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Managing Agricultural Production Risk Innovations in Developing Countries

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Managing Agricultural Production Risk Innovations in Developing Countries REPORT NO. 32727-GLB Managing Agricultural Production Risk Innovations in Developing Countries and Rural Development Department Agriculture Managing Agricultural Production Risk THE WORLD BANK Agriculture & Rural Development Department World Bank 1818 H Street, N.W. Washington, D.C. 20433 http://www.worldbank.org/rural Managing Agricultural Production Risk Innovations in Developing Countries THE WORLD BANK AGRICULTURE AND RURAL DEVELOPMENT DEPARTMENT © 2005 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, NW Washington, DC 20433 Telephone 202-473-1000 Internet www.worldbank.org/rural E-mail [email protected] All rights reserved. This volume is a product of the staff of the International Bank for Reconstruction and Development/The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accu- racy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development/ The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, http://www. copyright.com/. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail [email protected]. Contents ACRONYMS AND ABBREVIATIONS vii PREFACE AND ACKNOWLEDGMENTS ix EXECUTIVE SUMMARY xi 1 Introduction 1 2 Risk and Risk Management in Agriculture 5 Informal Mechanisms 6 Formal Mechanisms 8 3 Approaches to Agricultural Risk in Developed Countries 11 Crop Insurance Programs in Developed Countries 11 Why the Experience of Developed Countries is not a Good Model for Developing Countries 14 4 Innovation in Managing Production Risk: Index Insurance 15 Index Insurance Alternatives 15 Basic Characteristics of an Index 15 Relative Advantages and Disadvantages of Index Insurance 17 The Trade-off Between Basis Risk and Transaction Costs 17 Where Index Insurance Is Inappropriate 17 50 New Approaches to Agricultural Risk Management in Developing Countries 21 Role of Government 21 Policy Objectives 23 Constraints in Agricultural Risk Management 24 Risk Principles: Layering and the Role of Index Insurance 25 Addressing the Market Insurance Risk Layer 26 Market Failure Layer 29 iii iv Contents Policy Instruments 30 Index Insurance as a Source of Contingent Funding for Government Disaster Assistance and Safety Net Programs 32 6 From Theory to Practice: Pilot Projects for Agricultural Risk Transfer in Developing Countries 35 Nicaragua: A Seven-Year Incubation Period 36 Morocco 38 India: Private Sector Led Alternative Agricultural Risk Market Development 39 Ukraine 41 Ethiopia: Ethiopian Insurance Corporation and Donor Led Ex Ante Disaster Risk Management 43 Malawi and SADC: Weather Risk Transfer to Strengthen Livelihoods and Food Security 47 Peru: Government Led Systemic Approach to Agricultural Risk Management 48 Mongolia: World Bank Contingent Credit for Livestock Mortality Index Insurance 49 Global Strategy: The Global Index Insurance Facility (GIIF) 51 7 Potential Roles for Governments and the World Bank 53 Government Roles 53 World Bank Roles 54 REFERENCES 59 Appendix 1: Weather Risk Management for Agriculture 63 The Financial Impact of Weather 63 The Weather Market 64 Weather Risk and Agriculture 65 Structuring a Weather Risk Management Solution 67 Valuing Weather Risk 74 Weather Data 79 Further Reading 81 References 81 Appendix 2. Case Studies of Agricultural Weather Risk Management 83 Indexed-based Insurance for Farmers in Alberta, Canada: The AFSC Case Study 83 Alternative Insurance Through Weather Indices in Mexico: The Agroasemex Case Study 85 Weather Insurance for Farmers in the Developing World: Case Studies from India and Ukraine 90 Technology Application Case Studies: Grassland Index Insurance Using Satellite Imagery 107 References 108 NOTES 111 Contents v Tables 2.1 Risk Management Strategies in Agriculture 8 4.1 Advantages and Disadvantages of Index Insurance 18 5.1 Risk Transfer Strategies 28 6.1 Summary of Case Studies 36 6.2 Reasons for Buying Weather Index Insurance in India 43 A2.1 Options for CHU Contracts 85 A2.2 Total Liability Factored into the Agroasemex Business Plan for Autumn-Winter 2001––2002 86 A2.3 Summary of the Methodology to Calculate the Eleven FCDD Indices 87 A2.4 Comparative Analysis Between the Observed Historical