Weather Index Insurance

8/2/2019 Weather Index Insurance

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Innovations in Risk Transfer for Natural Disasters in Lower-IncomeCountries (Jerry Skees, University of Kentucky and Barry Barnett, Uni-versity of Georgia, Organizers)

WEATHER INDEX INSURANCE FOR A GRICULTUREAND R URAL A REAS IN LOWER -INCOME COUNTRIES

BARRY J. B ARNETT AND O LIVIER MAHUL

Innovations in risk transfer for natural disas-ters in lower-income countries, in particularweather index insurance products, can be usedto shift various weather-related risks. This arti-cle discusses the linkage between weather riskand poverty; provides background informa-tion on weather index insurance products; de-scribes requirements for the implementationof weather index insurance and possible rolesfor governments, donors, and internationalnancial institutions in facilitating implemen-tation; and briey reviews recent efforts toprovide weather index insurance products inrural areas of some middle- and lower-incomecountries.

Weather Risk and Poverty

Approximately 1 billion people live on lessthan $1 per day. Three-quarters of those livein rural areas (Chen and Ravallion 2007), andover one-half depend on agriculture or agricul-

turallaborastheirprimarysourceoflivelihood(International Fund for Agricultural Develop-ment 2001). Thus, poor rural households areparticularly susceptible to the nancial conse-quences of weather-related natural disasters.

Barry Barnett is Associate Professor in the Department of Agri-cultural Economics at Mississippi State University. Olivier Mahulis SeniorInsuranceSpecialistand Program Manager, Insurance forthePoorUnit, Financialand Private DevelopmentVice Presidencyof the World Bank.

This article was written when Barnett was Associate Professorin the Department of Agricultural and Applied Economics at the

University of Georgia.This article was presented in a principal paper session at theAAEA annual meeting (Portland, OR, July 2007). The articles inthesesessionsare not subjected to the journalsstandardrefereeingprocess.

Even if they are not directly involved in agri-cultural production, many of the rural poorhave income sources that are tied to the suc-cess ofagricultural production orareotherwisehighly susceptible to extreme weather events.

While health problems are often cited asthe greatest risk facing many rural house-holds, uninsured weather risks also contributeboth directly and indirectly to the existenceof chronic poverty. Extreme weather events,such as droughts and oods, can directly de-stroy productive assets that have accumulatedat high opportunity cost through years of fore-gone consumption. Households that are thrustinto poverty by such shocks often nd it dif-cult to recover and restart the long process of accumulating productive assets (Carter et al.2007).

Therisk of extreme weather events also con-tributes indirectly to the existence of chronicpoverty. Households that recognize the poten-tial for weather-related shocks are often re-luctant to forego short-term consumption toinvest in risky productive assets. Instead, theyadopt low-risk, low-return investment strate-gies that reduce their exposure to extremeweather events but also keep the householdtrapped in chronic poverty (Rosenzweig andBinswanger 1993; Carter and Barrett 2006).

In some areas the rural poor protect them-selves from weather-related losses using vari-ous structural mitigation measures. Exampleswould include supplemental irrigation to off-set the risk of insufcient rainfall or dams

and levies to control ooding. However, thesestructural mitigation strategies are not alwaysfeasible, reliable, or cost-effective. Householdscan also mitigate the nancial effects of risk

Amer. J. Agr. Econ. 89 (Number 5, 2007): 12411247Copyright 2007 American Agricultural Economics Association

DOI: 10.1111/j.1467-8276.2007.01091.x

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1242 Number 5, 2007 Amer. J. Agr. Econ.

through savings, diversi cation, share tenancy,producing lower risk outputs, or producingoutputs that require less investment in riskyproductive assets. However, these strategiesmaynotbeavailabletoallhouseholds.Further,the implied risk premium on such risk mitiga-tion strategies can be very high. Rosenzweigand Binswanger (1993) estimated the impliedrisk premium for risk mitigation strategiesemployed by some households in rural Indiaat 35%.

In principle, traditional insurance instru-ments, including crop insurance, can be usedto transfer the risk of extreme weather events.However, insurance markets are underdevel-oped and often nonexistent in rural areas of lower income countries due to poor contract

enforcement, asymmetric information, hightransaction costs, and high exposure to spa-tially covariate risks (Skees and Barnett 2006).These problems are particularly acute for cropinsurance.

