Implementing a Pilot Program for Index Based Weather Risk

Management: The Case of Malawi

Erin Bryla, Joanna Syroka, Shadreck MapfumoCommodity Risk Management Group,The World BankDecember 5, 2007

COMMODITY RISK MANAGEMENT GROUP• Focus on Agriculture

• Provides technical assistance on:– Market based price risk management instruments– Index based weather insurance

• Working to improve access to risk management opportunities by:– Researching risk management alternatives– Introducing new products through pilot programs– Working with regulators and governments – Disseminating best practices and lessons learned

• Works with:– Banks, microfinance organizations, other financiers– Insurance companies– Ginners, processors– Cooperatives and producer associations– Governments

INDEX BASED WEATHER INSURANCE IN DEVELOPING MARKETS

Multi-peril Crop Insurance High Administrative Costs Moral Hazard Adverse Selection

Index-Based Weather Insurance

Rainfall is a proxy for damage

Objective triggers and structured rules for payouts

Improved correlation between need and provision

• Traditional crop insurance for smallholder economies is extremely challenging– Main constraints for traditional products, based on individual loss

assessments:• Poor rural insurance infrastructure and capacity • Operationally difficult for small farmer agriculture • Loss adjustment, availability of farm level data• Moral hazard• Adverse selection due to asymmetric information• High monitoring and administrative costs

• Agricultural production risk needs reinsurance– Covariant risks (e.g. drought) are an inherent characteristic

VS

WHY WEATHER INSURANCE IN MALAWI• Malawi Facts:

– Population: 12 million; 165th Human Development Index

– Food crop - maize; export crop - tobacco, tea, cotton, coffee, sugar

– One rainy season, November-April– 45% of GDP comes from agriculture– 87% of total employment is ag– 64% of rural income is from agriculture

• Drought and Lending (2004/2005):– Recovery rates for ag lenders in the range 50-

70%– Ex. One big bank that lost $110,000 to

smallholders farmers stopped lending to those farmers

– Major government and donor lending program lost 50% of value over 5 years due to drought-blamed default and the program was discontinued.

– Microfinance institutions stopped lending

In 2004 the National Smallholder Farmers Association of Malawi (NASFAM) wanted to expand its operations and grow the Malawi groundnut market domestically and for export, but high risks from drought and high loan default rates deterred financing institutions from providing loans.

The Pilot Program aimed to: • Gives farmers the ability to mitigate drought risk

– Secure access to finance and inputs for improved production– NASFAM training and higher quality seed will improve long-term

production and revenues• Protects both producer and loan provider from weather-related production risks

– Allowing banks to expand their lending portfolios in a managed way• Gives insurers the opportunity to re-enter rural markets

– No regulatory impediment and reinsurance potential– Little (and bad!) experience with traditional agriculture insurance

• Opportunity for NASFAM to expand its operations and grow the Malawi market domestically and for export

PILOT OBJECTIVES

Historical weather data & weather stations– Length of historical record - 30 years or more– Quality controlled, cleaned, enhanced– Reliable ongoing collection and reporting procedures– Third-party settlement data

Ability to index risk Basis Risk or “How good is this insurance?”

• Mismatch between coverage and actual result• How can it be minimized?

Yield data that shows strong correlation with weather event

Local insurance company willing to intermediate product

PRE-CONDITIONS

Weather Infrastructure

• Malawi Met Office data excellent: over 30 years, few gaps, 21 primary synoptic stations (red)

• In addition over 200 rain gauges around the country which can be leverage.

• CRMG/Met Office piloting the installation of new automatic weather stations (green) and creating historical synthetic data, opening new agricultural areas to weather insurance for this year

• Securing donor funds to scale-up infrastructure pilot significantly next year

Dense, high-quality network

Standardized Contract Design

• Balance simplicity that farmers and stakeholders can understand, with the complex dynamics that characterize water stress impact on crop yields: – Easy to communicate to farmers and stakeholders– Performs well from agro-meteorological

perspective – Provides required protection for all stakeholders

at an affordable level– Captures local conditions and environment– Simple to replicate to other locations and crops so

that programs are scalable– Local ownership, so programs are sustainable

Standardized Contract Design

• Given a target premium and set pricing guidelines, and a required maximum payout per phase, red dots are calibrated to a simple crop water-balance model – the FAO WRSI – cross-checked against historical yields and local experts (blue dots) to minimize farmer income Value-at-Risk and maximize payout correlation to yields

Deficit Rainfall (mm)

Payo

ut (

$)

PHASE 1Sowing & Establishment

PHASE 3Yield Formation to Harvest

Deficit Rainfall (mm) Pa

yout

($)

Deficit Rainfall (mm)

Payo

ut (

$)

PHASE 2Growth & Flowering

Cropping Calendar* Sowing Window &

Dynamic Start Date* Cumulative 10-day rainfall is capped to prevent excessive rainfall impacting the phase-wise total

THE PILOT• Loans to cover seed, insurance premium and interest:

