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 Drawing on social protection literature (Grosh et al. 2008) and a recent publication on index insurance by the International Research Institute for Climate and Society (Hellmuth et al. 2009), one sees that index insurance can be used as a tool for disaster relief or for development: Index insurance for disaster relief would protect people – their lives, health and assets – against catastrophic losses. It could help save lives and livelihoods through faster, more cost-effective responses to disasters. Index insurance for development helps farmers protect their investments, can open doors to ways to increase incomes (e.g. contract farming, access to credit), and can be part of a wider strategy to help farmers escape poverty. Of course, these two roles are not independent, but the primary objective of the products will be different, and thus the design, delivery channels and clients of these products will also be different. Index insurance for disaster relief Index insurance could help manage catastrophic and highly covariate risks such as hurricanes, floods and severe (possibly back-to-back) droughts. The clients for these products would typically be the public or NGO relief agencies that respond immediately after catastrophes. The purpose is to provide rapid and early assistance to help affected people cope with and recover from natural disasters. The insurance should be written against weather events that correlate highly with loss of life, livelihoods and major assets, and for which public relief is often given. One way the relief agency could use index insurance would be to retain the insurance payouts and use them to directly fund its own relief efforts (Case Study 1: Mexico). The index insurance could provide timely and certain access to funds in the event of an insured catastrophe. By selecting a weather-based index that is an early or lead indicator of an emerging crisis, an insurer can make quick payments to relief agencies and households, avoiding the usual delays incurred when relief agencies must first demonstrate an emergency and then appeal for donations from governments and donors. Studies have shown that the earlier that relief arrives after a shock, the greater its effectiveness in cushioning adverse welfare impacts, avoiding the distress sale of assets and speeding up recovery (Dercon, Hoddinott and Woldehanna 2005). As another approach, the relief agency could work in an ex ante manner and distribute insurance vouchers every year to targeted households, which could then cash them in during an insured emergency and use the funds for their own discretionary purposes. These benefits could be amplified if relief agencies distributed insurance coupons to households in advance of a catastrophe, since households could then have direct access to cash to meet some of their immediate needs. The use of vouchers would enable relief to be more precisely targeted to the more vulnerable 23
24 CHAPTER 2 WEATHER INDEX-BASED INSURANCE households. Since the voucher distribution would be undertaken annually, appropriate targeting procedures could be developed, avoiding the more chaotic allocations and associated leakages that can arise when relief must be hastily distributed. There are many questions and challenges associated with this idea that still need to be fully considered, including the logistical and operational implications of retailing such vouchers (e.g. what would happen if potential beneficiaries lose their vouchers in the catastrophe?; where could beneficiaries redeem the vouchers if the catastrophe chokes off supplies to markets and dramatically increases the price of what is left?), the massive raising of public awareness required, and the risks to the reputation of the relief agency, among others. In practice, some combination of the first and second options may be best. Using index insurance for disaster relief would also have implications for the way relief is funded. Instead of ad hoc fundraising whenever emergencies arise, the financial needs of relief agencies could be annualized in the insurance premium. Governments and donors would then face a predictable annual contribution, which could be easier to budget for. However, changeable government objectives and donor priorities could undermine the sustainability of this approach over time. Index insurance for development Index insurance for the promotion of agricultural development seems most promising for helping households, financial service providers and input suppliers manage lowto medium-frequency, covariate risks such as drought, major pest outbreaks and excess rainfall (see Table 2 on page 23). To serve a development purpose, the index should be defined against events that are highly correlated with regional agricultural production or against the loss of key productive assets. However, extending insurance to high-frequency, weakly covariate or independent risks (e.g. localized hail damage or small-scale flood events) would make it difficult to identify regional indices that have an acceptably low level of basis risk (the potential mismatch between indextriggered payouts and the actual losses suffered by the policy holder). Moreover, households and financiers often have alternative and more cost-effective ways of managing these less covariate risks (see Table 1 on page 14). With development-focused index insurance, households can play an important role in protecting their productive assets and consumption, thereby putting themselves in a position to pursue riskier, but potentially more profitable farming strategies. However, these gains may be too modest on their own to justify paying an unsubsidized insurance premium each year. The real payoff from development-focused index insurance arises when it unlocks access to high-value markets, modern technologies and inputs, agricultural information, and credit and other financial services (Case Study 2: India – PepsiCo). Such comprehensive agricultural development packages can lead to game-changing
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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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