Weather Index Insurance

In recent years, researchers and developmentorganizations have been exploring the po-tential for using weather index insurance toprovide risk management opportunities forthe rural poor. Weather index insurance paysindemnities based not on actual losses ex-perienced by the policyholder but rather onrealizations of a weather index that is highlycorrelated with actual losses. In its simplestform a weather index measures a speci cweather variable (e.g., rainfall or temperature)at a speci c weather station over a de nedperiod of time. Weather index insurance poli-cies specify a threshold and a limit that estab-lish the range of values over which indemnitypayments will be made. If the insurance pol-icy is protecting against unusually high real-izations of the weather variable (e.g., excessrainfall or extremely hot temperatures), an in-demnity is paid whenever the realized valueof the index exceeds the threshold. The limitis set higher than the threshold, and the in-demnity increases as the realized value of theindex approaches the limit. No additional in-demnity is paid for realized values of the index

that exceed the limit. Conversely, if the pol-icy is protecting against unusually low realiza-tions of the weather variable (e.g., drought orextremely cold temperatures) an indemnity ismade whenever the realized value of the index

is less than the threshold, and the limit is setlower than the threshold.

To illustrate how weather index insuranceworks, consider the following example of anindex insurance policy that protects againstinsuf cient rainfall over a three-month pe-riod, with rainfall being measured at a spe-cic weather station. The threshold is set at 100millimeters of rainfall and the limit at 50 mil-limeters. Assume the policyholder purchases$1,000 of insurance protection. If the realizedrainfall at the weather station is less than 100millimeters, the policyholder will receive anindemnity equal to $20 for each millimeterless than 100 millimeters, up to a maximum of $1,000 for rainfall realizations of 50 millime-ters or less. The indemnity does not depend on

losses incurred by thepolicyholder but is basedstrictly on rainfall measured at the weatherstation.

Relative to traditional insurance prod-ucts, weather index insurance has severaladvantages:

The insurance contract is relatively straight-forward, simplifying the sales process.

Indemnities are paid based solely on the re-alized value of the underlying index. Thereis no need to estimate the actual loss expe-rienced by the policyholder.

Unlike traditional insurance products, thereis no need to classify individual policyhold-ers according to their risk exposure.

There is little reason to believe that the pol-icyholder has better information than theinsurer about the underlying index. Thus,there is little potential for adverse selec-tion. Also, there is little potential for ex antemoral hazard since the policyholder cannotinuence the realization of the underlyingweather index.

Operating costs are low relative to tradi-tional insurance products due to the sim-plicity of sales and loss adjustment; the factthat policyholders do not have to be classi-ed according to their risk exposure; and thelack of asymmetric information. However,start-up costs can be quite signi cant. Re-liable weather and agricultural productiondata and highly skilled agro-meteorologicalexpertiseareallcritical for thesuccessful de-

sign and pricing of weather index insuranceproducts. Since no farm-level risk assessment or loss

adjustment is required, the insurance prod-ucts can be sold and serviced by insurance





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Barnett and Mahul Weather Index Insurance for Agriculture and Rural Areas 1243

companies that do not have extensive agri-cultural expertise.

An important limitation of index insuranceis that policyholders are exposed to basis risk.In this context basis risk refers to the imperfectcorrelation between the index and the lossesexperienced by the policyholder. It is possi-ble for the policyholder to experience a lossand yet receive no index insurance indemnity.Likewise, it is possible for the policyholderto receive an index insurance indemnity andexperience no loss. There are two potentialsourcesofbasisrisk.First,lossesmaybecausedby disease, insect infestation, or any numberof factors other than the weather variable onwhich the index is based. Unless the index is

based on a weather variable that is the dom-inant cause of loss in the region, basis riskwill be unacceptablyhigh. Second, theweathervariable used to drive the index may not behighlyspatiallycovariate. Thus, themeasure of the weather variable at the farm or householdmay be quite different than the measure at theweather station. Basis risk can be reduced byoffering weather index insurance only in areaswhere a particular, highly covariate weathervariable (e.g., drought or extreme tempera-

tures) is the dominant cause of loss.Finally, it is important to recognize thatin many cases the appropriate target mar-ket for weather index insurance may not beindividual households. Instead, the appropri-ate markets may be various local-level riskaggregators that is, organizations that dobusiness with many households in the localarea and thus are highly exposed to covari-ate weather risks. Examples would include mi-cronance entities and other formal or infor-mal lenders, mutual-aid associations, farmers cooperatives, input suppliers, output proces-sors,andevenlocalgovernmentsordisasterre-lief providers (Skees and Barnett 2006). Sincethese organizations aggregate risks from mul-tiple households, they can effectively pool id-iosyncratic risks; however, they remain highlyvulnerable to extreme covariate weatherevents.

