Weather Index Insurance, Lending to Small Farmers, and Credit Risk Management

Jerry Skees, President, GlobalAgRisk and HB Price Professor at the University of Kentucky

Our MissionGlobalAgRisk, Inc. is committed to improving financial services for the rural poor through innovative approaches for transferring weather risk

Current projects in Mongolia, Peru, and Vietnam

www.globalagrisk.com

Introduction MFIs are contributing to economic development in lower

income countries Experienced fantastic growth Empowered the poor Effective sustainable solution

Focus on improving MFI business Increasing access to credit for many segments Increasing MFI solvency Still agriculture and rural MFI access is limited

Innovations in risk transfer to ease constraints for Agricultural and Rural lending to small holders Household insurance for livelihoods disruption due to

catastrophic natural disaster risks Business interruption insurance for rural lenders

High Concepts

Lenders can attempt to pool risk May be possible when risks are independent Can lead to very poor results if risks of borrowers

are correlated

Agriculture still dominates the rural economies of many lower income countries

Financial markets are largely undeveloped in rural areas

Correlated Risk in agriculture remain a major reason

Consider 2 Villages Both villages have 30 households In an average year, each household expects

to receive US$1,000 Three income earning activities are available

1. Crops2. Livestock3. Off-farm income

Village 1 versus 2 In Village 1 — All 3 outcomes of income will all

occur in a single year (Independent Risk)0 1/3 of households1,000 1/3 of households2,000 1/3 of households

In Village 2 — All households get the same income in the same year (Correlated Risk) 0 1 in 3 years

1,000 1 in 3 years2,000 1 in 3 years

Goal — Assure that no household has less than $1,000 of income in any given year

Solutions for Village 1 Social solution – pre agreement for those 10 households with

$2,000 income to transfer $1,000 to those with $0

Banking solution – pre agreement for those 10 households with

$2,000 income to loan $1,000 to those with $0 Insurance solution – pre agreement for all 30 households to pay

$333 to pre finance the outcome of 10 households receiving $0

More on the Insurance Solution Village 1

Insurance: (1/3 = .3333)

Premium = .3333 x $1,000 = $333

Available: $333 x 30 households = $10,000 Remember in every year there will be 10

households with $0

Need: $1,000 x 10 households = $10,000 The pool works because exactly 10

households get $2,000 and can transfer $1,000 to the 10 households getting $0

Reaching the Goal in Village 2 Pooling risk is impossible since in any given

year all 30 households can get 0 income, $1,000 income, or $2,000 income

If everyone in the community receives $0 income, everyone will starve and there is no opportunity to help one anotherNeed: $1,000 x 30 households = $30,000 to protect against the $0 outcome (reserving)

In this scenario, microfinance and mutual insurance that are geographically limited will fail

Correlated Risk Affects Large Numbers Regarding correlated risks, the local community will

not be able to diversify their risk A major weather shock (drought, flood, etc.) can

affect Crop income Livestock Off-farm jobs

In reality, household incomes tend to be neither completely independent nor completely correlated within a community

Microfinance and mutual insurance works for pooling independent risk

The challenge is still the correlated risk

Insurance for Correlated Risk Goals for insuring correlated risk

1. Transfer risk out of local community2. Offer affordable coverage keep transaction

costs low

Insuring correlated risk has been problematic To make money selling insurance, premiums

collected must cover1. Expected indemnities (Price of risk)2. Administrative costs

Return to Village 2 If we knew that the 0 outcome for everyone

was clearly associated with lack of rainfall, an outside financial interest could write an insurance that would pay when there was a shortage of rainfall

Weather Index Insurance —Creating New Opportunities Indemnities based on an objective,

transparent measure that is important for livelihoods Precipitation Temperature Flood levels

Does not require inspection of losses Eliminates most asymmetric information

problems This is weather insurance, not crop insurance

Pricing Index Insurance

Price of Index Insurance =

Increases opportunities for affordable coverage

Weather Index Insurance Limitations Basis risk

Correlated risks only

Mostly single peril coverage

Weather data — Requires reliable historical and ongoing weather data

Example of an Excess Rainfall Insurance Product Extreme rainfall in India — Payments would

occur anytime rainfall exceeds 2000 mm Client might buy US$1,000 liability

500 1000 2000 3000 40000

Payout Structure for an Example Excess Rainfall Contract

$1 for every 1 mm excess of 2000 mm $1,000 limit at 3000 mm

Some Examples of Index Insurance Mongolia – Index on soum (county-level) mortality to

protect against dzuds (winter events that kill millions of animals) 14 percent of herders insured in year 2

India – Rainfall index insurance mostly against drought – nearly 1 million farmers purchased this is 2007