– Opportunity International Bank of Malawi – Malawi Rural Finance Corporation

• Policies:– Insurance Association of Malawi (seven companies pooled the risk) – Premium: 6-7%, Max Payout per farmer: Loan Size given by bank

• Seed & Product Distributor:– NASFAM: Groundnut in 2005, Groundnut & Hybrid Maize in 2006

• Participants:– Farmers all members of NASFAM clubs– 2005: 900 farmers, 4 weather stations, sum insured $35,000– 2006: 2500 policies, 5 weather stations, sum insured $110,000

• Insurance Payout Payment details:– Payout: channeled from insurance company directly to the bank; – No Payout: farmers benefit from selling the higher value production

CLUB

Insurance Association of

Malawi

MRFC/ OIBM

NASFAM

Step 2

Step 1

Step 3

Step 4 Step 5

Step 6

Step

8

Step 10

Step

9

MET OFFICEStep 7

Step 11CLUB

Insurance Association of

Malawi

MRFC/ OIBM

NASFAM

Step 2

Step 1

Step 3

Step 4 Step 5

Step 6

Step

8

Step 10

Step

9

MET OFFICEStep 7

Step 11

1 Club and NASFAM enter into sales agreement

2 Club enters into contract with bank for insurance & loan

3 Insurance purchased on behalf of clubs

4 Farmers authorize the bank to pay NASFAM for the seed

5 Seed distribution to clubs

6 Money paid to NASFAM for seed

7 Meteorological information distributed

8 Payout from insurers to banks

9 Farmers sell groundnut output to NASFAM

10 NASFAM pays off loan balance to the bank

11 Payment of any additional revenue from crop sale to club

ORGANIZATION OF THE PILOT PROGRAM

• Pilot program reinforced that weather insurance alone cannot solve agricultural lending problems

• Initial pilot programs faced:– Side-selling, due to a nascent agricultural supply chain for

groundnut– Leading to non-weather related defaults– Operational challenges in coordinating stakeholders

• Therefore for 2007 pilot efforts:– Focus on established agricultural supply chains, e.g. tobacco

• 70% of current loan portfolios• Cash crop loans also have a maize component that can also be

insured– Look to economies of scale and critical diversification for

insurers• Reduce premiums per policy • Increase volumes to attract reinsurers

– Looks at a portfolio level approach rather then an individual farmer policy

• Comfort for lenders when considering expanding their portfolio and reducing the risk (and therefore cost) of lending

• Tie-in with emerging contract farming relationships in Malawi– Will be expanded to individual farmers in 2008

EXPANDING THE PILOT: A PORTFOLIO APPROACH

MAJOR PILOT ACHIEVEMENTS

• Unlocking credit facilities for smallholder farmers.– 1800 farmers formerly excluded from financial markets.– Before pilot OIBM did not lend to agriculture, but now is using lessons

learnt from project to expand lending book.– Four other banks promised to unlock more than USD 10 million of

credit if weather risk is insured.• Access to high yielding seeds and fertilizers.

– Farmers interviewed indicated that they got an average of SIXTY 50 kg bags (by using hybrid maize seed) as opposed the usual 20-25 bags.

– Improved sustainability for contract farming operations• Sustainability of credit markets:

– Quantification of weather exposure– Can expand lending in a managed way – In case of another 2004/5 drought loans will be paid off– Banks have flexibility to protect themselves either through marketing

insurance directly to farmers or through a portfolio approach• Expansion of the risk retention capacity through risk transfer to the

international market

DATA REMAINS A CHALLENGE FOR GROWTH– Basis Risk

– Effectiveness of the index is driven by availability of weather (rainfall) data– Without local data, basis risk events are more difficult to control

– Contract Pricing– Without weather data insurers and reinsurers will need to increase the cost of uncertainty

for the weather insurance product as well as the risk margin– Increasing Participation

– Without more stations increasing the number of participating farmers will be challenging– Installing a new station in 2006/7 added 672 farmers– Upgrade of 50 other stations will capture 300,000 farmers– Need to leverage the existing rain gauge network

– Remote Observation and Satellite Data– Merging remote data with ground data can expand the market for index based products– Satellite rainfall data is only as good at the underlying ground data

– How can existing data be harnessed to expand the market for index based products

– In many cases data exists, it is just not accessible.– What will the market take?– How to make more data available?– Investment in new infrastructure

WHAT COMES NEXT …• Training and Capacity Building Program:

– Local capacity to design contracts– Technical training for the insurance industry– Training to other agriculture sector actors on products and

program management – Piloting– Risk assessment techniques for financiers

• Investment:– More new weather stations and better data

• Currently approximately 110,000 tobacco growers can be serviced by existing network

• An investment of $1.2 million can increase this to 280,000, 13% of which are currently receiving financing

• Broader risk management activities:– Linkages to other institutional arrangements, e.g. biometrics,

credit bureau, price risk management – Government-level weather risk management– Work with regulator on comprehensive regulatory framework