October 2, 2007

1. 4th Edition ICAR ForumBucharest, RomaniaWeather risk hedging: the role of insurance and weather risk marketsEugene N. Gurenko, Ph.D., CPCU, ARe Lead Insurance Specialist October 2, 2007

2. Agenda • What is parametric weather insurance and how does it work? • What is the relevance of weather insurance for Romania? • How can weather risk hedging be turned into a profitable opportunity for the Romanian insurers and businesses?

3. Agenda • What is parametric weather insurance and how does it work? • What is the relevance of weather insurance for Romania? • How can weather risk hedging be turned into a profitable opportunity for the Romanian insurers and businesses?

4. What is parametric weather insurance and how does it work? Why parametric weather insurance? Crop Insurance Premiums and Indemnities in the United States All previous attempts to protect farmers through universal indemnity-based multi-peril crop insurance programs have been financially unsustainable

5. What is parametric index-based weather insurance and how does it work? ABCs of parametric index-based weather risk insurance • An alternative to traditional crop insurance. • Payouts linked to the underlying weather risk defined as an index based on historical data (e.g. for rainfall, temperature, snow, etc) rather than actual damage, (e.g. crop yield loss and its monetary equivalent). • Objectivity of loss measurements eliminates moral hazard and translates into reduced administrative costs. • Helps companies avoid major downfalls in their overall income due to adverse weather related events. • Improves companies risk profile, enhances access to bank credit and reduces the cost of borrowing. • The basis risk is an inherent disadvantage of index-based parametric insurance due to a likely mismatch between payoffs and actual losses.

6. What is parametric index-based weather insurance and how does it work? Loss in yield 85mm 80mm 110mm 80mm 35mm 12mm Parametric rainfall insurance in agriculture: illustration Stages Sowing Harvest Growth 10Jun-14Jul 15Jul-28Aug 29Aug-02Oct Time 35 days 44 days 34 days 80mm 110mm 80mm Insurance Payout Rainfall Index $ per acre Output Source: Olivier Mahul, World Bank, 2007

7. What is parametric index-based weather insurance and how does it work? Hazard Module Historical weather Simulated Weather Generator Stochastic normal & drought events Vulnerability Module Crops Soil Mgmt. Crop Yield Model Planting Area Model Production losses Economic Module Macro-economic data Direct loss model Indirect loss model Direct & indirect economic losses Probabilistic agricultural risk assessment model • Customized from rapid onset disaster modeling framework • Probabilistic drought risk assessment model • Hazard module • Vulnerability module • Economic module

8. What is parametric index-based weather insurance and how does it work? Aid Funding in Ethiopia PRESENT APPROACH EVENT ASSESS APPEAL FUNDING AID time Aug/Sept Nov/Dec Jan/Feb Mar/Apr Jan CONTINGENCY FUNDING APPROACH ASSESS/ APPEAL EVENT AID time Oct/Nov Dec Aug/Sept Timing gains critical to saving lives and livelihoods (Ethiopia’02: ~1 Mil livelihoods lost) Source: Olivier Mahul, World Bank, 2007

9. What is parametric index-based weather insurance and how does it work? Aid funding in Ethiopia: key features of transaction • Insurance contract between UN Food Security Agency and Paris Re is based on a drought index: $7.1 mm for $0.93 mm premium • Index reflects the envisaged adverse impacts of deficient rainfall on livelihood of vulnerable population • Premium paid prior to season • Specified variation in index triggers a payout • Payout funds the agency’s emergency response for vulnerable population • Led to putting in place government contingency funding for up to 316,000 beneficiaries • Encouraged successful MET service capacity building

10. What is parametric index-based weather insurance and how does it work? Ethiopia Drought Index 1984 24th ten day period 21-31 Aug 34th ten day period 17th ten day period 11-20 June 2002 2006

11. What is parametric index-based weather insurance and how does it work? Index-based parametric insurance in Malawi Problem: • Groundnut farmers previously used only local seed for production but were interested in switching to better quality certified groundnut seed • Farmers had little cash and no access to finance • Banks were unwilling to lend primarily because of drought risk

12. What is parametric index-based weather insurance and how does it work? Index-based parametric insurance in Malawi Insurance Pilot: • Contract pays out if the amount of rainfall needed for groundnut production is insufficient • Two banks agreed to lend farmers if farmers buy weather insurance. • Loans were given to farmer clubs of 15-20 farmers • Farmers used loans to purchase certified groundnut seed • In case of a drought that triggers an insurance payout the money is paid to the bank • If no drought occurs farmers benefit from selling more of better quality groundnut • 892 farmers participated in the pilot in 4 groundnut growing areas

