Index Insurance in a Context of broader risk management strategies Risk Reduction for smallholder farmers: Making weather Index Insurance work

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Risk reduction for smallholder farmers:
Making weather index insurance work
Alain de Janvry and Elisabeth Sadoulet
University of California at Berkeley
IFPRI workshop on “Opportunities for the New PMFBY Agricultural Insurance
Program”, New Delhi, December 21, 2016

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1. Uninsured risk is a major cause of low investment in
agriculture and high rural poverty
• Agriculture is a risky business, especially due to extreme
weather events
• Most investments in improved productivity (HYV, high
value crops, fertilizers) increase exposure to weather risks
• Climate change makes exposure to extreme events more
likely and harder to predict
• Such events lead to:
oEx-post decapitalization to cope with shocks (e.g., sale
of assets, dis-saving, use of liquidity for consumption):
farmers are less able to plant the year after a shock
oEx-ante self-insurance by reducing investment in higher
risk-higher expected income options (such as high
yielding varieties, fertilizers) and distorting asset
portfolios (toward more liquid assets)

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2. Traditional approaches to risk-reduction do not work for
smallholder farmers
oInformal risk pooling arrangements (mutual insurance) do
not help address weather risks as covariate (Townsend 1994)
oTraditional indemnity-based insurance does not work for
smallholder farmers as too difficult to implement (lack of
regulation) and excessively costly

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3. Weather index insurance (WII) is an appealing way of
offering insurance to smallholder farmers
oPayouts are triggered by an observable indicator/index falling
below a threshold. Indicator can be:
oWeather events (rainfall) measured at meteorological
stations
oAverage small area yields measured by crop cuttings or
aerial/satellite observations
oPayouts are not based on actual individual damages as assessed
by an insurance adjuster

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Index insurance: Role of threshold in triggering payments

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oPresumed advantages
oAvoids lengthy and conflictual claims process,
oEliminates mis-behavior by client: no room for Moral
Hazard and Adverse Selection
oAllows quick, automatic, and transparent disbursements
oCheap to implement for large numbers of smallholder
farmers
oEx-post protection from shocks (insurance payouts) should
induce ex-ante investment effects (production response)

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4. However, index insurance has met with low uptake unless
heavily subsidized by government
Take-up of index insurance as a % of the market price: high take-up with high
subsidy, but falls to only 1-18% at market price
Source: ATAI 2016

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oAll large scale index insurance programs are heavily
subsidized by government
oIndia: 60% uptake with 75% subsidy (AICI)
oChina: 40% uptake with 60% subsidy (PICC)
oInterlinks between insurance and credit have not worked:
oLow demand (Gine and Yang for Malawi)
oDemand for interlinked loans lower than for standalone
loans: 2% uptake in Ethiopia (Ahmed et al.)

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5.Main reasons for low uptake are:
oBasis risk: an incomplete/imperfect insurance
oNo weather index is perfectly correlated with yields even
with data collected at the farmer’s field
oIndex measured at distant weather station or for average
area
§ In UP, demand for WII declines by 6.4% for every
kilometer in distance to weather station
oBasis risk creates ambiguity about the value of the
insurance product. Strong ambiguity aversion deters
demand for index insurance.
This makes WII into a partial insurance, with eventually a
double loss: pay the premium and do not get payout in bad year
(Clarke, 2016). Hence insurance can make the worst that can
happen eventually worse than without insurance.

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oHigh cost due to
oHigh loading (40-60% premium in excess of fair price in
developing countries)
oData premium (lack of long data series prevents from
accurately calculating risk, and this ambiguity is charged as
an extra premium)
oLack of re-insurance (hence insurance provider bears
extra risk)
oBehavior: index insurance difficult to understand for farmers
oLack of trust in insurance company that payouts will follow
triggering (opposite of microfinance)

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6. But index insurance works for shock-coping and risk
management where up-taken:
oIn Mexico, insured farmers plant more the year after a shock
than non-insured farmers (de Janvry et al., 2016)
oIn Kenya, insurance helps pastoralists avoid reducing
consumption (poor) and decapitalizing livestock (rich) in
response to a drought (Janzen and Carter, 2013)
oIn Andra Pradesh, farmers who receive insurance are 6%pts
more likely to plant cash crops rather than subsistence crops
(Cole et al., 2014)
oIn Andra Pradesh, Uttar Pradesh, and Tamil Nadu, insured
farmers use riskier higher-yielding production methods
(Mobarak and Rosenzweig, 2013)
oIn Ghana, index insurance induces farmers to plant more
maize and use more fertilizer (Karlan et al., 2013)
Hence, worth trying to induce more take-up at market prices

