Weather Derivatives

Recently in class we have been discussing derivatives and the role these play within risk management. We also specifically looked at weather derivatives and the affect these have on particular industries. I found this interesting so I found an article on a specific instance of a weather contract being used. The weather derivative contract in this article was entered into by Swiss Re and the International Development Association (IDA). The IDA is the arm of the World Bank that helps the world’s poorest countries.

I thought this was quite interesting, because usually individuals associate poorer, less developed countries with a higher agricultural industry, which seems to be true in this case. For this particular weather derivative that they entered into, Swiss Re will pay out up to $5,000,000 in the event that Malawi’s farmers suffer drought-related shortfall in maize production.

What was interesting about this contract was that it is structured on a rainfall index. Rainfall and maize production are highly correlated, so this worked well as a factor to base it upon. So, if the rainfall falls below a certain amount, Swiss Re will pay out an amount based on the projected loss. The article states that the maximum payout is reached if maize production drops to 10% below the historical average.

Like we discussed in class, it seemed that this derivative contract was well planned out as it is based on geography. Therefore, an individual farm owner must still do their work and it averages out for a certain geographic location within Malawi, since it depends upon the rainfall. This also works well because it reduces possible moral hazard. The contract is based upon historical maize production, and depends upon the rainfall which an individual cannot control, so it is definitely still in their best interest to farm as efficiently as possible. This is especially true since an easy comparison could be made between various farms within similar locations in Malawi with respect to their maize production.

Additionally, I found it interesting how heavily Swiss Re is involved in weather derivatives. From the article it seems as though they have been a huge member in dealing with weather risk transfer instruments. For example, they started with these risk instruments in India, reaching over 350,000 smallholder farmers. First looking at this, it seems like Swiss Re may have a lot of stake in weather derivatives, and is possibly not as diversified as they should be, given that there may unfortunate weather conditions around the world. However, I assume Swiss Re is a very large company and has significant stake in other industries and areas as well. Additionally, because Swiss Re has these types of contracts in areas around the world, it will most likely balance out in the end. For example, India may face very bad weather one year, harming their agricultural industry and costing Swiss Re money, but Malawi may have great weather and create a profit for Swiss Re since they won’t have to pay out any money to that specific country.

Swiss Re Weather Derivative