Ask small farmers in semiarid areas of Africa or India about the most important risk they face and they will tell you that it is drought. In 2003 an Indian insurance company and World Bank experts designed a potential hedging instrument for this type of risk—an insurance contract that pays off on the basis of the rainfall recorded at a local weather station.
The idea of using an index (in this case rainfall) to proxy for losses is not new. In the 1940s Harold Halcrow, then a PhD student at the University of Chicago, wrote his thesis on the use of area yield to insure against crop yield losses. In the past two decades the market to hedge against weather risk has grown, especially in developed economies: citrus farmers can insure against frost, gas companies against warm winters, ski resorts against lack of snow, and couples against rain on their wedding day.
Rainfall insurance in developing countries is typically sold commercially before the start of the growing season in unit sizes as small as $1. To qualify for a payout, there is no need to file a claim: policyholders automatically qualify if the accumulated rainfall by a certain date is below a certain threshold. Figure 1 shows an example of a payout schedule for an insurance policy against drought, with accumulated rainfall on the x-axis and payouts on the y-axis. If rainfall is above the first trigger, the crop has received enough rain; if it is between the first and second triggers, the policyholder receives a payout, the size of which increases with the deficit in rainfall; and if it is below the second trigger, which corresponds to crop failure, the policyholder gets the maximum payout. This product has inspired development agencies around the world, and today at least 36 pilot projects are introducing index insurance in developing countries.