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Malawi and SADC: weather risk transfer to strengthen livelihoods and food security

Country context and riskprofile

Malawi is dominated by smallholder agriculture, cultivating mostly maize - the staple food. Maize is very weather sensitive and requires a series of inputs, tte economy and livelihoods are affected by rainfall risk (and resulting food insecurity), soil depletion, lack of credit, and limited access to inputs. Malawi suffers serious capacity constraints because it is ravaged by poverty and AIDS. Very few people have the energy and skills to build financial service programs.

Current response

Malawi used to have a paternalistic state culture, tte role of the state in agricultural marketing (mainly tobacco, and also maize) is still strong and therefore, prices are not free and smallholder incentives are distorted due to food aid and the state marketing board sale of subsidized maize, tte state and donors respond to recurrent drought-induced food crises by ad hoc disaster relief programs.

Proposed agricultural riskmanagementstructures

Micro-level: At the farm level, weather-based index insurance allows for more stable income streams and could thus be a way to protect peoples' livelihoods and improve their access to finance, tte Government of Malawi has supported the implementation of an index-based weather insurance program at the smallholder level. In 2005, 900 groundnut farmers in Malawi bought weather insurance to increase their ability to manage drought risk and in turn access credit for better inputs. National Smallholder Farmer Association of Malawi, in conjunction with the Insurance Association of Malawi and the CRMG of the World Bank, designed an index-based weather insurance contract that would payout if the rainfall needed for groundnut production in four pilot areas was insufficient for groundnut production. Because these weather contracts could mitigate the weather risk associated with lending to farmers, Opportunity International Bank of Malawi and Malawi Rural Finance Corporation agreed to lend farmers the money necessary to purchase higher-yielding certified groundnut seed if the farmers bought weather insurance as part of the loan package. Given the success of 2005 pilot, 2500 farmers secured weather insurance-linked crop production loans for groundnut and hybrid maize in 2006, in a second pilot involving the same stakeholders. It is recognized that more weathers stations are required so that farmers in more locations can access insurance. To address this issue the Government of Malawi installed two new automatic weather stations and together with CRMG invested in creation of synthetic historical data at these sites. For the 2006/2007 pilot, one of these two new stations allowed previously excluded farmers to access weather insurance and input financing and the products were sold in five areas in 2006. ttere are plans to expand the pilot in 2007. CRMG and DECRG of the World Bank conducted a baseline survey partnering with the International Crops Research Institute for the Semi-Arid Tropics (ICRISAT) in 2006 to begin monitoring and evaluating the program (World Bank 2001).

Macro-level: A specific nationwide maize production index for the entire country could form the basis of an index-based insurance policy or an objective trigger to a contingent credit line for the government in the event of food emergencies that put pressure on government budgets. Applying the approach outlined above to the macro-level situation, we can define a Malawi Maize Production Index (MMPI) as the weighted average of farmer maize indexes measured at weather stations located throughout the country, with each station's contribution weighted by the corresponding average or expected maize production in that location. Given the objective nature of the MMPI, and the quality of weather data from the Malawi Meteorological Office, such a structure could be placed in the weather risk market. Analysis shows that Malawi could need up to USS70 million per year to financially compensate the government in case of an extreme food emergency (World Bank 2001). tte Government of Malawi has recently expressed interest in engaging in such a drought risk management program and with assistance from the World Bank1, tte proposal is to pilot the use of an index-based insurance contract to transfer the financial risk of severe and catastrophic national drought that adversely impacts the Government's budget to the international risk markets, tte aim of such a contract would be to secure timely and reliable funds for the Government if a contractually specified severe and catastrophic shortfall in precipitation occurs during the agricultural season, as measured by weather stations throughout the country. Access to such contingency funds in a time of crisis would generate a supplemental source of emergency financing in May to complement existing budget resources, giving the Government more flexibility in its drought response and enhancing the Government's ability to launch an efficient and cost-effective drought response.

tte weather index/drought risk management approach suggested for Malawi is one that could be extended to a regional level to include all members of SADC at some point in the future. Weather risk can be retained and managed internally if the areas under management are significantly diverse in their weather risk char

1 CRMG, January 2007.

acteristics. ttis immediately suggests that the weather sensitivity of neighboring countries, the SADC members, must be taken into account when considering Malawi's weather risk profile and its need for outside insurance. Analysis of the SADC region shows that on average, two countries suffer a drought each year (Hess and Syroka 2005). However, the distribution of drought events in SADC is extremely long-tailed, with the possibility of widespread drought events that could potentially devastate the region, ttis indicates that the most efficient way to layer and thus manage the risk is as follows:

SADC Fund: If the average financial impact of four average droughts in the region is approximately USS80 million for example, this could be the size of the SADC fund, with each member contributing its share determined by an actuarially fair assessment of the expected claim of each country.

Reinsurance and/or contingent credit lines: SADC-wide events incurring a financial loss of say US$80-350million could be transferred to the weather-risk reinsurance/professional investor market. Alternatively, the SADC members could have access to a World Bank contingent credit line in such situations.

Securitization: tte final and extreme layer of risk, such as drought in 10 countries, occurring 1 percent of the time, could be securitized and issued as a CAT bond (investors lose the principal if the event occurs in exchange for a higher coupon) in the capital markets, tte advantage of capital markets for this risk transfer is the immense financial capacity of these markets and also the longer tenure of CAT bonds - up to three years, possibly longer.

A more efficient means of transferring risk implies that costs could be greatly reduced for the member countries by transferring risk as part of a regional strategy rather than by transferring that risk one country at a time. For example, the SADC fund approach above would reduce insurance costs by 22 percent for Malawi due to risk pooling effects (Hess and Syroka 2005).

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