Requirements for Weather Index Insurance

While the basic concept is simple, effective im-plementationof weather index insuranceis notat all simple. The continuing availability of ac-curate historical weather data is critical. It isalso necessary to determine whether any of theavailable weather variables are in fact highly

correlated with realized losses and if so, thetime periods in which losses are most likely tooccur. International experience hasalsoshownthat effective implementation requires carefulattention to the services currently being pro-vided by local risk aggregators as well as legaland regulatory constraints.Governments, donors, and international -nancial institutionscanfacilitate theofferingof weather index insurance by assisting with de-mand assessment; establishing an appropriatelegal and regulatory framework; collecting andmanagingthe requireddata; training insurancesuppliers and providing objective informationto potential users of weather index insurance;developing and pilot-testing potential weatherindex insurance products; and possibly pro-

viding some level of catastrophic risk-sharing.Each of these is discussed below.

Demand Assessment

Before investing in data collection and prod-uct development, it is important to assess thepotential demand for weather index insurancein a particular area. Personal interviews, focusgroups, and surveys can be used to determineanswers to the following questions: What arethe key weather perils of concern? How fre-quently do the perils occur and how signi cantis the impact? Who is affected by these per-ils? What mitigation or informal risk transferstrategiesarecurrentlybeingemployed?Whatis the (opportunity) cost of those strategies?How much are end users willing and able topay for an insurance product?

Legal and Regulatory Framework

To facilitate the offer of weather index insur-ance, governments must establishan appropri-ate legal and regulatory framework. The legalframework should address not only the properregulation of insurance sales but also contractenforcement. In many lower-income countriesinsurance is so poorly understood that courtsoften force insurance providers to pay indem-nities for losses that were clearly not coveredunder the contract provisions. Conversely, in-surance providers may refuse to pay claims topoor policyholders because they know that the

policyholders cannot afford to have an attor-ney represent them in court. Thus, to protectthe interests of small-scale policyholders, somesort of binding arbitration procedure is typi-cally desirable.

Even in countries where the legal and reg-ulatory system is more highly developed, the





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existing regulatory standards for traditional in-surance products may not be appropriate forindex insuranceproducts. Index insurancecre-ates unique regulatory challenges because theindemnities are not based on the actual loss in-curred. Also, index insuranceis highlyexposedto spatially covariate losses; so the minimumcapital (or contingent capital) requirementsneed to be higher than those for traditionalinsurance.

Data Collection and Management

For weather index insurance to be successful,both the insurer and the policyholder musthave con dence that the index is being mea-sured accurately and the data are secure from

tampering. To build this con dence, the under-lying index should be measured by a trustedgovernment or private sourceof publicly avail-able weather data.

In addition, a suf cient amount of histor-ical (normally daily) data on the underlyingweather variable must be available for the in-surer to estimate premium rates. The amountof historical data required depends on thefrequency of occurrence of the risk. Twentyyears of data may be suf cient to set initialpremium rates for relatively frequent weatherevents. Thirty or forty years of data may not besuf cient for infrequent but potentially catas-trophic weather events. Withoutsuf cient dataon which to base premium rates, the insurerwill either refuse to sell the insurance or add alarge premium load to account for uncertainty.

Since weather data have public goods char-acteristics, they are unlikely to be collected,cleaned, archived,and made publicly availableby private-sector companies. Government me-teorological bureaus usually provide these ser-vices. However, many lower-income countriesnd it dif cult to adequately fund meteoro-logical bureaus or sustain a suf cient net-work of weather stations. To facilitate theavailability of weather index insurance, somedonor organizations have provided fundingforexpanded meteorological services in lower-income countries.

Training of Insurance Suppliersand Consumer Education

Insurance suppliers in lower-income countriesare unlikely to be familiar with weather indexinsurance. Thus, they require training and ca-pacity building opportunities to build the ex-pertise needed to offer these unique insuranceinstruments.

