PRODUCT NOTE

Index-Based Weather DerivativeHighlights•••

The MultiCat Program helps member
countries issue catastrophe bonds to insure
themselves against the risk of natural
disasters.
Supports a wide variety of structures,
including the pooling of multiple risks inmultiple regions.
The World Bank acts as an arranger: assists
in formulating disaster risk management
policy; offers off-the-shelf documentation;
supports the preparation of legal andoperational framework; selects service
providers.

An index-based weather derivative is a financial contract
designed to provide compensation for financial loss to anentity affected by weather volatility. Weather contracts are
based on measurable weather events such as excessive orinsufficient rainfall, temperatures (extreme heat or cold),
tropical storms, hurricanes, cyclones, and typhoons.
TheWorld Bank offers index-based weather derivatives as part ofa broad spectrum of disaster risk financing instruments
designed to assist member countries in planning efficient
responses to natural disasters.

Exposure to Weather Risk
Adverse weather conditions can substantially affect publicfinances by damaging housing and other assets, or by
negatively affecting agriculture production. Countries withlimited access to market tools designed to manage these risks
are often forced to reallocate budgetary resources to meet
immediate needs or depend on humanitarian appeals. These
countries can use weather hedging products to manage thefinancial risks associated with adverse weather events in thecontext of a wider risk management framework.
A weather derivative contract can, for instance, help a country
transfer a portion of the risk of severe drought to theinternational financial markets by using rainfall as a proxy forloss. Many countries with a significant agricultural sector use
index-based weather models to monitor commodity
production risk and forecast production. This data can often
Index-Based Weather Derivative

be used to create a weather derivative. Hydroelectric power
plants can also benefit from weather derivatives, using thecontracts to mitigate the risk of rainfall dropping below acertain level.

Key Features
An index-based weather derivative is a financial instrumentthat is used to manage weather risk based on an index ofweather-related data. The index is designed to reflect losses
or liquidity needs caused by an adverse weather event. A
country that wishes to hedge a specific weather risk purchasesa derivative contract by paying a premium upfront. The sellerof the derivative contract accepts the risk of the adverse event
occurring in exchange for the premium, similar to an insurance
contract. The buyer receives a payout if the index crosses a
specified threshold before the end of the contract period.
These derivative contracts can be customized according to a
country’s specific needs based on the type of weather hazard,desired level of protection, and the estimated financial loss
associated with the event.
In general, weather derivatives are most cost-effective for covering lowprobability events with severe impacts, such as drought. Unlike
traditional insurance schemes, index-based weather derivatives allow
for rapid disbursements as there is no need for an assessment of loss
incurred. Weather derivatives thus help countries plan and implement
responses to adverse weather events before they occur.

World Bank as a Counterparty
The World Bank can intermediate on behalf of countries,
providing its expertise and comparative advantage in financial
markets transactions. The Bank and the member country signa Master Derivatives Agreement, which serves as thecontractual basis for the execution of the financial derivative.
The Bank and the country enter into a derivative contract thatspecifies the risks to be covered, the agreed-upon trigger thatwould initiate a payout, the amount of the payout, and thepremium. The Bank then enters into an offsetting contract witha financial market participant, thus transferring the risk to theinternational financial markets. If the index value hits the predetermined trigger, the Bank receives a payment from themarket counterparty, and the same amount is paid to theclient country.
The World Bank also works with countries to help build theircapacity to engage in such transactions, so that countries are
eventually able to continue implementing similar risk
management strategies independently.

Updated as of May 2023

PRODUCT NOTE
Sample Weather Derivative ContractReal-time weather data is collected through Country X’s national meteorological services. The data is verified
and validated on an ongoing basis.

Country X designs a Maize Index linking rainfall and maize production so that if precipitation falls below a certain
level, the index will reflect the projected loss in maize production. The level of rainfall is the only variable in theindex.

Country X and the World Bank agree on a contract (an “options contract”) that specifies the payout trigger (maizeproduction falls by a certain percentage below the historical average as estimated by the index) and the payout
amount. The availability of the derivative to Country X is dependent upon the availability of a market counterparty(options counterparty) for the World Bank.

Country X pays a premium to the World Bank.

The World Bank enters into an offsetting agreement with a market counterparty.

If the index hits the pre-determined trigger, Country X receives a payout from the World Bank. If the index does
not hit the pre-determined trigger, the contract expires at maturity.

Contact: Miguel Navarro-Martin, Manager, Financial Products & Client Solutions, The World Bank Treasury
 mnavarromartin@worldbank.org  +1 (202) 458 4722
1225 Connecticut Avenue NW, Washington, D.C., 20433, U.S.A.

Index-Based Weather Derivative

Updated as of May 2023