World Bank to Offer Index-based Weather Derivative Contracts

The World Bank has now announced the launch of it’s new scheme to aid poorer nations through the use of weather derivatives. Press release below:

WASHINGTON, June 24, 2008 – The World Bank is moving ahead with plans to use the weather derivative market as part of a comprehensive strategy to reduce the impact of drought in developing countries. Under a proposal approved recently by its Board of Directors, the World Bank will now offer financial intermediation services to low-income client countries of the International Development Association (IDA), and will add to the range of risk-management tools available to middle-income client countries of the International Bank for Reconstruction and Development (IBRD). Malawi is expected to be the first country to take advantage of this new financial product offering from the World Bank.

The Bank will intermediate the risk of weather-based catastrophe by entering into mirroring transactions with the client country and a financial market counterpart. In the event of a severe weather event, client countries, such as Malawi, would receive a payout from the Bank, the total value of which would be based on an index used as an estimate of the financial impact. This would be funded with the payout that the Bank would receive from the mirroring transaction.

“This new product offering expands upon the World Bank’s ongoing work in the use of market-based tools to manage risk,” said Gloria Grandolini, Director of Banking and Debt Management Department.  “It is part of an accelerated World Bank effort to develop financial solutions to reduce countries’ reliance on ex post donor funds and plan efficient responses to catastrophic events. These products are most effective as part of a broader risk management strategy.”

Grandolini added: “Index-based derivatives can provide a hedge to protect governments against financial disruption in the aftermath of adverse weather events. They allow for immediate disbursement of funds as, unlike most insurance schemes, they do not require an assessment of the actual loss incurred.”

In Malawi, the World Bank will act as an intermediary between the country and reinsurance companies or investment banks that offer weather risk management products. An independent third-party will monitor the weather data which will be then entered into a crop-rainfall model that determines whether Malawi receives a payout.

The weather derivative for Malawi requires an upfront premium and is designed to manage the risk of low probability but high severity events, like severe droughts, rather than the risk of events that occur more frequently, like minor or normal droughts.

The first weather derivatives transaction for Malawi will test the market with a small contract that is expected to pay out a maximum of approximately US$3 million if severe drought occurs. Donors are supporting the initiative, the World Bank will act as intermediary, and the premium is being paid by the UK Department for International Development (DFID).

The use of the weather market and index-based insurance products in agriculture in developing countries is new. The 10-year-old weather derivatives market has been growing rapidly but is mainly used by private companies to manage risks.

“What’s novel in this case is that you’ve got one of the world’s ten poorest countries that also has substantial weather risks getting access to those same tools … and that’s the exciting thing,” said Timothy Gilbo, World Bank Country Manager in Malawi. “It’s all about trying to find a new way to deal with risk. We know from poverty assessments that, by the time an emergency is officially declared, followed by an appeal and then seeing governments start to put in money, many poor have sold what little assets they had, like a cow or a goat.”

The World Bank hopes the new weather derivatives product, along with a growing number of catastrophe risk financing products it has developed, will help close a “serious market gap between the banks, insurance companies and commodity trading companies that offer hedging products and the developing countries that need them,” said Julie Dana, Technical Specialist in the World Bank’s Agriculture and Rural Development Department.

“The development of this proposal,” said Dana, “reflects heightened interest within the World Bank Group and among donor partners in helping countries develop ex ante approaches to managing the risk of external shocks since traditional ex post responses can be costly, inefficient, and difficult to manage when a country is already in crisis.”

In 2005, Malawi was hard hit by drought that brought widespread hunger to many countries in Southern Africa. The country’s maize crop withered in the fields and the government was forced to seek help. Malawi spent US$200 million responding to the crisis, and the World Bank and donors contributed a similar amount. Even though the government carefully planned its humanitarian response, the actual cost of the interventions was much higher, resulting in a larger fiscal deficit.

It’s great to see this finally come to fruition, after a few years of discussion on the topic of weather derivatives the World Bank has finally found a way to allow the developing world to gain access to an affordable way to hedge their weather risks. Hopefully this deal with Malawi will be successful and open the doors to other nations for whom protection such as this is a necessity. The World Bank continues to work on other methods of catastrophe risk financing; so hopefully before too long we should see developing nations able to at least partially protect themselves proactively from the impact of many types of natural catastrophe and also reduce their reliance on aid hand-outs after the event.