Rainfall Insurance: A Promising Tool for Drought Management

Abstract

Diverse and complex water management systems have been created in many areas of the world to manage the risk of drought. The primary challenge is the inherent uncertainty of water supply and demand over time, which makes the process of correctly allocating water rights annually a difficult and costly task. As a result, risk averse water authorities make overly conservative estimates of water supply. This paper introduces the use of a rainfall index contract as a tool to improve drought management. An irrigation district in New South Wales, Australia, is used as an illustration of the concept.

Notes

1. For example, the water authority would have an incentive to cause a water shortfall if it was the insured (the contract holder) and the potential indemnity payment exceeded expected water market revenues.

2. For a more complete description of the water market situation in NSW see Crase (1999).

3. Murrumbidgee Irrigation, the company that operates the water market in the MIA, posts the allocations on its website (http://www.mirrigation.com.au).

4. The irrigation or ‘water’ year is typically 1 July–30 June, but drought conditions may cause an earlier deadline (e.g. May).

5. Irrigators who wish to sell their water rights post the quantity of water and price on the water market website (http://www.murrumbidgeewater.com.au).

6. Water users purchase an entitlement and are also charged a fixed price per unit of water based on their entitlement (high security users are charged a higher fee) and water usage (http://www.mirrigation.com.au).

7. During the California drought of 1976–77, net farm income actually increased because the prices of California's specialty crops rose (Howitt & M'Marete, 1989).

8. Different sets of continuous months were tested.

9. The actuarially fair premium = the actuarially fair premium rate × the liability. The actuarially fair premium rate = the expected indemnity/the liability.