13. What is parametric index-based weather insurance and how does it work? Insurance Insurance MET OFFICE MET OFFICE Step 7 Step 7 Association of Association of S S Malawi Malawi t t e e p p Step 3 Step 3 8 8 Step 6 Step 6 MRFC/ MRFC/ NASFAM NASFAM Step 10 Step 10 OIBM OIBM S S t t Step 5 Step 5 Step 2 Step 2 Step 4 Step 4 e e p p 1. Club and NASFAM enter into a sales agreement 9 9 Step 11 Step 11 2. Club enters contract w/ bank for insurance & loan CLUB CLUB 3. Insurance purchased on behalf of clubs authorize the bank to pay NASFAM for the seed 4. Farmers - Step 1 Step 1 5. Seed distribution to clubs 6. Money paid to NASFAM for seed 7. Meteorological information distributed 8. Payout from insurers to MFI 9. Farmer sells output to NASFAM/ NASCOMEX 10. NASFAM pays off loan balance to the bank 11. Payment of any additional revenue from sale of nut to club Index-based parametric insurance in Malawi Source: Olivier Mahul, World Bank, 2007

14. What is parametric index-based weather insurance and how does it work? Maximum Payout 5467.5 MKW 27.34 MKW per mm Malawi: insurance contract payout structure PAYOUT STRUCTURE FOR LILONGWE PHASE 1 70 mm Trigger Level Groundnut Rainfall Index Source: Olivier Mahul, World Bank, 2007

15. What is parametric index-based weather insurance and how does it work? Malawi: insurance contract payout structure Source: Olivier Mahul, World Bank, 2007

16. What is parametric index-based weather insurance and how does it work? Tanzania: maize rainfall insurance in Mbulu district Maize cropping calendar • Main contract features: • Covers 3 growth phases • Index reflects dependence of maize yields on rainfall from sowing to maturity • Sum insured = loan principal [cost of improved seed + cost of insurance] + loan interest Source: Olivier Mahul, World Bank, 2007

17. What is parametric index-based weather insurance and how does it work? Tanzania: Indicative design for Mbulu rainfall index insurance policy Source: Olivier Mahul, World Bank, 2007

18. What is parametric index-based weather insurance and how does it work? Weather station network in Tanzania

19. Contracts cover weather-related uncertainty in demand/supply volume and related cash flows (sales income and/or costs) on time scales of months to years. What is parametric index-based weather insurance and how does it work? smoothing earning volatility Tradable weather risk hedging contracts: key benefits Advantages: • Decreased volatility allows a more efficient use of equity and reduces capital costs • Stakeholders (i.e. government, investors, financial markets) honor more predictable cash flows by increasing the market value of a company Source: Swiss Re, 2007

20. What is parametric index-based weather insurance and how does it work? Tradable weather indices

22. What is parametric index-based weather insurance and how does it work?

23. What is parametric index-based weather insurance and how does it work?

24. Agenda • What is parametric weather insurance and how does it work? • What is the relevance of weather insurance for Romania? • How can weather risk hedging be turned into a profitable opportunity for the Romanian insurers and businesses?

25. What is the relevance of weather insurance for Romania? Climate change as the main driver of current and future losses

28. What is the relevance of weather insurance for Romania? Relevance of index-based parametric weather insurance for Romania • Availability of financially sustainable weather risk insurance will increase the productivity and international competitiveness of the Romanian agricultural producers, processors, exporters, and other businesses exposed to the risk of weather. • Can assist the country to prepare fiscally for income shocks caused by major floods and droughts. • Can assist countries to identify segments of population vulnerable to climate change and put in place effective climate adaptation plans.

29. What is the relevance of weather insurance for Romania? Reducing the impact of weather extremes on agricultural producers - Ecuador

30. Agenda • What is parametric weather insurance and how does it work? • What is the relevance of weather insurance for Romania? • How can weather risk hedging be turned into a profitable business opportunity?

31. How can weather risk hedging be turned into a business opportunity? Preconditions for a vibrant weather risk market • Availability of quality weather data • A country-wide network of weather measurement stations • Weather radars • Fraud-and-tempering-proof system of weather data reporting by the responsible weather services • Accessibility of weather databases • Creation of weather tradable weather indices • Development of customer base for such new risk transfer instruments.

32. How can weather risk hedging be turned into a business opportunity? Enhancing the traditional insurance business model Weather risk market Reinsurance market Hedges weather risks Transfers weather risk Insurer Cover against weather related risks Cover against traditional insurance risks Local businesses Traditional insured

33. How can weather risk hedging be turned into a business opportunity? A possible way forward for a Romanian P&C insurer? • Step I: Enters into a reinsurance agreement with a large specialized global weather underwriter (Swiss Re, Paris Re, etc.) by which it would cede up to 90+% of risk written to the treaty or buys weather risk hedges in international weather risk market, when these become available for Romania. • Step II: Hires several underwriters that would focus exclusively on writing weather risk (initially operating more like trained agents). • Step III: As the company develops its internal underwriting expertise in weather risk, it may increase its own risk retention.

34. The World Bank Regional Climate Adaptation and Hazard Risk Management Program for SEE countries • Offers know-how to countries of SEE in areas of catastrophe risk insurance and weather risk hedging through commodities and capital markets. • Assists countries with the creation of weather risk market infrastructure • Facilitates the development of the regional weather risk market.