Ethiopian drought insurance

This is one of those stories which raise more questions than they answer: an innovative approach to aid in Africa. The World Food Program, a United Nations agency, spent $930,000 on an insurance policy with French insurer AXA Re. If there's a drought in Ethiopia, the policy will pay out as much as $7.1 million.

At first glance, I thought that the $7.1 million would go towards the enormous expenses that the World Food Program is bound to incur in such an event.

When a severe drought hits Ethiopia or some other poor country prone to the ravages of nature, aid agencies typically spend and spend. This year, though, one aid organization may get some money back.
Instead of waiting for drought to hit and people to suffer, and then pursuing money from donors to be able to respond, the World Food Program has crunched the numbers from past droughts and taken out insurance on the income losses that Ethiopian farmers would face should the rains fail.

That sounds like a good idea: in any natural disaster, it saves money and lives to respond promptly – and insurance money can be put to work without bureaucratic wrangling and Congressional ratification and all the other things that normally have to happen before aid finds its way to a disaster area.

But other parts of the story – along with the official press release – make it seem that the money is for Ethiopian subsistence farmers, and that the World Food Program would rather not touch the money at all:

AXA Re, a large French insurer, will pay up to $7.1 million to partly cover expected losses by farmers.
Mr. Wilcox said the ultimate goal was for African governments to take out their own insurance policies so that a year of drought would have less of an impact on their populations.
Under the insurance policy, the food agency will receive a payoff if rainfall drops so low that 17 million subsistence farmers lose the equivalent of $55 million in income.

If it turns out that the $7.1 million is meant to be distributed to 17 million subsistence farmers to partly offset their drought losses, then I think this is actually a very bad idea. The costs of distributing the money would almost certainly be more than the amount of money distributed, for one thing. I know this is only a pilot program, but still, the maximum loss envisaged is only $3.23 per farmer, and I doubt such sums can be transferred in Ethiopia for less than that.

The farmers do seem to be central to this whole scheme: the insurance policy was based very explicitly on farmers' losses. Nomads, by contrast, "have been left out of the insurance model" because it's harder to model their income.

This I don't get. It would make sense to me if the World Food Program went up to AXA Re and said, essentially, "we, the World Food Program, are going to need to spend a lot of money in Ethiopia if there's a drought; we'd like to insure against that risk". But that has nothing directly to do with farmers' losses. Instead, the World Food Program seems to think that it's simply intermediating (and paying for) an insurance contract which is basically between AXA Re and 17 million Ethiopian farmers.

Note the quotation at the end of the story, from a US official:

"I would like to see it spread," he said in an interview from Washington, noting that most American farmers already had insurance in case of drought.

That's insurance, of course, which results in cash payments directly to the farmer in the event of a payout. Is that what he would like to see in Ethiopia too? Ethiopia does not have the institutions, including the payments system, of the USA.

As for the idea that African governments should be spending precious dollars on insurance payments to foreign reinsurers, I will need a lot of convincing. It's a question of opportunity cost: what could those dollars do if they were spent domestically? If you hired a domestic company to dig wells instead, maybe you could increase crop yields in drought years and pump a bunch of money into the domestic economy while doing so – money which would go to laborers and small construction companies who would then turn around and spend it on other things.

Robert Shiller thinks this is all fabulous:

"The portfolio effect of bringing emergency aid into the international risk markets is a win-win for developed and developing countries. With this deal, WFP is making a bold move towards more equitable and effective international risk management," said Robert Shiller, Professor of Financial Economics at Yale University and author of 'The New Financial Order: Risk in the 21st Century'.

Maybe I should talk to him and get him to talk me through it. Because this is the sort of thing which, it seems to me, is much more useful for middle-income countries than for countries like Ethiopia.

A country like Ecuador, for instance, could hedge against El Nino, the weather phenomenon which devastates its shrimp harvest, possibly with some kind of oil-for-hedge swap. That way Ecuador doesn't need to commit to spending dollars: it just commits to diverting a certain number of barrels of its oil exports to a vehicle set up for the purpose. That vehicle then swaps the future oil flow for a contract which starts to pay out money when domestic shrimp revenues fall below a certain level: the more that such revenues fall, the more it pays out. I can think of a few bankers off the top of my head who would love to structure such a deal, possibly even on a pro bono basis, in conjunction with the World Bank Commodity Risk Management Group.

But Ethiopia? I just have a gut feeling it's trying to run before it can walk. (Via)

Posted by Felix at 3:01 EST