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


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


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


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)

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