Why not hedge on the monsoon?

Richard Sandor, the author of Good Derivatives: A Story of Financial and Environmental Innovation , noted that the Indian monsoon provides a great opportunity for designing derivatives for hedging rainfall risk. While a thriving ₹250 billion monsoon (betting) market does exist, albeit illegally, in India hedgers and speculators can participate legally in monsoon weather trading only when certain amendments have been made in the Forward Contract (Regulation ) Act (FCRA).

An Indian Meteorological Department report of a recent study on climate change covering the period 1961-2012 noted that “...spatially coherent decrease in monsoon season is a cause for worry”. Ambivalent monsoons are the major source of risk not only for agriculture, which sustains over 60 per cent of the Indian workforce but also for other segments of the economy including hydro-power generation, agro-processing, agri- insurance and finance, construction and tourism.

Governments are also financially exposed to monsoon risk as they are called upon to write off farm loans and spend on drought and flood relief packages, apart from sponsoring expensive crop insurance programmes.

The focus on ex-post policy choices for managing monsoon shocks can be costly and inefficient, apart from being oppressive to risk markets. It is possible to reduce the impact of recurring monsoon shocks by shifting the focus from post-event disaster response to a proactive ( ex-ante ) and self-sustainable risk management by transferring risks to insurance and capital markets.

The ecosystem of monsoon (rainfall) risk markets basically comprise three interdependent and complimentary components: (1) crop/rainfall index insurance at the ground level, (2) re-insurance markets that are critical for the expansion of crop/rainfall index insurance markets, and (3) rainfall derivatives markets ( see figure ).

Penetration levels of the crop insurance programme in India, in spite of its long history, remain abysmally low. The programme is plagued by classic problems such as high transaction cost in marketing and loss assessment, adverse selection and moral hazard. According to a World Bank study, the viability of crop insurance is a problem due to high loss to premium ratio.

Rainfall index-based insurance products are a new approach in insurance at the farm level. Under index insurance, a substantial variation of well-monitored natural parameters such as rainfall, temperature or humidity are considered a proxy for the actual loss. India is one of the leading countries developing the rainfall index-based farm insurance scheme.

The first weather insurance product in India, and indeed in the developing world, was a rainfall insurance contract underwritten in 2003 by ICICI-Lombard General Insurance Company, followed by IFFCO-Tokio and the public insurer, the Agricultural Insurance Company of India (AICI). The merits of index insurance compared to traditional crop insurance are: no cost of assessment of field losses, actuarially-priced structure, expedited compensation and simple claims settlement.

Attracted by these features, many private insurers have joined the bandwagon. However, the major challenge here is ‘basis risk’, which is the chance that the indemnity payment triggered by index does not match the actual loss. To minimise this, rain-gauge stations need to be present within a radius of 5-10 km.

Maharashtra, Andhra Pradesh and Karnataka, which account for more than 50 per cent of farmer suicides in India due to crop failure, are focusing on weather index insurance as an alternative to traditional crop insurance. If Agriculture Minister Krishna Byre Gowda’s resolve to set up a rain-gauge station in every panchayat materialises, Karnataka will be at the forefront of the index insurance programme in India.

The ecosystem of rainfall risk markets is incomplete in the absence of a rainfall derivatives markets that would facilitate hedging rainfall risk by a wide range of stakeholders. The development of such markets requires elaborate research and regulatory support. The standard metrics for measuring deficit/excess rainfall need to be defined on par with heating/cooling degree days (HDDs/CDDs) underlying temperature derivatives popularly traded on the bourses of western markets.

Studies have attempted to define these metrics for measuring deficit/excess rainfall as DRDs/ERDs (deficit/excess rainy days) on par with HDDs/CDDs underlying temperature derivatives. DRDs/ERDs can be determined separately for each of the rain-gauge stations or meteorological subdivisions that would serve as benchmarks for designing rainfall options and futures contracts for trading both in over-the-counter and organised markets.

But regulations in India do not define weather as a commodity, thus impeding trading. The law does not allow indices trading, so a suitable instrument such as rainfall indices cannot be designed.

The trading platform allows participants to buy or sell contracts based on DRD/ERD indices for settlement on a future date. This means one set of participants, such as farmers and agri-insurers who expect a deficit rainfall, may buy DRD-based contracts, while another set, including speculators who expect a normal rainfall, may sell DRD-based contracts.

The existing architecture of active stock derivatives market India can be exploited to create a platform for trading rainfall derivatives. This requires: (1) accurate and secured measurement and dissemination of timely and reliable rainfall data to all involved, (2) developing appropriate DRD/ERD indices and designing of pricing mechanisms for rainfall derivatives, and (3) educating market participants for better understanding of benefits and risk associated with rainfall derivative products and their effectiveness.

Rainfall derivatives can be an innovative product in our markets; they have a vast potential for creating sustainable rainfall risk markets by streamlining the massive monsoon speculative tendency. Rainfall derivatives can be to India what temperature derivatives are to the west. They represent a great opportunity.

The writer is a professor at the University of Mysore