Similarly, in rural areas of many lower-income countries, insurance products are notwidely available. Even if potential policyhold-ers are familiar with other types of insuranceproducts, they will almost certainly not be fa-miliar with weather index insurance. To makean informed purchase decision, it is criticallyimportant that potential policyholders under-stand the basis risk inherent with weather in-dexinsurance. That is, they need to understandthat they may experience a loss but not receivean indemnity. Thus, the successful introduc-tion of weather index insurance will require asignicant educational effort. While insurancesupplierswill provide some informationaspartof their sales efforts, potential policyholdersalso need information from objective sources.

Government entities and donor organiza-tions can provide training on weather indexinsurance to insurance suppliers. They canalso serve as an objective source of informa-tion and educational materials for potentialpolicyholders.

Product Development

Once a weather index insurance product is de-veloped and offered for sale by an insurancesupplier, it can easily be copied by competi-tors, since the underlying index is based onpublicly available data. This free rider prob-lem makes it very unlikely that private-sectorinsurance suppliers will invest in the researchand development required to bring a weatherindex insuranceproduct to themarket. For thisreason governments and donors have tendedto fund feasibility studies and pilot tests of newweather index insurance products.

Catastrophic Risk-Sharing

Local suppliers of weather index insurancepoliciesmustbeabletotransfertheirlossexpo-sure outside of the local area. Traditional linesof insurance (e.g., automobile, life, propertyandcasualty)areofferedonlosseventsthatarelargely uncorrelated, so the law of large num-bers reduces the variance in indemnities forlocal insurance providers. But weather indexinsurance protects against spatially covariateloss events. When a policyholder collects an

indemnity on a weather index insurance prod-uct, all other holders of that same policy willbe collecting indemnities as well. This impliesthat, in any given year, indemnities can be veryhigh relative to premiums collected. While inprinciple it may be possible for insurance sup-pliers to set aside adequate liquid reserves





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to cover the potential for large indemnities,in practice this is highly unlikely. There is ahigh opportunity cost associated with keepingsuch large amounts of capital in investmentsthat can be readily liquidated. Further, inmany countries there are tax disincentives forholding large reserves. Thus, index insurancesuppliers generally obtain contingent capi-tal via reinsurance. Catastrophe bonds andcontingent loan mechanisms can also be usedas sources of contingent capital.

Governments and donors may also assistwith providing contingent capital to suppliersof weather index insurance. Some evidencesuggests that those at risk tend to ignore theprobability of themost extreme andinfrequentloss events (Kunreuther 1996; Kunreuther and

Slovic 1978). But insurers and reinsurers of weather index insurance cannot afford to ig-nore the potential for such events. They mustload premium rates to re ect the potentialfor highly infrequent weather events, includ-ing events that are more extreme than any inthe available historical data. Since there areno data from which to calculate the frequencyand magnitude of such extreme events, insur-ers and reinsurers tend to be extremely con-servative when calculating the premium load.This creates a gap between what buyers arewilling to pay and what sellers are willing toaccept for protection against extreme weatherevents.

To address this market failure, governmentsor donors can provide contingent nancing(e.g., reinsurance or contingent loans) for ex-treme realizations of the weather variableunderlying the weather index insurance prod-uct. To keep from crowding-out private sec-tor risk transfer markets, any government ordonor contingent nancing should be carefully

Table 1. Weather Index Insurance Policies Sold in Middle- and Lower-Income Countries

Country Product(s) Clients Comments

Mexico Drought index insurance State governments 1.2 million hectares covered;premium volume of US$17million

India Drought index insurance formain crops (rice,groundnut)

Small farmers servicedthrough direct agents orrural nancial institutions

250,000 policies sold in200506; premium volumeof about US$20 million.

Ukraine Drought index insurance Large farms Only 2 contracts sold in 2005Malawi Drought index insurance forgroundnut

Small borrowing farmers 2,500 policies sold in 2006.Premium volume of US$7,000

Ethiopia Drought index insurance World Food Program US$7 million coverage.China Drought index insurance for

vegetablesBorrowing farmers Small-scale pilot in Shanghai.

structured so that it covers only the most ex-treme weather events. If insurance supplierscan obtain contingent nancing for this ex-treme tail risk at a reasonable cost, they canpass along the bene ts in lower premium coststo policyholders. This will increase the num-ber of policies sold, thus increasing marketopportunities for reinsurers to provide contin-gent nancing against all but the most extremeweather events.

