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| | Index insurance, an innovative tool for poor farmers
International Research Institute on Climate and Society (IRI)
Among exogenous agricultural risk management instruments, private insurance mechanisms are increasingly more widespread, especially since the WTO blacklisted state support policies because of their distortive effect.
Yet, as pointed out by Olav Kjorven, the UNDP Assistant Administrator and Director of the Bureau for Development Policy, because of cost, - only 3% of the world agricultural population is currently covered by insurance. The majority of farmers are in a maximum risk situation, even though they are the most vulnerable.
However, a new type of insurance known as index insurance, based notably on weather indexes, offers new perspectives. It provides significant opportunities as a risk management tool, particularly climate risk, in developing countries. A report from the International Research Institute for Climate and Society (IRI), entitled "Index Insurance and Climate Risk: Prospects for Development and Disaster Management" recently addressed the issue, demonstrating the advancements this type of system provides for agricultural risk management in poor countries 1.
We recommend that you read this report and we have provided an extract below
PFM
Extract from the report "Index Insurance and climate risks: prospects for development and disaster management” by the IRI
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A brief introduction to index insurance
Index insurance is insurance that is linked to an index, such as rainfall, temperature, humidity or crop yields, rather than actual loss. This approach solves some of the problems that limit the application of traditional crop insurance in rural parts of developing countries. One key advantage is that the transaction costs are lower. In theory at least, this makes index insurance financially viable for private-sector insurers and affordable to small farmers. Another important advantage is that index insurance is subject to less adverse selection and moral hazard than traditional insurance2.
An example of index insurance, and the most common application in developing countries so far, is the use of an index of rainfall totals to insure against drought related crop loss. Payouts occur when rainfall totals over an agreed period are below an agreed threshold that can be expected to result in crop loss. Unlike with traditional crop insurance, the insurance company does not need to visit farmers’ fields to assess losses and determine payouts. Instead, it uses data from rain gauges near the farmer’s field. If these data show the rainfall amount is below the threshold, the insurance pays out.
As well as reducing costs, this means that payouts can be made quickly – a feature that reduces or avoids distress sales of assets. This process also removes moral hazards such as the ‘perverse incentives’ of crop insurance, where under certain conditions farmers may actually prefer their crops to fail so that they receive a payout. With index insurance, the payout is not linked to the crop’s survival or failure, so the farmer still has incentives to make the best decisions. Another feature that reduces moral hazard is that index insurance uses objective, publicly available data, so individuals are unable to distort a situation to their benefit.
Rapid payouts are the major advantage of index insurance when this is used as a disaster management tool. Again, time-consuming loss assessments are not needed, as payouts are based on objective data. With index insurance in place, governments and relief agencies can plan ahead of crises, knowing that funds will be available when they need them. Planning is also facilitated because governments and relief agencies can track the index and prepare an early response.
But several critical components need careful attention if index insurance is to be workable. Index insurance is new, and can be difficult for stakeholders to understand – time and resources must be invested in explaining how it works. It depends on the availability and reliability of quality data, which is a significant challenge in most developing countries. But perhaps most importantly, index insurance is vulnerable to basis risk. Simply put, basis risk is when insurance payouts do not match actual losses – either there are losses but no payout, or a payout is triggered even though there are no losses. Obviously, if either of these situations occurs too frequently, the insurance scheme will not be viable, and may even damage livelihoods3. The contract design, and in particular the selection of an appropriate index, is crucially important in minimizing basis risk. Other factors that have implications for basis risk are proximity of the insured crop to a weather station, and availability of climate data4.
The potential of index insurance has been demonstrated by a number of projects in various developing countries. A selection of these projects, representing different regions of the world and different applications of index insurance, are presented as case studies in this publication. Index insurance is just one of a number of related index-based financial risk transfer products that work on the same principles . In this publication, the term index insurance is used loosely to include the range of products. Some of the case studies, for example, use other related products such as weather derivatives, but for ease of reading we call them all index insurance. The reader should bear in mind that much of the discussion is relevant to the broader range of products. Also, the discussion refers mainly to index insurance for crop failure due to drought, since this is the most common application so far; but much of it is also relevant to applications beyond drought and crop failure.
Index insurance for development
Index insurance may be able to help people manage the weather risk that is partially responsible for keeping them in poverty traps. Poor people are not only at direct risk from extreme weather events, but even without bad weather they are at a disadvantage because the risk blocks their opportunities. Lenders, for example, may not extend credit to them. They are therefore unable to invest in inputs that would improve productivity in good-weather years. Evidence suggests that farmers often sacrifice 10–20% of income when using traditional risk management strategies6.
But if they can take out insurance, either individually or collectively (by farmer associations, for example), the picture may change. When lenders know that borrowers are covered by insurance, they may be more likely to extend credit to them. Farmers may then choose to make investments that may raise their productivity. If the weather is bad and crops fail, the insurance will pay out and, as a Malawian farmer put it, “I do not have to worry about paying back loans in addition to looking for food to feed my family7” . This insurance can be sold either at the micro-level – to individual farmers or households, or at the meso-level – to banks or cooperatives for example.
Admittedly, index insurance must overcome a number of challenges before it can contribute to development on a significant scale: lack of capacity (base too restricted), lack of adequate data (notably statistics base), particularly in the developing countries it addresses, and especially its incapacity to mange systemic risks in the same way as conventional insurance mechanisms - this system is not a miracle solution to the agricultural problems that threaten global food security.
However, it is proof that imaginative risk management mechanisms, based on innovative methods and made available to us by science and technology are being studied and appear promising. A breath of fresh air for the agricultural sector, where, a number of experts still believe that the regulatory policies implemented in agricultural markets over the past 30 years should be removed. Nothing could be further from the truth - we must now innovate by implementing a global policy to cooperate at an international level for a common directive in the event of crisis, combined with a policy for insurance that covers “non-crisis” operating risks. PFM
1 The IRI published the report in partnership with the United Nations Development Programme, the International Fund for Agricultural Development, Oxfam America, Swiss Re, the US National Oceanic and Atmospheric Administration and the World Food Programme. You can find the full report on : http://iri.columbia.edu/csp/issue2
2 Adverse selection occurs when potential borrowers or insures have hidden information about their risk exposure that is not available to the lender or insurer, who then becomes more likely to erroneously assess the risk of the borrower or insuree. Moral hazard occurs when individuals engage in hidden activities that increase their exposure to risk as a result of borrowing or purchasing insurance. These hidden activities can leave the lender or insurer exposed to higher levels of risk than had been anticipated when interest or premium rates were established.
3 Skees J.R. (2008) Innovations in Index Insurance for the Poor in Lower Income Countries. Agricultural and Resource Economics Review 37: 1–15.
4 Carriquiry M.A. and Osgood D. E. (2008) Index Insurance, Probabilistic Climate Forecasts, and Production. CARD Working Paper 08-WP465.
5 For details of others, see Skees J.R., Barnett B.J. and Murphy A.G. (2008) Creating insurance markets for natural disaster risk in lower income countries: The potential role for securitization. Agricultural Finance Review 68: 151–167.
6 Gautam M.P., Hazell P. and Alderman H. (1994) Rural Demand for Drought Insurance. Policy Research Working Paper No. 1383. World Bank, Washington, DC
7 Hellmuth M.E., Moorhead A., Thomson M.C. and Williams J. (2007) Climate Risk Management in Africa: Learning from Practice. Climate and Society No. 1. IRI, Colombia University, New York. | |
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