Malawi – Rainfall index insurance against drought – tied to lending and purchased of improved seeds

Peru and Vietnam – Index insurance products designed to protect the portfolio of agricultural lenders

Mexico – Macro index insurance to pre finance public expenditures after a natural disaster

Lessons Learned from Experience with Weather Index Insurance

1. Works best for CAT risks Household risk coping approaches cannot

manage these risks These are the most disruptive events Reduces basis risk Better for low-quality data Most not be sold as crop insurance Can be used to protect against many livelihood

strategies

Maintaining Household Interest inCAT Coverage How do you keep households interested in

CAT risk coverage? Cognitive failure Limited resources — High opportunity cost for

purchasing insurance In the best interest of rural lenders that

households address CAT risk rural lenders dependent upon household cash flow

Two options1. Micro product — Livelihoods disruption for

households2. Meso product — Business interruption for credit

risk of rural lenders

1. Micro Level — Livelihoods Disruption Households involved in many livelihoods

(crop, livestock, off-farm) Disaster can affect all of them Income shocks can endanger lives of

household members Weather insurance for livelihoods disruption —

Provides risk management for all activities affected by that weather shock (e.g., drought affecting crops, livestock, etc.)

Benefits of Insurance forLivelihoods Disruption Household benefits of improved risk

management Protects many livelihoods, not just one household

crop More likely to specialize in higher-return activities

e.g., Improved seed varieties or inputs for higher-expected returns

For rural lenders this reduces the risk of borrowers Can use indemnities to repay loans Reduces need to ration credit Can lead to lower interest rates as correlated risks

must be built into interest rate charges

Increasing Uptake of Insurance for Livelihoods Disruption Households may still need incentives to purchase

Households need immediate benefits to overcome opportunity cost and cognitive failure

Linking insurance to services — Providing household benefits now Linking insurance to credit

Improved access to credit Credit at lower rates Reduced delivery costs for both products

Linking insurance to savings Improved access to savings Insurance for CAT risks complements savings for

small/moderate risks Linking insurance to inputs (Improved seeds, fertilizer)

Can protect loans to cover inputs Increases investments/use of credit

Household Products Are Difficult to Create Household products to address CAT risk

directly is ideal, but can be difficult to create Problem of household interest Problem of delivery Need appropriate insurance company

Instead, a business interruption product for firms may be an important first step

Framing this as business interruption insurance should have a strong appeal to insurance regulators

2. Meso Level — Business Interruption Portfolio risk is a major problem when lending

for production has correlated risks in the region MFIs could purchase product to insure its

lending portfolio Low basis risk — Idiosyncratic effects are

smoothed across portfolio Benefits

Increases lending for MFI Provides cash when debt restructuring/defaults are

leading to cash flow problems Helps ensure solvency of MFI Pass-through to households?

Peru — Proposed Business Interruption A severe El Niño adversely impacts farmers, processors,

transporters, and retailers A severe El Niño raises default rates for loans for agriculture

(as much as 12-20 percentage point increase in current rates)

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year

De

fau

lt R

ate

s

ENSO

RFA High Rice Prices

Risk Is Loaded into Interest Rate Charges Cost of capital 10 Administrative cost +18 Cost of risk loading? +12

percentage points Cost of Loans to farmers 40

Challenge — Could Risk Transfer of El Niño Risk take even ½ of the 12 percentage points out of this equation?

Peru — Proposed Business Interruption Payouts based on NOAA measure of sea

surface temperature To be sold to MFIs for business interruption Provided by local insurer Global reinsurer providing risk transfer Regulator has approved El Niño product

Measuring El Niño

Positive ENSO 1.2 Sea Surface Temperature Anomalies 1950-2005(Three-month moving average)

1998

Designing an Index Contract Extreme values of the ENSO 1+2 Index during the

January–April growing season are strongly correlated to catastrophic rains in Piura

1998

Vietnam — Proposed Business Interruption Vietnam State Bank to purchase business

interruption for early flooding in Mekong Delta Early flooding affects summer rice crop Much of the bank’s lending is tied to rice

production at this time When early flooding occurs, default rates/loan

restructuring increase at the state bank Contract details

Based on water levels at a trusted river station Covers a portion of bank portfolio risk Contract provided by local insurer Global reinsurer providing risk transfer for insurer Approved by regulator

Summary and Conclusion

Managing correlated weather risk has been a major constraint financial services for agriculture in many regions

Weather index insurance is creating new opportunities to manage correlated risk in lower income countries

For households, weather index insurance may be most effective for protecting all livelihood strategies fromCAT risk

Catastrophic business or livelihoods interruption insurance for small holders or business interruption insurance for rural lenders exposed to correlated weather risk offers some promise for expanding rural lending