The Potential for Scale and Sustainability in Weather Index Insurance

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CHAPTER 2
WEATHER INDEX-BASED INSURANCE
types of indices that can be assessed remotely with satellites, such as cloud cover or soil
moisture content for a chosen region during critical agricultural periods. This kind of
data is becoming increasingly available and it may have the potential to replace
weather stations for disaster relief insurance. Despite this potential, the writing of such
contracts for individuals is constrained by a credibility problem: people may not trust
payout decisions made by insurers on the basis of ‘unseen’ data that may, because of
basis risk, fail to correlate highly with their own on-the-ground observations.
Apart from basis risk, insurance companies are usually not prepared to design
index insurance products for agriculture. The adoption of creative solutions such as
the ones mentioned above (e.g. cloud cover, soil moisture) could be quite useful, but
these are even more challenging for most insurance companies. As a result, companies
in the developing world usually need significant support and training to design index
insurance contracts, which obviously limits their diffusion and expansion.
Reinsurance
While insuring for covariate risks reduces basis risk, it increases the total amount of
payouts in any one season, because when an insured event occurs, everyone must be
paid at the same time. Moreover, if the insured risks are indexed against different
rainfall stations that happen to be highly correlated, then in some years the insurer
may have to make very large payments in multiple regions. Ontario’s Forage Rainfall
Plan insurance, for example, has experienced loss ratios varying between 0.02 (in
2008) and 4.77 (in 2001). 7 The insurer can hedge part of this risk by diversifying its
portfolio to include indices and sites that are not highly and positively correlated,
which is more likely possible in larger countries. But it may also be necessary for the
insurer to sell part of the risk to international financial markets.
International reinsurance is already available for some natural disaster risks. The
simplest form is a stop-loss contract in which the primary insurer pays a premium to
get protection if its losses exceed certain levels. Other forms of reinsurance are also
common. Quota-share arrangements involve sharing both premiums and
indemnities. Despite significant growth in recent years, the reinsurance markets for
index insurance are still thin, with few large international firms and a limited appetite
for weather index-based contracts.
As an alternative to reinsurance, recent developments in global financial markets
are making it increasingly feasible to use new financial instruments to spread
covariate risks more widely, such as weather derivatives and catastrophe bonds.
However, the high transaction costs associated with these arrangements have been a
major impediment to their use in developing countries and for agricultural risk
management. These costs could be reduced if governments play a role in aggregating
risk nationally and in insuring part of the aggregate risk itself before going to the
7 The loss ratio for an insurance company is equal to total claims paid out plus adjustment expenses, divided by
total earned premiums. Insurance companies with very low loss ratios are collecting significantly more in
premiums than they are paying out in indemnities, while those with very high loss ratios may not be collecting
enough premiums to pay claims and expenses and still make a profit.