HEDGING WITH INDIVIDUAL AND INDEX-BASED CONTRACTS

We examine the optimal hedging strategy with an individual insurance policy, sold at an unfair price, and a fair contract based on an index, which is imperfectly correlated with the individual loss. The tradeoff between transaction costs and basis risk is first analyzed in the expected utility framework in order to highlight the role of the agent's attitude toward risk, and then in the linear mean-variance model to stress the importance of the degree of correlation between the individual loss and the index.Agribusiness,

The macro financing of natural hazards in developing countries

The authors propose a financial model to address the design of efficient risk financing strategies against natural disasters at the country level. It is simple enough to shed analytical light on some of the key issues but flexible and realistic enough to provide some quantitative guidance on the ex ante financing of catastrophic losses. The risk financing problem is decomposed into two steps. First, the resource gap, defined as the difference between losses and available ex-post resources (such as post-disaster aid), is identified. It determines the losses to be financed by ex ante financial instruments (reserves, catastrophe insurance, and contingent debt). Second, the cost-minimizing financial arrangements are derived from the marginal costs of the financial instruments. The model is solved through a series of graphical analyses that make this complex financial problem easier to apprehend. This model captures and explains the main impacts of financial parameters (such as insurance premium, cost of capital) on efficient risk financing structures.Insurance&Risk Mitigation,Banks&Banking Reform,Financial Intermediation,Natural Disasters,Non Bank Financial Institutions

Managing agricultural risk at the country level : the case of index-based livestock insurance in Mongolia

This paper describes the index-based livestock insurance program in Mongolia designed in the context of a World Bank lending operation with Government of Mongolia and implemented on a pilot basis in 2005. This program involves a combination of self-insurance by herders, market-based insurance, and social insurance. Herders retain small losses, larger losses are transferred to the private insurance industry, and extreme or catastrophic losses are transferred to the government using a public safety net program. A syndicate pooling arrangement protects participating insurance companies against excessive insured losses, with excess of loss reinsurance provided by the government. The fiscal exposure of Government of Mongolia toward the most extreme losses is protected with a contingent credit facility. The insurance program relies on a mortality rate index by species in each local region. The index provides strong incentives to individual herders to continue to manage their herds so as to minimize the impacts of major livestock mortality events; individual herders receive an insurance payout based on the local mortality, irrespective of their individual losses. This project offered the first opportunity to design and implement an agriculture insurance program using a country-wide agricultural risk management approach. During the first sales season, 7 percent of the herders in the three pilot regions purchased the insurance product.Insurance&Risk Mitigation,Insurance Law,Hazard Risk Management,Debt Markets,Banks&Banking Reform

HEDGING CROP RISK WITH YIELD INSURANCE FUTURES AND OPTIONS

This paper analyses the optimal hedging decisions for risk-averse producers facing crop risk, assuming crop yield insurance futures and options can be used. The first-best optimal hedge requires a futures position or an option position proportionate to the individual beta depending on whether the financial markets are perceived unbiased or biased. Using yield data for a sample of wheat producers in France, the producers' hedge ratios are derived. These new hedging instruments are more effective to reduce farm yield variability than the individual yield contracts, except if the individual yield guarantee is at least equal to the individual average yield.crop insurance, hedging position, incomplete markets, Marketing, Risk and Uncertainty,

The impact of climate change on catastrophe risk models : implications for catastrophe risk markets in developing countries

Catastrophe risk models allow insurers, reinsurers and governments to assess the risk of loss from catastrophic events, such as hurricanes. These models rely on computer technology and the latest earth and meteorological science information to generate thousands if not millions of simulated events. Recently observed hurricane activity, particularly in the 2004 and 2005 hurricane seasons, in conjunction with recently published scientific literature has led risk modelers to revisit their hurricane models and develop climate conditioned hurricane models. This paper discusses these climate conditioned hurricane models and compares their risk estimates to those of base normal hurricane models. This comparison shows that the recent 50 year period of climate change has potentially increased North Atlantic hurricane frequency by 30 percent. However, such an increase in hurricane frequency would result in an increase in risk to human property that is equivalent to less than 10 years’ worth of US coastal property growth. Increases in potential extreme losses require the reinsurance industry to secure additional risk capital for these peak risks, resulting in the short term in lower risk capacity for developing countries. However, reinsurers and investors in catastrophe securities may still have a long-term interest in providing catastrophe coverage in middle and low-income countries as this allows reinsurers and investors to better diversify their catastrophe risk portfolios.Climate Change Economics,Natural Disasters,Hazard Risk Management,Insurance&Risk Mitigation,Disaster Management

