The United Nation's World Food Programme is the first international humanitarian agency to tap into the evolving weather derivatives market with a $1 million policy from AXA Re, which will pay out if the rainfall in areas of Ethiopia falls below a prescribed level.
"The idea is to make sure the family doesn't deplete its assets and sell off their livestock," says Ulrich Hess, chief of business risk planning at the global food agency's headquarters in Rome. "We want to give people enough to buy food and keep their children in school and keep going."
Analysts say the development of the weather derivatives market and parametric risk modeling over the past decade has opened up a window of opportunity for humanitarian agencies and developing countries, as insurers get a chance to spread their risks to new parts of the globe.
"It's a way to manage the risk of humanitarian problems prospectively," says Warren Isom, a senior vice president at Willis Re, "to look at these risks through the risk management lens rather than a humanitarian lens."
And as relief agencies slowly transform their outlook on how to secure funding for handling disasters from droughts to earthquakes, insurers and reinsurers can shift their catastrophic risks outside traditional areas such as the hurricane-prone East Coast of the United States or the tumultuous earthquake zones of Japan.
"Spread is important in catastrophic insurance, and right now these low-frequency, high-severity risks occur in a relatively small number of places," says Isom, citing Northern Europe, the West Coast and Mexico as other locales. "This gives the market some more spread."
And this diffusion is exactly what enticed AXA Re.
"We saw this as a way to diversify our risk into an area where we have no exposure," says Jean-Christophe Garaix, who's in charge of weather coverage at AXA Re, part of the Paris-based AXA Group. Right now, most of the French reinsurer's risk lies in the United States, Europe and Japan.
At the same time, developing countries--if armed with insurance coverage against perennial natural disasters like drought, floods, windstorms or earthquakes--could benefit by gaining more economic stability.
"This can provide a more stable environment for investment and economic growth," says Brian Tobben, vice president of weather at PartnerRe Ltd. in Greenwich, Conn. "Aid can save lives, but this type of mechanism can also help build an overall economy."
Analysts agree the index-based products aren't able to cover the cost of food or housing for people displaced by manmade disasters, such as civil conflicts that turn citizens into refugees in their own country or send them fleeing across borders. The absence of a measurable, objective criteria in such scenarios--such as low rainfall or rising water levels--would create an underwriting nightmare.
"There's no index for civil conflicts . . . so there would be no market for that type of insurance," says Hess of the WFP.
But the development of data-sensitive insurance products has created a small success story for the U.N. food agency as it fights poverty and hunger in Ethiopia.
"It's a new concept . . . parametric-based instruments that use risk-modeling techniques. You can understand what the risk is and how to price it," says Eugene Gurenko, lead financial services specialist for the World Bank in Washington, D.C. "It provides objective verification."
That's exactly what persuaded AXA Re to assume the risk.
"In Africa, it's not very easy to have good data. But this let us define what the risk is and gave us precise data," says Garaix, adding that the company reviewed decades of Ethiopia's weather history to determine no trends existed. "We have no expectations . . . negative or positive."
So 26 weather stations spread around this northeastern African nation of nearly 75 million people, except for southern areas close to Somalia, will be monitoring rainfall during the two rainy seasons that run from March 10 to Oct. 31. If rainfall dips below a certain level at the end of the covered period, the policy will pay out $100, in the form of cash or food, to each affected household in the drought-stricken area.
The annual premium of nearly $1 million was financed with a $930,000 grant from the U.S. Agency for International Development. The payout could tally $7.1 million if all 67,000 households were impacted by drought. The local branches of USAID and WFP will oversee the distribution of any claims by the Ethiopian government's food security bureau.
By having an insurance mechanism in place, Ethiopia can distribute relief to farmers in a smooth manner and avoid waiting for humanitarian agencies to gather funds from donor countries, which sometime supply aid with unwanted strings attached, Hess says.
"This is a way for countries like Ethiopia to get out of the food-aid business and to have the money in people's hands within a few days," Hess adds.
The use of the mechanism meshes with the United Nations' ongoing efforts to ensure more predictable and timely funding of humanitarian response efforts around the world.
Earlier this year, the organization launched the Central Emergency Response Fund as a way to jump-start lifesaving relief operations immediately after disaster strikes, instead of putting out a donor appeal and waiting for money to flow in.
Fueled by voluntary contributions from governments, the private sector and individuals, the fund aims to funnel money to appropriate U.N. agencies in three to four days.
Paul Schultz, president of Aon Capital Markets in Chicago, says the recent WFP deal with AXA Re shows how global humanitarian agencies can tap into the capital markets and products like weather derivatives to provide relief for victims of natural disasters.
"It's a viable sort of alternative to the traditional markets," says Schultz, adding that the weather market is a "young market that is developing quickly."
While used for nearly a decade by companies in the agricultural and entertainment sectors, such as theme parks, to protect against losses from weather conditions, the weather derivatives market is only now moving into the global humanitarian arena.
"It really hasn't taken that long, considering that it only started about 1997," says Isom. Humanitarian agencies needed to be sure the market was sufficiently developed with enough players and smoothly executed transactions before offering the mechanisms to third parties such as developing countries or farmers.
"They wanted to be sure it was an appropriate thing to do and there would be a beneficial effect," Isom says.
The deal is part of global humanitarian agencies' slow shift to engage the private capital markets, rather than governments, to cover humanitarian risks.
The United Nations High Commissioner for Refugees, for example, recently teamed up with two European financial institutions to raise funds for its earthquake relief operations in Pakistan.
Known as the Kashmir Relief Note, the investment scheme lets investors buy an investment product in which 2 percent of the investment is donated immediately to UNHCR's earthquake relief operations in Pakistan-administered Kashmir. A minimum investment is $10,000, and the remaining money is invested in a basket of funds in the Indian subcontinent.
A spokesman for American International Group Inc. declined to comment on the issue and said the New York City-based insurer does not currently offer this type of product. Officials at Swiss Re also declined to comment.
PAULA L. GREEN
lives in New York City.
September 1, 2006
Copyright 2006© LRP Publications