Module 6 Book A: Principles of Contract Design. Agriculture Risk Management Team Agricultural and Rural Development The World Bank

Transcription

1 + Module 6 Book A: Principles of Contract Design Agriculture Risk Management Team Agricultural and Rural Development The World Bank

2 + Module 6 in the Process of Developing Index Insurance Initial Idea Foundation Concepts Modules 1, 2, 3 Assess Pre-Feasibility Modules 4 Assess Technical Feasibility Modules 5, 6, 7 Implement Pilot Test Module 8

3 + Requirements for an Index Insurance Product General considerations 1. An index based insurance contract must perform an insurance function for the buyer. It must: capture the agrometeorological risk in question provide timely and adequate payments 2. The performance of the contract must be checked against all possible sources of information (yield records, crop model output, expert information, etc.) in order to make sure that it would have triggered payouts when needed 3. Checks should be carried out also on how robust the contract design is, i.e. changes in the contract parameters or/and the local conditions should not alter the contract performance dramatically and how it is expeceted to perform in terms of minimizing basis risk

4 + Anatomy of a Contract Main elements of a Rainfall Index Contract 1. The Index 2. The Protection Period 3. The Maximum Payout 4. The Payout Typology 5. The Payout Parameters: Trigger, Exit and Rate (tick) Level(s) 6. The Premium

5 + Anatomy of a Contract Main elements of a Rainfall Index Contract 1. The Index: As discussed in detail in previous modules, the index is the critical element of any weather insurance contract developed on the basis of a parametric approach Once the index has been identified, a clear and exhaustive description of the index specifications and of the data used to construct it is the base of any index insurance transaction

6 + Anatomy of a Contract Main elements of a Rainfall Index Contract 2. The Protection Period The risk protection period of the contract is the length of coverage, it includes the START and END date of the contract It can cover any period of the crop cycle considered appropriate but sales activity needs to be set accordingly The protection period can be single or multiple (phases contract) The START of the coverage period can be FIXED or DYNAMIC, i.e. can vary to mimic the farmer decision to when to sow his crop

7 + Anatomy of a Contract Main elements of a Rainfall Index Contract 3. The Maximum Payout The maximum payout is the maximum compensation that the insurance contract can provide. If the contract is structured on multiple phases, each phase will also have its maximum payout

8 + Anatomy of a Contract Main elements of a Rainfall Index Contract 4. The Payout Typology The payout can be provided according to different arrangements: Lump sum Continuous

9 Payout (currency unit per area) + Anatomy of a Contract LUMP-SUM PAYOUT Crop: Rice - Risk: Low temperatures Payout of 800 Units if temperature falls below 12 C during flowering Minimum Temperature

10 Payout (currency unit per area) + Anatomy of a Contract CONTINUOS PAYOUT Crop: Maize - Risk: Rainfall deficit Continuous increase of payout per each mm of rainfall reduction between 50 mm and 10 mm Rainfall (mm)

11 + Anatomy of a Contract Main elements of a Rainfall Index Contract 5. The Payout parameters (in a continuous payout structure) Trigger (strike): Level at which the weather protection begins and financial compensation is received Exit (limit): Level at which maximum payout is made to the client Payout Rate: The financial compensation per unit index deviation above or below the trigger(s). In the continuous payout typology the payout rate is also known as tick.

12 Payout (currency unit per area) Payout (currency unit per area) + Anatomy of a Contract Main elements of a Rainfall Index Contract Payout rate (tick) = Deficit Rainfall Coverage Max Payout 16,000 = = = 400 Trigger Exit Excessive Rainfall Coverage Max Payout = Exit - Trigger Rainfall (mm) 0 Rainfall (mm)

13 + Anatomy of a Contract Example of a payout structure Tick Trigger

14 + Anatomy of a Contract Main elements of a Rainfall Index Contract 6. The Premium An initial estimate of the risk premium is provided by the Expected Loss defined as the arithmetic average payout of the contract in question from the historical dataset for the station: Y1 Y10 Y21 Y22 Y30 E.g. If there are 4 historical payouts for a contract in the past 30 available years of cleaned data the EL is: EL = ( )/30 = 1

15 + Anatomy of a Contract Payout and Premium Payout Frequency In general: high payout frequency causes larger premiums less interest in this contract by insurers/reinsurers higher administration costs for the insurer

16 + Anatomy of a Contract The power of the trigger (the trigger rules ) The trigger determines: The risk retention level The probability of generating payout The pure risk premium level

17 + Anatomy of a Contract Risk Retention Risk retention is also known as self- insurance and is similar to the deductible of the traditional indemnity based insurance policies In practice, it is the loss level which clients have manage before they external compensation provides financial support The retention level is influenced by the trigger level: Closer to seasonal average, lower the retention and the higher the payout probability Further away from seasonal average, the lower the contract premium