Catastrophe risk pricing : an empirical analysis

The price of catastrophe risks is viewed by many to be too high and/or too volatile. Catastrophe risk practitioners point out that, contrary to standard insurance, such as automobile insurance, catastrophe re-insurance is exposed to infrequent but potentially very large losses. It thus requires keeping a large amount of capital in hand, generating a cost of capital to be added to the long-term expected loss. This paper pulls together data from about 250 catastrophe bonds issued on the capital markets to investigate how catastrophe risks are priced. The analysis reveals that catastrophe risk prices are a function of the underlying peril, the expected loss, the wider capital market cycle, and the risk profile of the transaction. The market-based catastrophe risk price is estimated to be 2.69 times the expected loss over the long term, that is, the long-term average multiple is 2.69. When adjusted from the market cycle, the multiple is estimated at 2.33. Peak perils like US Wind are shown to have a much higher multiple than that of non-peak perils like Japan Wind, revealing the diversification of credit from the market.Markets and Market Access,Insurance&Risk Mitigation,Debt Markets,Access to Markets,Emerging Markets

Sovereign natural disaster insurance for developing countries : a paradigm shift in catastrophe risk financing

Economic theory suggests that countries should ignore uncertainty for public investment and behave as if indifferent to risk because they can pool risks to a much greater extent than private investors can. This paper discusses the general economic theory in the case of developing countries. The analysis identifies several cases where the government's risk-neutral assumption does not hold, thus making rational the use of ex ante risk financing instruments, including sovereign insurance. The paper discusses the optimal level of sovereign insurance. It argues that, because sovereign insurance is usually more expensive than post-disaster financing, it should mainly cover immediate needs, while long-term expenditures should be financed through post-disaster financing (including ex post borrowing and tax increases). In other words, sovereign insurance should not aim at financing the long-term resource gap, but only the short-term liquidity need.Debt Markets,Hazard Risk Management,Banks&Banking Reform,Insurance&Risk Mitigation,Natural Disasters

Disaster risk financing and contingent credit : a dynamic analysis

This paper aims to assist policy makers interested in establishing or strengthening financial strategies to increase the financial response capacity of developing country governments in the aftermath of natural disasters, while protecting their long-term fiscal balance. Contingent credit is shown to increase the ability of governments to self-insure by relaxing their short-term liquidity constraints. In many situations, contingent credit is most effectively used to facilitate risk retention for middle layers, with reserves used for bottom layers and risk transfer (for example, reinsurance) for top layers. Discussions with governments on the optimal use of contingent credit instruments as part of a sovereign catastrophe risk financing strategy can be guided by the output of a dynamic financial analysis model specifically developed to allow for the provision of contingent credit, in addition to reserves and/or reinsurance. This model is illustrated with three country case studies: agricultural production risks in India; tropical cyclone risk in Fiji; and earthquake risk in Costa Rica.Insurance&Risk Mitigation,Access to Finance,Debt Markets,Bankruptcy and Resolution of Financial Distress,Financial Intermediation

Financial protection of the state against natural disasters : a primer

This paper has been prepared for policy makers interested in establishing or strengthening financial strategies to increase the financial response capacity of governments of developing countries in the aftermath of natural disasters, while protecting their long-term fiscal balances. It analyzes various aspects of emergency financing, including the types of instruments available, their relative costs and disbursement speeds, and how these can be combined to provide cost-effective financing for the different phases that follow a disaster. The paper explains why governments are usually better served by retaining most of their natural disaster risk while using risk transfer mechanisms to manage the excess volatility of their budgets or access immediate liquidity after a disaster. Finally, it discusses innovative approaches to disaster risk financing and provides examples of strategies that developing countries have implemented in recent years.Debt Markets,Hazard Risk Management,Natural Disasters,Banks&Banking Reform,Insurance&Risk Mitigation

DESIGNING OPTIMAL CROP REVENUE INSURANCE

The optimal crop revenue insurance contract is designed from recent developments in the theory of insurance economics under incomplete markets. The message is two-fold. Firstly, when the indemnity schedule is contingent on individual price and individual yield, the optimal contract depends only on the individual gross revenue. Secondly, this policy is shown to fail if the indemnity function is based on aggregate price and/or aggregate yield. A closed-form solution, in which basis risks are ignored, is proposed. It differs from actual revenue insurance programs proposed to the U.S. farmers. When insurance and capital markets are unbiased, it can be replicated with existing crop yield and revenue insurance policies and hedging contracts if the decision variables are not constrained. The impact of yield and price basis risks on the form of the optimal crop revenue insurance contract is examined and a closed-form solution is derived.Agricultural Finance, Risk and Uncertainty,