Cooler Than Madonna

On the night of January 28th 1985, more than forty blockbuster musicians gathered in Hollywood to record a single song. “We are the World”, co-written by Michael Jackson and Lionel Ritchie, was the American version of a prior British effort (dubbed “Band Aid”) to raise emergency funds that may help alleviate the pain of drought-induced famine in Ethiopia. By the time that the record hit the stores (on March 7th, selling all 800,000 initial copies over a single weekend), more than one million poor Ethiopians had died of starvation and malnutrition. In all, “We are the World, “Band Aid”, and “Live Aid” (the mega concert simultaneously held in London and Philadelphia the following July) together raised some $100 million, a truly impressive sum. The valiant contributions of Madonna, Bruce Springsteen, Bob Dylan, and many other mega stars, however, had simply arrived too late. Just like all traditional aid programs, the efforts by the author of “Like A Virgin” and her peers represented “ex-post” approaches to humanitarian relief. That is, the money only started to flow way after disaster had struck. As early as March 1984, the Ethiopian government began to appeal for international help as a response to the unusual lack of rain in the early Spring season. By August, people were dying by the thousands. It was only in October, when TV images of moribund Ethiopian children with sunken eyes and bloated bellies shamed the world, that serious relief efforts began to take shape. By the end of the year, Western countries had donated tens of millions of dollars, but the damage had been done: 900,000 Ethiopian farmers were dead, and the rest were mostly destitute as a result of having had to dispose of all their assets in order to survive.

Today, thanks to the work of financial wizzards, the world has access to tools that can provide relief funds to poor countries such as Ethiopia before disaster strikes, thus potentially preventing situations like those of 1984 and 2000, when another large-scale drought took place, claiming once more thousands of lives. Weather derivatives, in sharp contrast to aid agencies or artistic initiatives, offer “ex-ante” solutions to humanitarian crisis. That is, the funds would be readily available before destitution and famine are allowed to take hold. Before embarrasing media reports depict a tragic reality. Before Britney Spears has to come up with an aiding song. Weather derivatives, in sum, have the power to save the world’s downtrodden from a tortuous death. What Madonna could not deliver, weather derivatives miraculously can.

Last March 2006, the United Nations World Food Programme (WFP) arranged the first ever “humanitarian insurance” weather deal. The contract, underwritten by French reinsurer Axa Re, was intended to provide $7 million in immediate contingency funding in case of an extreme drought during Ethiopia’s 2006 agricultural season (which spans the March-October period). Though obviously the key variable was rainfall data, and the derivative could reasonably be seen as precipitation-related, in practice the underlying was a so-called “livelihood losses index” that measured the economic losses (in $ terms) resulting from droughts for rural populations living in the agriculturally-productive regions of Ethiopia. To be precise, if the index value was above $55 million on 31st October 2006, WFP would instantly receive a payout from AXA Re of $0.35 for every $1 the index is above the trigger level, up to a maximum of $7.1 million. Conversely, if the index value was below $55 million, no payment would be made. In the end, it did rain quite a lot in Ethiopia last year, so the derivative did not expire in-the-money. However, the pilot has got to be deemed a resounding success, as being able to place Ethiopian famine risk in the international capital markets was certainly a superb challenge to begin with.

Ex-post approaches to humanitarian crisis risk significant loss of livelihoods and may not be able to cope. While well-meaning aid programs like those featuring celebrity artists in the mid 1980s are surely helpful, they can only alleviate some of the pain once disaster has struck, but cannot prevent the malaise from happening in the first place. Weather derivatives, in sharp contrast, can potentially perform the miraculous task of providing economic assistance precisely at the right time, before famine and destitution have taken hold. The hope is that initiatives such as the WFP’s Ethiopian program, with their ex-ante approach to economic relief, will make aid more efficient and timely. That is, with weather derivatives you do not need to wait until you see people dying on TV; you can actually prevent those images from ever becoming reality. The message couldn’t be more crystal-clear: before weather derivatives there was no sure-fire way to prevent famine in Ethiopia and other poor areas of the globe; after weather derivatives, the task is possible. While twenty years ago the beautiful “We are the World” theme made the planet tremble with emotion and determined to aid those destitute Ethiopians, today’s weather derivatives can sing a more effective tune and miraculously eliminate the problem once and for all.