18 + Anatomy of a Contract Layered risk transfer structure Insurance Risk Transfer Layer Self Retention Layer Reinsurance Catastrophe Gov

19 + Module 6 Book B: Designing a Three-Phase Deficit Rainfall Contract Agriculture Risk Management Team Agricultural and Rural Development The World Bank

20 + Phase Approach to Contract Design What level of sophistication to choose? Cumulative Indices: -Seasonal - Annual EASE TO COMMUNICATE Temporal distribution indices: -WRSI - Mechanistic models - Cognitive models INDEX COMPLEXITY

21 Weight + Phase Approach to Contract Design A distributional index 3 Sowing Head emergence Flowering Emergence 2 Tillering Stem elongation 1 0 Nov Dec Jan Feb Mar Ten day period

22 + Phase Approach to Contract Design First developed in India Great intuition developed by the Indian insurance company ICICI Lombard in After having implemented an initial distributional approach based on a weighted index, feedback from farmer led the Indian insurer to propose a simple segmented cumulative approach Such an approach carried the advantages of the weighted distributional index and the simplicity of a cumulated approach The design was chosen as the prototype groundnut structure for Malawi pilot in 2005 and for subsequent African pilots

23 Payout ($) Payout ($) Payout ($) + Phase Approach to Contract Design Different Phases, Different Parameters, Different Payouts 3. Trigger levels Deficit Rainfall (mm) Deficit Rainfall (mm) Deficit Rainfall (mm) 2. Phase lengths PHASE 1 Establishment PHASE 2 Growth & Flowering PHASE 3 Yield Formation to Harvest 1. Sowing Window & Dynamic Start Date Cropping Calendar Final Insurance Payout = min (Max Payout, Phase Payouts)

24 + Phase Approach to Contract Design Main advantages: Reduces basis risk by framing shorter period and taking care of rainfall distribution Allows to treat different requirements to water differently Easy to determine premium requirements and to relate to local agro-meteorological parameters/information Easy to communicate and retail to farmer clients.

25 + Three Phase Deficit Rainfall Main features A phase deficit-rainfall insurance contract has the following features: A dynamic start date that mimics the decision a farmer would make as to when to sow his crop Two or more phases, during which cumulative rainfall is measured, with a trigger and exit levels in each phase. Trigger levels that correspond to rainfall levels at which the crop would begin to feel water-deficit stress for each phase Exit levels that determine the level at which the farmer would receive a maximum payout for each phase A payout rate per phase

26 Standardized Contract Design: Honduras Example Sowing Trigger 25 mm Growing Period Prod. Cost Risk: Drought Phase Distribution Trigger Tick Exit (mm) Starts Ends (US$) (mm) (US$/mm) $ $ $ $ $ $35.00 Cancel Total Loss (Phase 2)

27 Malawi Tobacco & Paprika Contract Structure Examples Example: Kasungu Station Burley Tobacco Weighted Cumulative Weekly Excess, E Sum (W *max(0, Weekly Cumulative Rainfall 80)) e.g. 1.5 * * * * * * 3 = 55 Total Contract Payout = max(0, D 85)*375 + max(0, E 110)*375 Max Payout 231,000 MKW per hectare 85mm 90mm 85mm 87mm 95mm 83mm 80mm W 15 Nov 20 Dec 25mm W Transplanting Window & Dynamic Start Date Weighted Cumulative Weekly Deficit, D Sum (W * max(0, 25 Weekly Cumulative Rainfall)) e.g. 1 * * * * 10 = 37 15mm 10mm 15mm 23mm

28 + Selecting Contract Parameters 1. Sowing Window: The time window within which a farmer should plant. 2. Rainfall Sowing Trigger: Some rainfall criteria that defines farmers desire to sow. 3. Phase Lengths: Stages correspond to the three major phenological stages of the plant s growth. 4. Phase Trigger Levels : Levels of cumulative rainfall per phase below which the compensation begins. 5. Phase Exits Levels: Levels of cumulative rainfall per phase below which a max payout per phase is made. 6. Maximum Payout per Contract: Payout of the contract is capped at a max payout level per hectare. 7. Maximum Payouts per Phase: These are the maximum payouts received per farmer per hectare insured. 8. Tick per Phase: Tick per Phase = Maximum Payout per Phase / (Trigger Level per Phase - Exit Level per Phase) 9. Rainfall Cap: Capped cumulative dekadal rainfall which represents max amout of rainfall a crop can use or the soil can only store.

29 + Thank you