the risk taker – regulators and rating agencies, for example, use such tail-risk measures in determining the capital a bank, (re)insurer or corporation is required to hold to reflect the risks it is bearing – and therefore the associated capital charge for taking on the risk. Administrative costs are essentially the costs for the provider to run the business including charges for data, office costs, taxes and brokerage charges if necessary.

**Table 2: Example indicative premiums and payouts at different trigger levels for a sample contract with a US$20 million payout limit and a payout rate of $500,000 per MMI-%** **<u>below the trigger</u>**

|**Trigger Level**|**Expected Loss**|**Indicative Premium**|**Rate-on-Line**<sup>**1**</sup>|
|---|---|---|---|
|95|US$ 1,480,000|US$ 2,600,000|13%|
|90|US$ 1,170,000|US$ 2,200,000|11%|
|85|US$ 900,000|US$ 1,700,000|9%|
|80|US$ 640,000|US$1,300,000|7%|

Note 1: This table provides very tentative estimates of premium rates by trigger level the example contract; only through a competitive market-based process can the true price of Malawian weather risk be discovered. Note 2: The rate-on-line is defined as the premium divided by the maximum possible payout, in this example US$20 million.

The indicative premiums in Table 2 do not include administrative expenses and provide a simple illustrative example, using a straightforward return-on-VaR pricing approach and the historical data available<sup>9</sup> , of how premiums may expect to vary with MMI thresholds (ISMEA, 2006).

A simple example will clarify the operation of such a contract. Consider that the government enters into a weather derivative contract structure based on the MMI. The contract has a trigger level of 95 percent, i.e., a payout is only made if at the end of the agricultural season in April the MMI is calculated to be below the 95 percent trigger level (meaning that the season’s MMI value is 5 or more percent below its long term average, implying the total national maize production is also down due to deficit rainfall-related losses). If the MMI is above 95 percent at the end of April no payment is made. The contract is designed such that if the MMI is below the 95 percent threshold the government will receive US$500,000 for every percent point that the MMI is below 95 percent, up to a maximum payout limit of US$20 million. The operation of such a contract is illustrated in Figure 4.

The average payout, or expected loss of the contract, over 48 years is US$1.5 million (Table 2). For entering into this contract and transferring this expected loss to the market and securing the right to access contingency funds of up to US$20 million if there is a drought-related crisis as measured by the MMI, the government must pay an annual premium of approximately US$2.6 million (Table 2).<sup>10</sup> From a donor perspective this is can be viewed as an opportunity to leverage US$2.6 million premium contribution into a US$20 million drought-response contribution in a

> 9 To calculate the indicative premium rates, R, excluding administrative expenses, the following basic equation is used: R = E(P) +  * ( VaR99(P) – E(P) ), where E(P) is the 1962-2009 average payout of the contract, VaR99(P) is an estimate of the VaR at the 99% level of the potential payout – estimated by fitting a best-fit Beta General distribution to the historical MMI data from 1962-2009 – and  is the return-on-VaR risk loading, set at 7% for this illustrative example.  In reality market players will take factors such as data length, data quality, trends and forecasts into account when determining the final technical premium rate R and their own risk loading.

> 10 This is a simple premium rate estimate. In fact only through a competitive process as part of a risk transfer arrangement can the real market price of Malawian drought risk be discovered.

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