Efficiency of region-wide catastrophic weather risk pools: Implications for African Risk Capacity insurance program

Abstract

In an attempt to better manage extreme weather risk using (re)insurance and securitizing devices, the African Union recently established the Africa Risk Capacity (ARC) to pool extreme drought risk across Africa. We investigate the prevalence of systemic risk within potential ARC risk pools and its effect on diversifying drought risk using rainfall index-insurance. To develop an index that captures the tail behavior of losses, we employ a two-stage process that involves a vector autoregressive model and nested Archimedean copulas. Finally, using the loss distributions, we derive and compare buffer load and pooling effects across risk pools. Overall, we find strong benefits in pooling drought risk in Africa. However, the benefits are highly heterogeneous across risk pools, some of which are very inefficient. The heterogeneity was found to be driven by non-linear dependence among losses that tends to be stronger in the tails of the distribution.