The Potential for Scale and Sustainability in Weather Index Insurance

26
CHAPTER 2
WEATHER INDEX-BASED INSURANCE
achieved sufficient income growth to afford the premiums. Of course, subsidies on a
longer-term basis can create perverse incentive problems. Nevertheless, their use may
still be a more cost-effective and less distorting approach than some types of safety
net programmes.
Another important question is whether to insure development providers or to
insure farmers directly. Each strategy has potential benefits and pitfalls.
There is continuing debate as to whether financial service providers (or other actors
in the supply chain) would be interested in using index insurance to cover their own
lending portfolios against low-frequency, highly covariate events. In principle, such
policies would protect their capital against widespread defaults during major
catastrophes. But these policies would not help their household-level borrowers cope
with risk, nor would they help repair providers’ relationships with clients after the
clients have defaulted. The provider would still have the bad loans on its records, and
it would be very reluctant to lend to these borrowers again. As a result, financial service
providers may prefer that their borrowers use the index insurance as part of their
household risk-management strategy and thus deal directly with the risk where it
occurs. In this case, the ultimate responsibility for repaying the loan remains with the
individual borrower, while in times of distress, the payouts from the index insurance
would repay the debt and prevent the eventual rescheduling of or default on the loan.
That said, the retailing of products such as index insurance directly to individuals
is the most difficult, time-consuming and costly approach, particularly in developing
economies with limited access to financial services. The use of aggregators
(e.g. agricultural processors, input suppliers, financial service providers, farmers’
associations) is key to reducing these transaction costs, reaching more clients, and
eventually bringing the reach of the products to a meaningful scale. To achieve this,
index insurance products could be designed to cover the portfolios of aggregators as
well as the household-level risk of individual farmers. Under this strategy, the
aggregators that are still facing major systemic risks could mitigate part of the risk with
an index insurance policy, while a longer-term effort reaches out to cover individual
households with index insurance as part of a wider development and disaster
management approach.
Challenges for index insurance
Demand
Relief agencies would provide the demand for disaster-relief index insurance. While
the number of contracts written may be few, their size could be large enough to
constitute a market and attract bids from international insurers. There are many areas
in which humanitarian crises are sparked by major weather shocks, and where public
and NGO relief agencies could usefully be insured with an index product. An
important constraint, however, would likely be the hesitation of governments to use
public funds to pay insurance premiums that in most years do not generate a visible