SYNOPSIS. EXTRA-TERRESTRIAL INFLUENCES ON NATURE S RISKS Brent Walker. Key words: Exploration of the physics behind extreme weather and seismic events

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1 EXTRA-TERRESTRIAL INFLUENCES ON NATURE S RISKS Brent Walker Key words: Exploration of the physics behind extreme weather and seismic events Synopsis: The conclusions of the paper presented in the IAA mini-conference in Hong Kong are as follows: 1) Actuarial models used to predict nature s risks should include inputs from extra-terrestrial factors. 2) There is a wealth of data being produced in the space-age that will provide actuaries with predictive tools to assess future changes in many of nature s risks. 3) Actuaries should be aware that the risk of natural catastrophes is not normal during a solar grand minimum. Actuaries should also be aware that these not normal periods only usually occur every few hundred years but they do last for decades. This means that the higher incidence of catastrophic events that have occurred in 2010 and 2011 should not be regarded as a random fluctuation but rather as the new normal for the next few decades. 4) Although research into long term climate change is important for mankind and for the profession, actuaries currently face the considerable threat that they are underestimating the natural risk frequency and severity caused by the new solar grand minimum. This paper will be a reduced and updated version of that paper.

2 VIABILITY OF WEATHER INDEX INSURANCE IN MANAGING DROUGHT RISK IN AUSTRALIA Adeyinka A.A, Krishnamurti C, Maraseni T, Chantarat S Key words: Weather Index, Insurance, Revenue stabilization, Quantile regression, Copulas, wheat farming, Australian Drought Policy, Climate Change, relative Value-at-Risk, Burns Analysis Purpose of the paper: The purpose of this paper is to consider the viability of using Weather Index Insurance to facilitate response to covariate drought risk. Review of literature shows that the previous attempts to stabilize farmers revenues have been inefficient due to moral hazard and adverse selection resulting from asymmetric information. Weather Index Insurance (WII) is considered as a solution but at the cost of structural and geographical basis risks. Basically, the relationship between yield shortfall and drought indices (Standardized Precipitation Indices) has been established using the Ordinary Least Square (OLSReg), Quantile (QReg) and Panel Regression (PReg) analyses. It was observed that the OLS does not effectively capture the relationship at the extreme tails but the QReg does. The result from the PReg shows that contracts would be different from region to region. Using Burns Analysis, contracts are priced and it was found that revenue stabilization is possible with WII. Optimizing the relationship between yield and drought indices based on the phenological phases of the crop growth cycle of wheat is expected to improve the statistical relationship and consequently the revenue stabilization effect. Similarly, Loss Ratios and Copula Analyses are used to study the diversification prospects inherent in a portfolio of insurance contracts. It is hoped that this study will facilitate swift and objective response to drought risk in Australia. 1.0: Synopsis 1.1: Background to the problem The insurance system is getting over stretched given the frequency and intensity of extreme weather events in recent years (Keenan & Cleugh 2011; Parry et al. 2007). Although, extreme weather events like drought affect most sectors in the economy at least indirectly, some sectors are more vulnerable than others. The agricultural sector is among those sectors most vulnerable because rainfall deficit has grave implications on dry land crop yields and livestock grazing (Chantarat et al. 2007; Ghiulnara & Viegas 2010; Kimura & Antón 2011; Meuwissen, Van Asseldonk & Huirne 2008). Previous efforts to insure against the covariate nature of drought risk have been considered inefficient (Miranda & Glauber 1997). Most recently, Kimura and Anton (2011) recommended the exploration of insurance markets to manage drought risk in Australia. This suggestion by Kimura and Anton (2011) is in tandem with Bardsley (1986) that the viability of rainfall insurance is contingent on the relationship between yield losses and the payout from the insurance contracts and the behavior of a portfolio of the contracts when aggregated over time and space. Literature on the use of weather index insurance as a means of hedging climate related risk is growing, but there has been a focus on temperature related

