made some progress and managing these additional risks. This limitation must be clearly communicated to all parties, and the underlying indices should be jointly developed with government partners to ensure that the index correlates as well as possible with the underlying risk, and to ensure appropriate country ownership and understanding of the approach. For the same reasons, wherever possible, the index should also be adapted from locally developed models that have been used by countries for some time, for example those used for early warning or production forecasting. Nevertheless, basis risk, whether real or perceived, means that indexbased product offerings must always be accompanied by other risk management or mitigation opportunities, and contingency plans, if the full value of these products, and of risk transfer, is to be realized.<sup>6</sup> A further disadvantage to such an approach is that the contract has an upfront, annual nonrefundable cost, which is additional to the cost of a full-scale government drought response. Donors often provide additional financial resources in response to a humanitarian crisis; hence, there may be a financial loss for the government if it takes on the cost of the insurance premium annually. Such a perverse incentive against an _ex-ante_ approach to risk management should be discussed with development partners to seek support in the payment of at least part of the premium.

# **4. Developing an index-based weather derivative contract to manage drought risk in Malawi**

The very high correlation between maize yields and rainfall, and the substantial role played by maize production in the economy and in household food security in Malawi, suggest that a weather risk management contract for Malawi could be designed based on a maize production index. The Malawi Department of Climate Change and Meteorological Services’, hereafter the Malawi Meteorological Services, rainfall data is of excellent quality, therefore satisfying a key prerequisite for risk transfer.

# _The Malawi Maize Index_

The success of a weather risk management program for the Government of Malawi depends on the design of the underlying rainfall index on which the contract is based. As outlined above, an index-based strategy does not cover the actual production loss of maize; instead it covers the shortfall in rainfall needed for adequate maize growth and development during a drought year. Because rainfall and maize yields are highly correlated, changes in rainfall – its timing, cumulative amount and distribution – can act as a proxy for maize losses. Risk mitigating payouts are made from the market counterparty if the index crosses a specified trigger level at the end of the contract period, indicating situations where a loss is most likely to have occurred, i.e., payouts are made based on the index and not on the actual loss itself.

The index proposed for Malawi – the Malawi Maize Index (MMI) – has been constructed using rainfall data from 23 weather stations throughout the country (Figure 2). The MMI is based on the Malawi Meteorological Services’ (MMS) national maize yield assessment model, used by the

> 6 See Hess, Wiseman and Robertson (2006) for a discussion on contingency planning with respect to contingency financing.

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