Index-based Insurance in AgricultureManaging Risks and Uncertainty for Smallholder Farmers

Michael R. Carter

University of California, DavisBASIS Collaborative Research Support Program

I4 Index Insurance Innovation Initiative.

The CGIAR Research Program on Climate Change, Agriculture and Food Security(CCAFS)

CGIAR Science Seminar

September 19, 2012

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Outline

The ’same old story’ about risk:Uninsured risk makes & keeps smallholders poorCorrelated risk undercuts rural financial market developmentCycle continues

Crafting a new ending to this same old story:Change the structural conditions (uninsured risk) that createthese problemsIndex Insurance as an instrument to remove correlated risk andchange this story

Index insuranceLogicSocial protection through satellite-based livestock insurance inNorthern KenyaCrowding in credit supply & demand in Ethiopia for improvedproductivity

Moving forward: a research agenda for index insurance

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Risk Makes Smallholders PoorThe same old story, part 1

  Peruvian coastal agriculture is a commercially-oriented, high potential area   Dominated by small holders (land reform beneficiaries)   Yet a recent study suggests that financial market constraints on both demand and supply sides may reduce production by 25%   Index insurance can work on both sides of the financial market

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Risk Keeps Smallholders PoorThe same old story, part 2

  Evidence of poverty traps in N. Kenya

  Households whose assets fall below a critical threshold are unable to recover nor craft a pathway from poverty

  This dynamic over time creates ever growing numbers of food aid dependent people

  Index insurance can potentially alter this dynamic with ex ante & ex post effects

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Index InsuranceCrafting a new ending to the story?

Neither markets nor the public sector have been able tosurmount the risk & information conditions to find a happierending to this same old story about riskBut, is it possible to modify these conditions that underlieboth market and policy failures and open the door to a newending to this story?

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Index InsuranceCrafting a new ending to the story?

Index Insurance Hypothesis is that the removal of correlatedrisk with index insurance contracts will have importantdevelopment impacts because it will:

Serve as a novel form of social protection & alter povertydynamics in risk-prone areasIn higher potential areas, it will:

Crowd-in credit institutions and credit supplyRelax risk rationing & enhance demandUndercut destructive political economy

In both, it will incentivize prudential risk taking, spurring smallfarm productivity & income growth

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Index InsuranceWhat it is and how it functions

Conventional insurance measures individual losses and makesindemnity payouts based on those losses.Index insurance does not require measurement of individuallosses and makes common payments to insured based on thelevel of a single index correlated with lossesIndex insurance avoids problems that make individualinsurance unprofitable for small scale agricultural:

No transactions costs of measuring individual lossesPreserves effort incentives (no moral hazard) as no singleindividual can influence whether the index pays outAdverse Selection does not matter as payouts do not dependon the riskiness of those who buy the insurance

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Design of Index InsuranceIBLI Project in Northern Kenya (an I4-ILRI-Cornell collaboration)

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Design of Index InsuranceIBLI Project in Northern Kenya

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Design of Index InsuranceIBLI Project in Northern Kenya

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Evaluating the Development Impacts of Index InsuranceIBLI Project in Northern Kenya

Insurance functions, but will it modify poverty dynamics–theforces that keep households poor?Experimental design to test its impacts against conventionalaid

Region has a pilot cash transfer scheme„ the HSNPMeans-tested transfers are around $15/family/month

Theory suggests that we will see reduced long-term povertyrates when index insurance complements cash transfersthrough both ex post effects (fewer slide into poverty) and exante effects (more are incentivized to graduate from poverty)

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Evaluating the Development Impacts of Index InsuranceIBLI Project in Northern Kenya

Implemented privately provisioned index insurance in pastoralregions of Northern Kenya2x2 research design to measure impacts

Long-term design, but in 2011, payouts made throughout theinsured areaTook a quick look at impacts of these payouts on coping andasset accumulation/de-accumulation

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Evaluating the Development Impacts of Index InsuranceIBLI Project in Northern Kenya

33% drop in households employing hunger strategies (withsevere long-term consequences for the young)50% drop in distress sales of assets33% drop in food aid reliance (aid traps)In addition, accumulation & market effects:

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Evaluating the Development Impacts of Index InsuranceIBLI Project in Northern Kenya

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Ethiopian Project on Interlinking Insurance & Credit inAgriculture

Substantial yield gap for food grain farmers, even in higherpotential areasSmall fraction of farmers use improved varieties & fertilizersFlimsy system of agricultural finance based on state bankingthat almost completely collapsed in 2009 following a droughtTheoretical work indicates that interlinked credit-insurancethat transfers correlated risk can:

Relax lender portfolio restrictions on ag loans that make creditscarce & expensiveUndercut the destructive political economy that creates debtamnestiesEliminate risk rationing of borrowers

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Ethiopian Project on Interlinking Insurance & Credit inAgriculture

Research team from UC-San Diego, FAO and University ofAthens took on this challengeDashen Bank, which had never before lent to small-scaleagriculture, agreed to lend up to 15 million Biir under theinterlinked contract arrangementBundled credit-insurance is marketed as ‘state contingent loan’contracts to cover seed and fertilizer purchases;Marketed to farmers through village cooperative associations,which bundle demand and present it to DashenCurrent contract is a (sub-optimal) rainfall contract, withinsurance provided by Nyala InsuranceContract rolled out in July 2012 to producers in NorthernShoa, South Wolo, and Gojam.Demand estimated at 50 million Biir.

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Ethiopian Project on Interlinking Insurance & Credit inAgricultureResearch Design

Two arm trial in which 120 eligible Kebeles randomly dividedinto:

A control group (initially 40 Kebeles) receives no insuranceand no credit.A ‘standalone’ arm (40 Kebeles) receives only the indexinsurance product; we don’t prevent the use of credit but wealso don’t provide any explicit form of interlinking.The ‘interlinked’ arm (40 Kebeles) receives state-contingentloans.

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Ethiopian Project on Interlinking Insurance & Credit inAgricultureResearch Design

The study will then be conducted by comparing each of thetwo treatment arms to the control, and to each other.Provides a simple, transparent measure of the impact ofinsurance, the impact of interlinked insurance, and the impactof the interlinking itself.Three years of household surveys to track technology use andeconomic well-beingDashen Bank also needs to be convinced that the correlatedrisk concerns that have kept the Bank out of this market are infact addressed by the interlinked productStay tuned ...

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An Index Insurance Research Agenda

While these and other pilot projects seem promising, there ismuch still to learn about whether and how to do indexinsurance for developmentNeed innovations that:

Reduce the uncovered basis risk faced by farmers under indexinsurance contractsRespond to the risk management needs of women farmers bytargeting crops typically grown by women and, or that offerpayoff structures that meet the needs and preferences ofwomen producersIncentivize climate change adaptation investmentsProtect producers against price or revenue fluctuationsAre informed by insights from the behavioral literature on howhouseholds choose amongst risky and uncertain (ambiguous)prospects.Cost-effectively scale-up index contracts without undercuttingtheir effectiveness as risk transfer and developmentinstruments.

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Looking Forward

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While it is clearly importantto invest in new agriculturaltechnologies, also need tofind ways to realize theunderutilized potential ofalready existing agriculturaltechnologies

Innovative financialtechnologies offer animportant complement tomore conventionalagricultural technologyprogramsDrought resistancethrough financial or seedtechnologies?Still much to learn toresolve demand-sidechallenges & resolvingrisk as a developmentproblem

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