Climate contributes to poverty directly through actual losses in production due to climate shocks and indirectly through the responses to the threats of the crisis. Direct impact : When a small holders farm is destroyed due to extreme weather conditions like drought or flood Indirect Impact: The farmers become excessively risk averse and abandon any new innovation that could lead to increase in production.

Together these factors leads to increase in poverty. Recent studies have shown that extreme climatic events will increase in frequency and magnitude. The human population is on rise increasing the pressure and demand on agricultural sector.

Weather index insurance is a form of insurance that is linked to weather index such as rainfall rather than a possible consequence of weather, such as crop failure This distinction resolves number of fundamental problems that makes traditional insurance unworkable in rural parts of developing countries

It reduces the high monitoring and administrative costs: Unlike the traditional insurance against the crop failure the insurer doesn't need to visit the farm to determine the premium or access the damages. The structure of index insurance is such that it makes the payout more quickly and efficiently. It removes the possibility of perverse incentive in crop insurance where the farmer prefers the crop to fail to receive the payment. With the index insurance the payout is not based on crop failure, so the farmer has the incentive to make the best possible decision for a good production.

Reliable network of weather stations Quality rainfall data High density of farmers around each specified weather stations Relatively Uniform weather pattern in pre defined radius Similar soil condition Ability to provide training and education to the farmers

The Weather Index Insurance doesn't measure the change in yield rather it measures change in weather factor like rainfall. It provides compensation to farmers when the rainfall during the crop growing cycle is insufficient to get an optimum yield. This form of insurance assumes that the weather factor like rainfall is highly correlated to the yield. To establish the correlation the yield is plotted against the rainfall and regression coefficient is calculated.

Weather insurance is defined by – A reference weather station – The weather index – Term period of the insurance – Threshold level – Structure of the product – Premium 8

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The Indemnity function defines the dynamics of the payout. It is defined by three parameters a) Strike Rainfall : The value at which the Insurance is triggered b) Stop Loss : The value at which maximum damage has been done c)Payout per millimeter of rainfall: Amount of money to be paid to the farmers per millimeter of deviation in rainfall from the strike rainfall level.

11 Payout Rainfall Max Payout Payout per mm (slope) Strike level Stop Loss The Graphical demonstration of the Payout is as follows:

Developing the rainfall index: – The rainfall index is defined as the cumulative rainfall in a specified period of time – Define r(i) = actual rainfall received per day Then the rainfall index is given by: 12 Where R(t) is the Rainfall index in year t.

This is the method used to calculate the Risk Premium for the contingent claim The price of the claim P is given as: P = e -r.T E Q [ψ(I)] I is a stochastic variable that expires at time T ψ(I) = payoff at expiration r: is the risk free rate of interest E Q : is the expectation 13

Historical weather data are cleaned and detrended Determine the slope of the payoff diagram Determine index value – hypothetical payoffs for each year Calculate payoff average and discount with rate r 14

Basis Risk: The rainfall recorded at a weather station may not be the same as that at the farmers field. Availability of quality weather data and reliable network of weather stations. Farmers Training and Education: Explaining them the dynamics of the product and the risk that the insurance covers. Farmers ability to pay the premium: Their economic condition might result in their unwillingness to buy the insurance

Identification of potential area and weather stations Studying the crop cycle and identifying the major risk associated with it Studying the weather factor correlation with the yield and deciding if the factor is insurable Quantifying the risk and finally arriving at the premium. Field testing of the contract

Refinement of the contract based on the farmers feedback Training and education Marketing the product Monitoring