March 08, 2006
Hedging Against Natural Disaster
Posted by Christine Hurt

I am always on the lookout for news of a convergence of speculation methods -- in the securities markets, insurance markets, and gambling markets.  Marginal Revolution discusses an article in today's NYT that reports the World Food Program has spent almost $1M for an insurance policy based on what the rainfall in Ethiopa is this year.  If rainfall falls beyond a certain level (not reported) between March and October, the World Food Program would receive up to $7.1M, which will be used to aid farmers.  The metric used reflects a drought so substantial that "17 million subsistence farmers lose the equivalent of $55 million in income."  In this situation, the risk of loss of the farmers is shifted somewhat to an organization that can insure against that risk.  Presumably, famers in Ethiopia are not able to afford individual crop insurance, if such insurance is available.

This policy is being touted as the first natural disaster insurance coverage for an international aid agency.  The agency would otherwise try to gather charitable donations for drought relief after the fact.  the agency isn't speculating for speculation sake, it is hedging against a known risk that affects its operations.  This move by the World Food Program seems like a good one, but the premium seems pretty steep for a policy limit only 7X premium.  Drought must not be that unlikely.  The article reports that "only a few years in the last quarter-century" would qualify under the policy, but that phrase means the incidence could be as high as one in 8 years or more. 

Of course, it would be illegal to bet on whether there is a drought next year.

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