The Potential for Scale and Sustainability in Weather Index Insurance

THE POTENTIAL FOR SCALE AND SUSTAINABILITY IN WEATHER INDEX INSURANCE
FOR AGRICULTURE AND RURAL LIVELIHOODS
Chapter 2
Weather index-based
insurance
The concept of index insurance is not new. 4 Proposals for this type of insurance were
first articulated by Halcrow (1948) and Dandekar (1977), and area-yield insurance
has been tried on a heavily subsidized basis in Canada, India, Sweden and the United
States (Miranda 1991; Mishra 1996; Skees, Black and Barnett 1997). The Australian
Government commissioned a feasibility study of rainfall insurance in the mid-1980s,
but decided not to pursue it (IAC 1986).
Index insurance is a financial product linked to an index highly correlated to local
yields. Contracts are written against specific perils or events (e.g. area yield loss,
drought, hurricane, flood) that are defined and recorded at regional levels (e.g. at a
local weather station). Indemnifications are triggered by pre-specified patterns of the
index, as opposed to actual yields, which eliminates the need for in-field assessments.
In addition, because the insurance product is based on an independently verifiable
index, it can be reinsured, thus allowing insurance companies to transfer part of their
risk to international markets.
All buyers in the same region are offered the same contract terms per dollar of
insurance coverage. That is, they pay the same rate of premium and, once an event has
triggered payouts, receive the same rate of payout; their total payout depends on the
value of the insurance coverage purchased. Payouts can be structured in a variety of
ways, ranging from a simple zero/one contract (i.e. once the threshold is crossed, the
payment rate is 100 per cent), through a layered payment schedule (e.g. a one-third
payment rate as different thresholds are crossed), to a proportional payment schedule.
There are several advantages to index insurance. Since all buyers of the same
contract pay the same premium and receive the same indemnity per unit of insurance,
regardless of their actions, index insurance avoids the problems of adverse selection
and moral hazard. Thus a farmer with rainfall insurance possesses the same economic
incentives to manage her crop as an uninsured farmer.
Once established, index insurance can be less expensive to administer than
traditional agricultural insurance, because there are no on-site inspections or individual
loss assessments to perform. It uses only the data of a regional index, which can be
based on data that are available and generally reliable. At the extreme, contracts could
4 This paper focuses on the use of weather index-based insurance, but will also use the term ‘index insurance’ for
the sake of simplicity and brevity.
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