Severity Indices (indemnities/total liability) and the Estimated Severity Indices for the Crops and Risks Selected 88 A2.5 Specifications of Call Option Structures Considered by Agroasemex 89 A2.6 Estimated Commercial Premium for Weather Derivative Structures (in US$) 90 A2.7 Weather Insurance Contracts Offered to Groundnut and Castor Farmers 94 A2.8 Pilot Statistics, 2003 95 A2.9 Payout Structure Per Acre for Groundnut Weather Insurance Policy for Narayanpet Mandal, Mahahbubnagar District (2004) 96 A2.10 Payout Structure Per Acre for Castor and Groundnut Excess Rainfall Weather Insurance Policy for Narayanpet, Mahahbubnagar 97 A2.11 Relationship Between SHR and Winter Wheat Yields During the Vegetative Growth Phase of Plant Development 101 A2.12 Relationship Between SHR and Financial Losses Associated with Winter Wheat Yield Fluctuations 102 A2.13 Correlation Coefficients for the Interannual Variability of Cumulative Rainfall, Average Temperature, and the SHR Index Measured at Five UHC Weather Stations in Kherson 103 Boxes 2.1 Asset-Based Risk Management 7 5.1 Reinsurance 22 6.1 India Impact Assessment 42 7.1 Examples of Potential World Bank Investment Lending Projects to Facilitate Risk Management 57 Figures 2.1 Independent Versus Correlated Risk 9 3.1 Crop Insurance Premiums and Indemnities in the United States 12 4.1 Payout Structure for a Hypothetical Rainfall Contract 16 5.1 Framework for Governmental Agricultural Risk Management Policy Formulation 23 5.2 Average April to October Rainfall for Thirteen Malawi Weather Stations 26 5.3 Histogram of Simulated SADC Drought Events 29 5.4 Government-Sponsored DOC as Risk Transfer Product Between National and International Risk Markets 30 vi Contents 7.1 Potential Impacts of Natural Hazards 54 A1.1 Notional Value of All Weather Contracts in US$ 65 A1.2 Percentage of Total Weather Contracts by Location (excluding CME trades) 66 A1.3 Potential End User Market by Economic Sector 2003–2004 66 A1.4 Call Option Payout Structure and Wheat Grower’s Losses 72 A1.5 Collar Payout Structure and Agrochemical Company’s Deviation from Budgeted Revenue 73 A1.6 Schematic of Historical Revenues of a Business and the Impact of Weather Hedging 78 A2.1 Relationship Between the Daily Rate of Development of Corn Minimum and Maximum Temperatures 84 A2.2 Comparative Accumulated Distribution Probability Function Based on a “Probability of Exceedence Curve” for the Historical and Modeled Results (payouts in US$) 89 A2.3 Mahahbubnagar District Groundnut Yields Versus Groundnut Rainfall Index 93 A2.4 Payout Structure of Groundnut Weather Insurance Policy Held by Farmers with Small, Medium, and Large Land Holdings 94 A2.5 Payout Structure of Groundnut Weather Insurance Policy for Narayanpet Mandal, Mahahbubnagar District, 2004 97 A2.6 An Example of the Marketing Leaflet for Groundnut (DGN), Castor (DCN), and Excess Rainfall (EN) Protection in Narayanpet Mandal, Mahahbubnagar District, 2004 98 A2.7 Winter Wheat Yields for Kherson Oblast, 1971–2001 100 A2.8 Cumulative Rainfall and Average Temperature for Behtery Weather Station for April 15 to June 30, 1973–2002 104 A2.9 SHR Index for Behtery Weather Station, 1973–2002 105 A2.10 Sample Contract for Behtery Weather Station 106 Acronyms and Abbreviations ACP Africa-Caribbean-Pacific APF Agricultural Policy Framework of Canada APH actual production history ARD Agriculture and Rural Development Department of the World Bank Group BASIX Livelihood Promotion and Microfinance entity of Andhra Pradesh BIP base insurance product BSFL Bhartiya Samruddhi Finance Limited (part of BASIX) CAIS Canadian Agricultural Income Stabilization CAT catastrophe COFIDE Corporación Financiera de Desarollo S.A. (Development Finance Corporation located in Lima, Peru) CRDB Cooperative and Rural Development Bank Limited, a private commercial bank CRMG Commodity Risk Management Group (ARD, The World Bank) DECRG Development Economics Research Group of The World Bank DOC disaster option for CAT risk DPPC Disaster Prevention and Preparedness Commission (Ethiopia) DRP disaster response product EC/ACP European Commission/Africa-Caribbean-Pacific EIC Ethiopia Insurance Corporation ENESA Entidad Estatal de Seguros Agrarios, the National Agricultural Insurance Agency of Spain ENSO El Niño southern oscillation (sea surface temperatures)
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