Axa bets on weather.
As reported in the IHT, the World Food Programme and Axa Re have entered into what they describe as the “the world’s first insurance contract for humanitarian emergencies”:
For food relief groups, the primary problem is raising enough money; the second problem is getting it on time. In March, the UN World Food Program announced a novel way to combat both problems: It has paid $930,000 for an insurance policy against drought in Ethiopia. If rainfall indicators at 26 sites drop below a certain level between March and October of this year - a sign the harvest could fail - the French insurer AXA Ré will pay the agency up to $7.1 million, which it will distribute to 67,000 affected households.
The contract or policy is described by the WFP as a derivative based upon a calibrated index of rainfall data gathered from 26 weather stations across Ethiopia, taking advantage of financial and technical innovations in the weather risk market. Payment will be triggered when data gathered over a period from March to October 2006 indicates that rainfall is significantly below historic averages, pointing to the likelihood of widespread crop failure.
The Lex column of the FT digs into the math:
[The WFP] will pay Axa a $930,000 annual fee in return for a maximum payout of $7.1mn. Unlike insurance, the payout is not related to loss. Axa will stump up if Ethiopian rainfall is below a defined level.
Derivatives redistribute risk, for a price. Has the WFP got value for money? Based on 30 years data it estimates a 10% chance of a payout in any year, compared to a fee equivalent to 13% of the payout value. Superficially that does not look attractive. Weather, however, is volatile and, broadly, follows a “random walk”: two consecutive droughts are possible. Axa, which beat four other bidders, also says a 3-year contract would be cheaper, although climate change means it will not usually write cover beyond this.
The WFP’s pilot is logical. It creates an economic synergy in ther form of a risk uncorrelated to insurance companies’ existing exposures. The alternative is disasterously slow. The Axa contract should allow the WFP to start disbursements to farmers within 6 weeks of it identifying that a harvest has failed. Conventional aid might take three-five months to arrive, by when the damage to farmers’ livelihoods has occured.
This is indeed very exciting stuff. But a few observations.
If this example doesn’t illustrate the semantic fallacy of distinguishing between trading and hedging or betting and insuring, I don’t know what it will take to convince those that perpetuate this mythology. In this case, the two parties framed their transaction as an insurance policy. I would guess this is because: (a) the counterparty (Axa Re) is an insurance company, (b) the legal documentation I would assume takes the form of an insurance policy and (c) ‘insurance’ sounds sensible and prudent. However, the (same identical) transaction could just have easily (and accurately, at least in terms of economic effect) been described differently. If the counterparty had been an investment bank for instance, the transaction could well have been described as the WFP having purchased a digital out-of-the-money put on rainfall (with a strike set at some defined point below the historical average, paying an option premium of $930,000, with a fixed pay-out of $7.1mn.) Indeed, option pricing models (and some assumption of implied volatility of future rainfall) are needed to price this properly (a fact the FT alludes to in their back-of-the-envelope analysis.) If the counterparty had been William Hill, or if Axa Re had traded on Betfair, the transaction would have been described as the WFP ‘backing*’ (to the tune of $930,000) future rainfall being below average, at (decimal) odds of 7.63 to 1. Obviously, Axa Re is ‘laying*’ the outcome.
Now imagine if those Ethopian farmers the WFP is trying to help had access directly to this market using a mobile phone to trade on a market on local meteorological conditions. Or combined with microfinance to increase access to capital; as a lender you would be much happier lending against a crop that was insured against failure. Similar to what I wrote last week:
And people in these countries understand markets:Imagine 200 million Chinese farmers trading and hedging their inputs and outputs every week with a few clicks on a 3G phone… a real living smart sensor network on a vast scale. Markets meet the flat world.
“This insurance scheme is a good idea,” says Hamu. “If I’m promised 900 birr (100 dollars) before the real drought begins, this will help. I might not have to sell my animals and I can buy some food to feed my family. “I may even buy haricot beans and maize seeds to renew my stocks and keep them for sowing until the rains come.” … “If I had some capital, I’d invest it in buying and selling different goods, I’d become a tradesman, an entrepreneur. Salesmen are very clever people and the life is lucrative and good,” he says. But although he dreams of bigger and better things, at the moment what Hamu really needs is the peace of mind that when the next drought hits, which is more probable than not, he will not have to part with the family’s much prized, and hard won, goat, oxen sheep and donkey.
The nexus of prediction markets and microlending and mobile technologies and climate change is one I find fascinating and offers great potential for improving the lives of millions and millions of people across the globe.
*To Back a selection is to place a bet for something to happen. To Lay a bet is to back something not to happen.