3 risks in the energy industry without much consideration given to rainfall insurance as a means of hedging shortfalls in agricultural productions (Sharma & Vashishtha 2007; Vedenov & Barnett 2004; Yang et al. 2009, 2010; Bokusheva 2011; Chantarat 2009). Researchers have related crop yields to weather indices but concluded that there is need for an in-depth analysis of crop and region specific studies (Meuwissen et al. 2008; Turvey 2001; Vedenov & Barnett 2004). This region-specific analysis of rainfall insurance focusing on wheat was conducted by Bardsley, Abey and Davenport (1984) in Australia without much consideration given to spatial and time-wise diversification of the contracts. The conclusions in Quiggin (1984) and Bardsley, Abey and Davenport (1986) suggest that rainfall index insurance could make a contribution to alleviating risk in the Australian wheat industry (Bardsley 1986). 1.2: Objectives of the study The overarching goal of this study is to determine the viability of rainfall index based insurance for Australian farmers using wheat farming in Queensland and Western Australia as a case study. 1.3: Specific Objectives More specifically, we will determine; the relationship between rainfall index insurance and wheat yield across the shire of Queensland and Western Australia. the revenue stabilization effect of weather index insurance, and; the dependence structure of rainfall index insurance in Queensland and Western Australia. 1.4: Hypotheses There is no relationship between rainfall index and wheat yield across the different shires of Queensland and Western Australia. Weather index insurance has revenue stabilization effect. A portfolio of rainfall index insurance contracts is diversifiable between Queensland and Western Australia. Gaps in literature This study will bridge some gaps in previous studies that considered the hedging of stochastic nature of yield risk only (Chantarat 2009 & Kapphan 2012). Further, there are no evidences that these studies adjusted the prices of wheat used for inflation. In this study, the average of inflation adjusted prices of wheat available till date will be calculated and used with shire-wide quantity of wheat produced to calculate the revenue derived from wheat annually. This fixed average price will be used in the analysis of the revenue stabilization effect of WII under a constant price regime. In another analysis, the actual price taken per year, after adjustment for inflation, will be used in the analysis of the hedging efficiency. In the first analysis, the stochastic nature of yield alone is implicitly hedged while in the second analysis we consider the hedging efficiency of WII that captures both the yield and price variation. Further, we consider the effect of rolling contracts that are priced on a four year rolling basis to analyze the time-(in) variant nature of WII. Also, the effect of optimizing the relationship between yield and rainfall by capturing the optimal weighting of the phenological phases of wheat growth cycle will be considered. In addition, we use longer and more recent time series data than Bardley, Abey and Davenport (1984). By pooling risks in each region separately and mutually over different time frames (1 year, 2 years, 5 years and 10 years) in the two regions with different growing seasons to consider the risk smoothening effect of time and space from the insurer s perspective. This will help to capture the effect of non-affected areas compensating the insurer for affected areas, the extent to which good years could compensate for bad years and the effect that different and larger sample period could have on the viability of rainfall insurance

4 contracts. In addition, the effect of optimizing the relationship between yield and weather indices on the hedging efficiency of the contracts will be analyzed. 1.5: Contribution of the study The major significance of this study is that it would provide empirical evidence to resolve the debate on the viability of rainfall index insurance for wheat farmers in Australia (Bardsley, Abey & Davenport 1984; Bardsley 1986; Quiggin 1986). The result from the analyses of the research questions will test some of the necessary conditions for the viability of rainfall insurance in Australia as put forward by Bardsley (1986). This analysis will be used to inform the prospects of market based alternatives in handling the risk at different trigger levels and exits and the prospects of nationally domesticating rainfall risk within Australia or taking the risk offshore through reinsurance. It is hoped that the findings of the study will provide the theoretical background for the attainment of the tenets of ADP. Hence, the results will inform a public private partnership that will add to the portfolio of risk management alternatives available to farmers and create an ex ante disaster funds to swiftly respond to drought risk. References: Bardsley, P 1986, 'A note on the viability of rainfall insurance reply', Australian Journal of Agricultural and Resource Economics, vol. 30, no. 1, pp Bardsley, P, Abey, A & Davenport, S 1984, 'The economics of insuring crops against drought', Australian Journal of Agricultural and Resource Economics, vol. 28, no. 1, pp Bokusheva, R 2011, Measuring dependence in joint distributions of wheat yield and weather variables, Agricultural Finance Review, Vol. 71 No. 1, 2011 pp Emerald Group Publishing Limited DOI: / , viewed 4 July 2011, USQ library database. Chantarat, S 2009, 'Pro-poor risk management: essays on the economics of index-based risk transfer products', Cornell University Faculty of the Graduate School. Chantarat, S, Barrett, CB, Mude, AG & Turvey, CG 2007, 'Using weather index insurance to improve drought response for famine prevention', American Journal of Agricultural Economics, vol. 89, no. 5, pp Ghiulnara, A & Viegas, C 2010, 'Introduction of weather-derivative concepts: perspectives for Portugal', Journal of Risk Finance, The, vol. 11, no. 1, pp Kapphan, I Calanca, P & Holzkaemer, A 2011, Climate Change, Weather Insurance Design and Hedging Effectiveness, Institute for Environmental Decisions (IED) Working Paper 17, September. Keenan, T & Cleugh, H 2011, Climate science update: a report to the 2011 Garnaut Review, Centre for Australian Weather and Climate Research. Kimura, S & Antón, J 2011, Risk management in agriculture in Australia, OECD Publishing. Meuwissen, MPM, Van Asseldonk, MAPM & Huirne, RBM 2008, Income Stabilisation in European Agriculture: Design and Economic Impact of Risk Management Tools, Wageningen Academic Pub. Miranda, MJ & Glauber, JW 1997, 'Systemic risk, reinsurance, and the failure of crop insurance markets', American Journal of Agricultural Economics, vol. 79, no. 1, pp

