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Index Insurance for the Poor in Lower-Income Countries
Tiffany Shen
Weather Risks in Agriculturally Dependent Economies
In agriculturally dependent economies, the weather is a critical determinant for their economic well-being. Agricultural productions rely on adequate rainfall level, temperature, or wind speed. If natural disasters occur, an agricultural household’s current income such as growing crops is usually destroyed. What’s worse, household assets that accumulated over years of savings may also be destroyed. According to a study by Carter in 2005, extreme weather events widen the income gaps between wealthier and poorer farming households, as the latter often lack the assets necessary to generate sufficient new income for recovery. Recognizing their incapability to undertake losses from extreme weather events, poorer households will incorporate low-risk strategies such as crop diversification and off-farm employment (generating extra income by working off of the farm). Although this strategy helps reduce the financial risk, it also leads to a lower expected return. As a consequence, those lower-income households are pushed into a cycle of poverty.
Index Insurance for the Poor in Lower-Income Countries: About
Figure 1. Economic Impact of a Natural Disaster on Households with Different Asset Positions
Source: Adapted from Carter et al. (2005).Â
Initially, both households’ asset levels increase, although Household B is still close to the poverty line. When a catastrophic weather event hits, both households’ assets decline immediately due to product damage or recovery cost. Household A can recover more quickly since it retains more productive assets to weather economic difficulties. For a poorer household, such as B, the depletion of assets may push the household below the poverty line.
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Constraints to Traditional Weather Insurance
After natural disasters hit, a simple solution is to borrow money to cover the loss. However, many poor households in lower-income countries cannot easily borrow money due to their poor credit history or a lack of collateral. Therefore, savings and insurance may be more obtainable for the poor since they serve as protection before the onset of a loss event. Insurance is a business that depends upon trust. Traditional weather insurance pays indemnities when farmers incur a loss. To pay indemnities to households, the insurance company makes estimates of loss case-by-case. However, there are two major problems associated with traditional weather insurance (and most types of insurance products) are adverse selection and moral hazard. Adverse selection occurs when one party has more information than the other party. For example, farmers living in an area with a higher probability of extreme weather events will be more incentivized to purchase the insurance than those who live in a safer area. Moral hazard refers to the fraudulent behaviors of the insured after purchasing the insurance. For example, farmers may blame the loss of crop failure on weather factors although it is mainly due to careless management practices. It is difficult to tell if a loss is due to a natural or human factor, and the monitoring and administrative cost to control adverse selection and moral hazard problems can be costly. Another constraint of traditional weather insurance is the financing of large losses. For extreme weather events, all insurance buyers within the same geographical area will rush to make claims at the same time. The total claims are very likely to exceed the amount the insurance company can provide. Insurance companies need careful planning to ensure adequate capital is available for potentially huge losses, or sometimes they simply avoid providing weather insurance products. In higher-income countries such as the United States or Canada, their insurance products involve subsidies to mitigate the expense of premiums. However, it is difficult to apply this method to lower-income countries due to their lack of financial capital or poor design of the subsidy scheme to deal with adverse selection and moral hazard problems.
The New Approach—Index Insurance for Weather Risk
Given the insurance companies in lower-income countries typically do not have the financial resource to follow the solution conducted in higher-income countries (e.g. subsidies for weather insurance), index insurance may serve as an alternative for weather risk protection. Index insurance pays out the claim based on values obtained from an index, such as rainfall, temperature, or wind speed, instead of traditional proxies such as farmer’s crop yield. For example, an index insurance contract related to drought risk will make indemnity payments if rainfall does not reach certain levels during a defined period, such as a month or a season. As shown in Table 1 (Skees, 2008), if the rainfall is 100 mm or less, the insurance company begins to make payments, and the maximum payment of $50,000 is made when rainfall is at or below 50 mm for the season. The total accumulated rainfall is measured at a local weather station for the cropping season.
Index Insurance for the Poor in Lower-Income Countries: About
Table 1. Payments Due Under Different Rainfall-Level ScenariosÂ
Source: Adapted from Skees (2008)
Index Insurance for the Poor in Lower-Income Countries: Image
Pros of Index Insurance
Time-saving for information assessment processes:
Since index insurance indemnity payments are not tied to actual losses incurred, it saves time and cost for classifying potential policyholders’ risk exposure.
Reduction of adverse selection and moral hazard:
Index insurance is based on widely available information, thus it prevents either party from exploiting informational asymmetry. Since the indemnity is determined by the index value, the policyholders cannot change his or her behavior to increase the likelihood of receiving payment.
More objective for loss measure:
As the indemnities are based on the index value, the extent of the loss can be determined more objectively.
Cons of Index Insurance
Basis risk:
Basis risk arises when the indemnity payment the policyholder receives does not match his or her actual loss. Poorly designed products and geographical discrepancy are the two major reasons for basis risk. With robust product design and backtesting of policy parameters, product design basis risk can be minimized. Geographical basis risk occurs when the index measured at the measurement location is not representative of the loss in the actual situation. The greater the distance between the measurement instrument and the production field, the greater the basis risk.
Reliable and accessible data:
The underlying index must be publicly objectively and accurately measured. If either party cannot trust the index, the system will fail.
Education:
Generally, agricultural households in lower-income countries have no previous experience with index insurance or similar products. Without a clear understanding of the products, they do not know whether the products can provide effective risk management or not. Therefore, educational initiatives are necessary for introducing the concept of index insurance to these countries.
Examples of Weather Index Insurance
India:
Since 2003, rainfall index insurance has been offered by private firms to compensate farmers for agricultural losses. In 2005, about 250,000 small Indian farm households purchased index insurance for weather risk. In the same year, the Indian government also started selling this type of insurance. Private investments in Indian weather stations are increasing, which helps reduce basis risk and enable the weather index insurance market to grow prosperously.
Malawi
In 2005, the World Bank helped groundnut farmers in Malawi develop a rainfall index insurance pilot to protect against drought losses. In the first year, around 900 farmers purchased the insurance. The objective is to improve smallholder farmers’ access to credit. Two rural financial institutions agreed to extend credit to index insurance buyers, enabling those farmers to obtain loans for purchasing higher-quality seed.
Prospects
As mentioned at the beginning of this article, the poorer households will continue to stay below the poverty line if there is no mechanism to cease the vicious cycle of poverty. Index insurance may solve the problem. With advanced technology, we can obtain data more accurately. For example, satellite technology provides better quality and up-to-date information on flood events and pasture conditions. While the cost of obtaining these data has decreased in recent years, it is beneficial for the development of index insurance. With careful planning, we hope the structure of weather index insurance will be more developed, and the weather index insurance will be offered to more households around the world, enabling them to cease the vicious cycle of poverty.
References
Carter, M. R., Little, P. D., Mogues, T., Negatu, W., & Ababa, A. (2005). The long-term impacts of short-term shocks: Poverty traps and environmental disasters in Ethiopia and Honduras. Basis Brief, 28.
Skees, J. R. (2008). Innovations in index insurance for the poor in lower income countries. Agricultural and Resource Economics Review, 37(1), 1-15.
Index Insurance for the Poor in Lower-Income Countries: About
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