The Potential for Scale and Sustainability in Weather Index Insurance

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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. 21
22 CHAPTER 2 WEATHER INDEX-BASED INSURANCE even be rather like traveller’s cheques or lottery tickets to any willing buyer, though the existing insurance law in many countries would not allow this option. Index insurance also has its disadvantages. It is expensive to launch: significant resources and technical expertise are required to conduct the initial research and development, build the capacity of local insurers and others in the delivery channel, effectively raise the awareness of potential clients and market the product, and, in some cases, access data. Index insurance is potentially useful at different levels: at the micro level, households can benefit from the additional risk-management strategy; at the meso level, financial service providers, input suppliers and traders can balance their portfolios and manage certain business constraints; and at the macro level, index insurance can aid governments and relief agencies in development and disaster management. Table 2. The framework – index insurance for disaster relief and development, and the various beneficiaries Index insurance for Index insurance disaster relief for development Macro Government Government protects itself against shocks: early liquidity/ first relief outlays Government reinsures insurers Relief agency Funds its operations through an index-based risk-transfer contract or provides coverage through an index trigger contingent voucher Meso Financial service FSP buys portfolio insurance or provider (FSP) group insurance to retail to Government could use banks, farmers, linked to credit Farmer association FSPs, input suppliers, farmers’ Farmers’ association buys group associations and NGOs to insurance to retail to farmers, distribute vouchers for linked to credit Input supplier catastrophe insurance Input supplier buys group insurance to retail to farmers, linked to input purchases NGO NGO buys group insurance to retail to farmers Micro Farmer Farmer receives explicit, Farmer buys insurance as part of redeemable, predictable coverage a package (e.g. credit and other against a well-defined shock, financial services, technology, and the premium is paid for mostly by government agricultural information)
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Contacts IFAD Francesco Rispoli f.r
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The Potential for Scale and Sustainability in Weather Index Insurance

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