5 Parry, ML, Canziani, OF, Palutikof, JP, van der Linden, PJ & Hanson, CE 2007, IPCC, 2007: climate change 2007: impacts, adaptation and vulnerability. Contribution of working group II to the fourth assessment report of the intergovernmental panel on climate change, Cambridge University Press, Cambridge. Quiggin, JC 1986, 'A note on the viability of rainfall insurance', Australian Journal of Agricultural and Resource Economics, vol. 30, no. 1, pp Sharma, AK & Vashishtha, A, 2007, Weather derivatives: risk hedging prospects for agriculture and power sectors in India, Journal of Risk Finance, vol. 8, no 2, pp Emerald Group Publishing Limited DOI / viewed 4 July 2011, USQ library database. Vedenov, DV & Barnett, BJ 2004, Efficiency of Weather Derivatives as Primary Crop Insurance Instruments, Journal of Agricultural and Resource Economics 29(3): Vedenov, DV & Sanchez, L 2011, 'Application of Weather Derivatives in Multi-Period Risk Management', Agricultural and Applied Economics Association. Yang, CC, Brocket, PL & Wen, M 2009, Basis Risk and hedging efficiency of weather derivatives, The Journal of Risk Finance, Vol. 10 No. 5, 2009, pp Yang, CC, Shihong Li, L Wen, M 2010, Weather Risk Hedging in the European Markets and International Investment Diversification, The Geneva Risk and Insurance Review, 1 21 viewed 20 February 2011, <

6 The Market Price of Insurance Risk Jon Tindall Key words: Profit margins, Market Price of Risk, Solvency, MCR, Insurance Risk, Arbitrage-Free Pricing Purpose of your paper: This paper seeks to better understand the differences in the effective pricing of risk, in an insurance context, between the various mediums through which insurance risk is exchanged. Synopsis: This paper begins with a summary of the different approaches to pricing risk across insurance, reinsurance and in wider capital markets. It describes the application of modern financial theory to the pricing of insurance risk and in particular discusses the relevance of arbitrage-free pricing methods to insurance risk. It attempts to establish the various market prices of risk that are inherent in these different mediums for the provision of insurance capital. It seeks to highlight some of the inconsistencies that exist between the way in which insurers internally price their insurance products and the treatment of insurance risk by capital market. The paper then investigates the relationship that exists between the riskiness of an insurance portfolio and the solvency capital required to back it. From a better understanding of this relationship insurers (and other capital providers) can select risks that enable them to move their portfolio towards an improved risk/return profile and hence towards the efficient frontier.

7 ACTUARIAL VALUATION OF THE NZ SOCIAL WELFARE SYSTEM Alan Greenfield Key words: New Zealand Social Welfare System, Actuarial Valuation, Investment Approach Purpose of your paper: The presentation summarises the background, approach and results of the valuation of lifetime costs of clients in the NZ Social Welfare System. Synopsis: Taylor Fry was contracted by The Ministry of Social Development in New Zealand ( MSD ) and the NZ Treasury to carry out a feasibility study into an Investment Approach to the NZ social welfare system and a follow-up actuarial valuation of the system. The valuation of the social welfare system was released publicly in September 2012 and is available on the MSD website. The full actuarial valuation of the social welfare system is thought to be a world first. The inflated and discounted liability for benefits and associated expenses has been estimated to be NZ$78 billion and includes liabilities for those working-age clients in receipt of a benefit in 2010/11 and covers all benefits including unemployment benefits, invalids benefits, domestic purposes benefits (i.e. the sole parent pension) and sickness benefits. The approach used in the valuation of the key benefits involves modelling of the probability of moving around the benefit system. Therefore the valuation provides significant insight into the characteristics of behaviour of clients on welfare in NZ and provides a good basis for MSD financial management of the system. The presentation will cover: Background discussion of the project including the reasons for the valuation and how it is expected to be used; The approach used to estimate the liability; and Key results of the valuation.