ration credit or build in a credit premium to cover these risks. Yet, access to affordable credit is a key to development (and therefore reduced vulnerability to future disaster - Eds). The authors state that effective risk-sharing markets for natural disaster risks are largely lacking the world over and that if such markets existed, one might expect, more access to affordable credit, more rapid adoption of new technologies, more specialisation in production and a more adaptive and flexible agricultural sector.

There are several reasons why private markets have not developed for risk sharing. These include the fact that:

1. Government actions have crowded out such market development by operating highly subsidised public crop insurance programmes thereby competing unfairly with private insurers and stifling development of innovative insurance products.
2. The costs of insuring farm level yields are high because the insurers have to invest in elaborate information collection in order to set appropriate premiums and assess loss.

The authors recommend that what is needed is an index-linked contract rather than insuring individual crop yields, i.e. insurance that pays up when a trigger point is reached - like rainfall shortfall.

The authors suggest a number of different rainfall index policies which may be taken out (zero-one contract, layered contract and percentage contract). Each policy differs in the way payouts are calculated in relation to rainfall deficit but have in common the principle of 'strikes' when deviation from the rainfall norm triggers some form of payment.

The advantages and disadvantages of rainfall contracts include the following:

Advantages

• lower administrative cost since no on-farm inspections are needed and no individual loss adjustments required;
• the insurance can be sold to anyone who has income that is correlated to rainfall and can be sold as a simple certificate in low denominations.

Disadvantages

• need to have reliable and secure rainfall measures for a large geographical area;
• the need to model inter-temporal weather events such as El Niño;
• the possibility of mistakes in selection of critical rainfall periods;
• the difficulty of potential purchasers understanding how to use the insurance contracts.

The authors suggest that some government help will definitely be needed in developing countries in order to realise this type of insurance initiative e.g.: developing research to understand critical periods of rainfall, investing in infrastructure for secure and reliable rainfall stations, educational efforts to help potential users know how to evaluate insurance purchase decisions.

¹Skees.J (2000). A role for capital markets in natural disasters; a piece of the food security puzzle. Food Policy, vol 25, (2000) pp 365-378