Tuesday, February 9, 2010

National drought insurance

Some aggregate shocks can have a very large and costly impact. Not your typical business cycle in a developed economy, but rather shocks like earthquakes, droughts or major hurricanes. They put a lot of strain on affected regions, who would clearly gain from acquiring some sort of insurance against such adversities. Robert Shiller has been advocating cross-country insurance mechanisms against GDP fluctuations (say ... markets), but it calamities would have an even more pressing need for that.

Joanna Syroka and Antonio Nucifora explore this in the case for draught insurance in Malawi. With the help of the World Bank, this country is now offering a derivative contract based on index computed from the measurements of 23 weather stations in the country. The hope is that if international markets buy these instruments, the financial consequences of weather fluctuations will be born outside of the country, and macroeconomic stability will help growth and poverty alleviation.

It will be interesting to see whether there will be demand for these derivatives. Experiments have run in Ethiopia and Mexico, but in both cases it was with re-insurers. This time, a government is directly involved. If this works, there are many other candidates for this, think for example Bangladesh, whose GDP depends crucially from the yearly monsoon. And once such markets are well developed, smaller risks like GDP fluctuations in GDP countries may be insurable as well for governments.

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