Monday, February 7, 2011

Lessons from the Developing World Come to Chicago

This morning on NPR I heard a story about the sale of snow derivatives by the Chicago Weather Brokerage on the CME (Chicago Mercantile Exchange). This is the first I've heard of what amounts to weather-indexed insurance in the U.S. It's apparently been around 2 years, and -- as of Feb. 2, 2011-- they are now selling rain derivatives. Payouts are triggered by measurements at pre-set weather stations (Chicago's O'Hare Airport; Minneapolis/St. Paul; Detroit; Boston; and New York's LaGuardia Airport and Central Park). The pay-out amount is set in advance, and depends on what kind of policy you get (i.e., betting on the snow being above average or below average). This is generally how weather-indexed insurance works.

Listen to another NPR story from "Marketplace" on snow derivatives.

Weather-indexed insurance is usually designed to issue quick, pre-set payouts in the case of severe drought using the banks where farmers already have loans. They were rolled out most systematically first in India, and then spread to Sub-Saharan Africa and beyond. It's historically a developing-world mechanism designed to quickly smooth things out for farmers who would otherwise have to sell their hard assets in the case of drought.

The benefit of weather-indexed insurance? It pays quickly-- and speed is key when you are trying to survive a total crop loss.

The drawback? The payout might not be sufficient to cover your losses. And, from the insurer's point of view, your weather-indexed policy holder might not live anywhere near the weather station being used to trigger the pay-out, so the drought might not have affected them at all, leading to overpayment.

But farmers might prefer a weather-indexed payout in any case, because the traditional claim-based insurance policy requires a time-intensive assessment process, and pay-outs might be late or gradual, requiring negotiation-- a problem, like climate change impacts, not restricted to the developing world.

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