International Experience

Experience with weather index insurancein middle and lower income countries isboth too limited and too recent to drawconclusions about its long-run sustainability.Table 1 lists some middle- and lower-incomecountries where weather index insurance hasbeen sold to date. However, except forMexico and India, sales have occurred withinpilot programs; so the volume of business hasbeen marginal. In addition, weather index in-surance products are currently being devel-oped in several countries (table 2).

Among middle- and lower-income coun-tries, MexicoandIndia currentlyhave themostdeveloped weather index insurance programs.

In both countries the products offered fo-cus primarily on rainfall de ciency (drought).Also, in both countries technical support, pro-vided by international organizations, facili-tated the offering of weather index insuranceproducts.

Mexico

The Mexican public reinsurance companyAgroasemex has been providing weather in-dex insurance since 2001. Most of the poli-





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Table 2. Weather Index Insurance Policies under Development in Middle- and Lower-IncomeCountries

Country Product(s) Clients Comments

Tanzania Drought index insurancefor maize

Small borrowing farmers Dry run launched in 2007.Full implementation in

late 2007.Nicaragua Drought index insurance Small farmers Under implementationThailand Drought index insurance Small borrowing farmers To be implemented in 2007Kazakhstan Drought index insurance Medium and large farms Complements compulsory

multiple peril cropinsurance.

Senegal Drought index insurancefor peanuts

Small borrowing farmers Possible link with an areayield insurance scheme.

Morocco Drought index insurancefor major crops

Borrowing farmers Complements theindemnity-baseddrought insurancescheme.

Bangladesh Drought index insurancefor rice

Small borrowing farmers To be piloted in 2008

Bangladesh Flood index insurance Natural disaster fund Work in progressVietnam Flood index insurance Small borrowing farmers Work in progressCaribbean Islands Drought index insurance

and hurricane indexinsurance

Cash crop farmers Newly establishedCaribbean CatastropheRisk Insurance Facility

cies are based on rainfall, but some havebeen based on temperature and wind speed.The policies are marketed primarily to state

governments in Mexico to protect againstcalamities (mainly drought) in the statesand are linked to the social program FondoNacional para Desastres Naturales (NaturalDisasters Fund FONDEN). In 2005, 1.16million hectares in eighteen states were cov-ered by the contracts. In 2006, 2.3 millionhectares were covered. This represents 28% of the dry-land (nonirrigated) crop area in Mex-ico. Themain limiting factor to providingwidercoverage is a lack of rainfall data and weather

stations. India

Agriculture accounts for around 23% of India s gross domestic product. An estimated65% of the population is engaged in agricul-ture and associated activities. Most of the agri-cultural production is small-scale. Of the morethan120 million landowners, 80% own parcelsof less than 2 hectares. Weather risk is a majorconcern to agricultural producersandagribusi-

nesses alike. It is estimated that rainfall vari-abilityaccounts for more than 50% of the vari-ability in crop yields.

Weather index insurance was rst intro-duced in India in 2003. In collaboration withthe micro nance institution BASIX, ICICI

Lombard General Insurance Company be-gan selling a rainfall index insurance product.BASIX holds no risk on the insurance poli-

cies but instead acts as an intermediary thatreceives commissions from selling the indexinsurance to its customers. Between June 2003and March 2006, BASIX sold a total of 7,653rainfall index insurance policies in six Indianstates.

The parastatal agriculture insurance com-pany AICI introduced a weather index in-surance product in 2004. In 2005 06, AICIsold weather index insurance policies to morethan 125,000 farmers. Most (98%) were sold

to farmers in the State of Maharashtra. TheWorld Bank has provided technical assistanceto the Government of India and AICI in thedevelopment of weather index insurance. Thisassistance has focused on product design, rat-ing, and large scale implementation.

Conclusion

Effective mechanisms for transferring risk cancatalyze investment and economic growth,

thus contributing to poverty reduction in ru-ral areas of lower income countries. Weatherindex insurance is a relatively simple conceptthat under certain circumstances can effec-tively transfer spatiallycovariateweather risks.While experience to date is too limited and too





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recent to draw general conclusions about thelong-run sustainability of weather index insur-ance, the experience in Mexico and India sug-gests that at least in some areas, these productsmay prove to be a valuable risk transfer mech-anism for the rural poor.

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Weather Index Insurance

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