management internally, Kunreuther and Linnerooth-Bayer (2002) make the case that CAT bonds could be incorporated as a risk-transfer mechanism for developing countries. The authors suggest that a CAT bond, with subsidized premiums, could act as a substitute for a reinsurance contract to provide a source of contingent capital. They support the use of risk transfer mechanisms for emerging economies rather than disaster risk financing instruments which can over-burden government resources.
For countries with limited government resources, risk transfer (hedging) can have many advantages over ex post disaster financing in both the short and the long run by providing fast access to capital, and avoiding budgetary diversions and additional loans. Another important advantage is that unlike free disaster assistance, hedging instruments can be designed to provide incentives for disaster planning and mitigation (Kunreuther and Linnerooth-Bayer, 2002; Skees, et al., 2002).
Weather derivative contracts are one type of hedging instrument that has begun to emerge as a substitute for yield-based crop insurance. This type of insurance can be used to manage weather-related crop risks without providing incentives for poor management (Skees, et al., 2002; Skees, 1999). For example, indemnity payments are based on rainfall levels and can hedge against droughts or excessive rainfall. A nearly identical structure can also be used to establish CAT bonds for more extreme, infrequent risks while individuals or communities can bear the cost of managing lower layers of risks. Skees, et al., discuss several alternative instruments for utilizing the wealth of capital markets to aid the rural poor. They propose that index-based rainfall insurance could provide more efficient hedging than traditional forms of crop insurance.
An indexed-based trigger allows for immediate access to capital in the event of a catastrophe, circumventing time delays and reducing transaction costs. An indexed-based trigger also reduces opportunities for moral hazard, as the event measure can be independently verified and cannot be influenced by manipulation. A parametric index can be based on wind speed, Richter scale measurements, or rainfall depending on the event to be measured. Payment would be calculated from the index, and could account for both severity and proximity to populations (an indicator of impact). A basic payment structure would determine the percentage payout based on the difference between the strike level (the trigger) and the recorded measure of the event, x, when x exceeds the strike value (Skees, 2001; Martin, et al., 2002).
Percentage Payment = (x-strike)/strike
For example, an earthquake index could have a strike of a 7.0 Richter scale reading. An earthquake with a magnitude above this level would trigger bond payment. The contract can be designed to scale payments incrementally for measures in excess of the strike to account for increased severity. A similar structure could be used to cover excess rainfall within a period of time or wind speed. The use of an index for determining relief payments for natural disasters may be best suited for quickly-emerging disasters (floods, earthquakes, hurricanes), than for those that emerge slowly (e.g., drought). Nonetheless, certain thresholds of too little rain can be indexed and used to make payments when there are severe droughts.
The tradeoff with using an index to reduce moral hazard is an increase in the basis risk. Index contracts depend upon a strong correlation between the event creating the index and the losses of the individual who is insured.
Establishment of such an index would be useful for numerous applications. The weather data required to create and make use of the index is a public good which has many beneficiaries.