Premise The concept of risk layering

Segmenting risk into different "layers" is a key risk management principle. Consider, for example, Figure 22.2, which shows the probability distribution for average April to October rainfall at thirteen weather stations in Malawi (Rejda 2001). Suppose that farmers start incurring production losses whenever rainfall is less than one thousand millimetres, tte domain of losses might be segregated into three risk layers, with different entities holding each layer:

• For rainfall in excess of 700 mm, farmers would retain the loss risk, either individually or with financial service providers: the risk retention layer.

• For rainfall between 500 and 700 mm, the risk would be transferred to an insurance company via a weather index insurance product: the market insurance layer.

• For rainfall levels below 500 mm, the risk in this example would not be insured due to cognitive failure and ambiguity loading: the market failure layer.

Farmers would absorb losses in the risk retention layer using self-insurance strategies such as those described in Chapter 22.2. Strategies for effectively transferring the other risk layers are described below.

Referring again to Figure 22.2, suppose that an insurance provider writes a rainfall index insurance contract with a strike of 700 mm and a limit of 500 mm. Limits are commonly used by weather index insurance writers to avoid open-ended exposure to catastrophic weather events, tte insured would select the amount of insurance (the liability) and the payment per tick would be calculated using this formula.

Liability

Payment per Tick =

Limit-Strike

Assume that a farmer has a crop with an expected value of $15,000. At only 500 mm of rainfall, the farmer is estimated to lose two-thirds of the value of the crop, ttus, the farmer purchases $10,000 of liability, with a payment for each tick (each mm of rainfall) of fifty ($10,000 divided by (700 x 500)). If the realized value for the rainfall index is 600 mm, for example, the indemnity will be $5,000 ((700 x 600) $50) (Barnett et al. 2005). tte limit of 500 mm caps the insurance provider's loss exposure on the index insurance product. Without the limit, the contract would be extremely expensive, since it would protect against losses in the extreme lower tail of the probability distribution. Buyers would exhibit cognitive failure regarding

Figure22.2. Average April to October rainfall for thirteen Malawiweather stations

the probability of events with less than 500 mm of rainfall, while insurance providers would load the premium for ambiguity regarding these same events, ttus, even if insurance was available to protect against rainfall events of less than 500 mm, few transactions would be likely, since the premium would exceed most buyer's willingness to pay.

Market failure layer: At the catastrophic loss layer represented by market failure, private decision makers will likely not purchase adequate insurance due to cognitive failure, ambiguity loading of premiums rates, and perhaps, expectations of government or donor disaster relief. Some form of government intervention may be required to facilitate adequate transfer of the risk.

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