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7.Many opportunities exist to make index insurance into a
better product
a.Better contract design
i. Fail-safe contracts: combine area indexing with audits.
Audit is provided if the index outcome is challenged
(Elabed et al., 2013)
ii. Institutional-level contracts: producer organization,
municipality, bank. Insured institution can in turn
distribute the index-based payouts based on observed
damages. Hence, focus on institutions with formal or
informal risk-sharing capacity
b. Better data and measurement
i. Better yield predictions at the plot level using remote
sensing (satellite) and crop modeling (Lobell, 2015)
ii. IFPRI proposal: drones data, geo-referenced crowd-
sourcing photography

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c.Better marketing
i. Regulation (like for seeds): Safe minimum quality
standards for index insurance. Guarantee that the
market price is below the reservation price (max price
that client can pay without being made worse off)
(Carter)
ii. Pricing and smarter subsidies: Demand is highly price
elastic. Subsidy is needed to promote adoption
(learning) or to reach a given uptake (40% for PICC in
China). If there is stochastic learning with recency bias
and discouragement, subsidy needs to be adjusted every
year based on past price (subsidy) and past payouts (Cai
et al., 2015)
iii. Offer subsidized index insurance as a social safety net:
avoid high fiscal cost of erratic relief expenditures
(CADENA Mexico, China)

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d. Better delivery
i. Financial literacy: extending the length of the
promotion session increases uptake from 30% to 50%
in China (Cai et al., 2016). Diffusion of information
through social networks help make financial literacy
training cost effective.
ii. Trust in insurance provider: learning-from-others by
witnessing insurance payouts increases own demand

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8.Combine index insurance with other risk-mitigating
instruments
a.Incentives to precautionary savings: nudges more
important than higher interest rates in motivating
precautionary savings (Karlan)
b.Emergency loans: BRAC indexed emergency loans offered
as an ex-ante credit line to good clients (minimum score
based on credit history)
c.Risk-reducing technology: use resilient technology for
small shocks; use index insurance for larger shocks when
technology fails (drought and flood tolerant varieties)
i. Resilient technology has yield advantage in bad years:
45% yield advantage after 10 days submergence

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Shock-coping value of flood tolerant rice

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Flooded rice field in Odisha and yield resilience

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ii. Down-side risk reduction induces farmers to invest
more in all years:
1.Cultivate more land, use more fertilizer, adopt more
labor intensive planting methods, hold less
precautionary savings, and take more credit.
2.Achieve higher yields in both flood and non-flood
years, with expected gains in good years about
equal to avoided losses in bad years.

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d.Managing risk with a portfolio of instruments: optimum
combination of self-insurance, resilient technology,
precautionary savings, emergency loans, and index
insurance
Portfolio management of weather risk for smallholder farmers
Based on concepts in Clarke and Dercon (2016) and Mahul (2016)
Frequency Severity Risk financing Ex-ante risk management Ex-post shock coping
of event of impact strategy (arranged before a disaster) (arranged after a disaster)
Low Major Risk transfer Social safety net Discretionary aid
Index insurance
Risk retention Contingent pre-approved credit line Emergency credit
Resilient technology Adjusted income strategy
High Minor Precautionary savings Expenditure reallocation
Risk layers

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Combining resilient technology, index insurance, and other financial products for
risk management
Traditional technology (Swarna)
Farmer gross income Resilient technology (Sub1)
(% of normal year)
Resilient technology and index insurance
100
Precautionary savings area
Resilient technology area
Contingent credit area
Index insurance area
Social safety net area
0 100 % yield shortfall
with traditional technology

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9. Conclusion
a.Weather index insurance can be uniquely effective for
smallholder farmers but has not worked commercially
b.There are many ways of improving the product and
enhancing its take-up making it into a viable commercial
product
c.Most important is to:
i. Reduce basis risk: better contract design, better
indices, better data
ii. Insure at the institutional level: banks, governments,
producer organizations, groups that already do risk
smoothing (Dercon, Ethiopia; McIntosh et al.,
Guatemala)
iii. Combine insurance with other risk-management
instruments (risk layering and portfolio approach):

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precautionary savings, resilient technology, contingent
pre-approved credit line, social safety nets
iv. Embrace and optimize the use of smart subsidies:
justified by social learning, externalities (better risk
management induces investment), predictable public
expenditures, better social safety nets, reduced
clientelism in relief
alain@berkeley.edu
esadoulet@berkeley.edu