Weather index insurance for agriculture and rural areas in lower-income countries.

Innovations in risk transfer for natural disasters in lower-income countries, in particular weather index insurance products, can be used to shift various weather-related risks. This article discusses the linkage between weather risk and poverty; provides background information on weather index insurance products; describes requirements for the implementation of weather index insurance and possible roles for governments, donors, and international financial institutions in facilitating implementation; and briefly reviews recent efforts to provide weather index insurance products in rural areas of some middle- and lower-income countries.

Weather Risk and Poverty

Approximately 1 billion people live on less than $1 per day. Three-quarters of those live in rural areas (Chen and Ravallion 2007), and over one-half depend on agriculture or agricultural labor as their primary source of livelihood (International Fund for Agricultural Development 2001). Thus, poor rural households are particularly susceptible to the financial consequences of weather-related natural disasters. Even if they are not directly involved in agricultural production, many of the rural poor have income sources that are tied to the success of agricultural production or are otherwise highly susceptible to extreme weather events.

While health problems are often cited as the greatest risk facing many rural households, uninsured weather risks also contribute both directly and indirectly to the existence of chronic poverty. Extreme weather events, such as droughts and floods, can directly destroy productive assets that have accumulated at high opportunity cost through years of foregone consumption. Households that are thrust into poverty by such shocks often find it difficult to recover and restart the long process of accumulating productive assets (Carter et al. 2007).

The risk of extreme weather events also contributes indirectly to the existence of chronic poverty. Households that recognize the potential for weather-related shocks are often reluctant to forego short-term consumption to invest in risky productive assets. Instead, they adopt low-risk, low-return investment strategies that reduce their exposure to extreme weather events but also keep the household trapped in chronic poverty (Rosenzweig and Binswanger 1993; Carter and Barrett 2006).

In some areas the rural poor protect themselves from weather-related losses using various structural mitigation measures. Examples would include supplemental irrigation to offset the risk of insufficient rainfall or dams and levies to control flooding. However, these structural mitigation strategies are not always feasible, reliable, or cost-effective. Households can also mitigate the financial effects of risk through savings, diversification, share tenancy, producing lower risk outputs, or producing outputs that require less investment in risky productive assets. However, these strategies may not be available to all households. Further, the implied risk premium on such risk mitigation strategies can be very high. Rosenzweig and Binswanger (1993) estimated the implied risk premium for risk mitigation strategies employed by some households in rural India at 35%.

In principle, traditional insurance instruments, including crop insurance, can be used to transfer the risk of extreme weather events. However, insurance markets are underdeveloped and often nonexistent in rural areas of lower income countries due to poor contract enforcement, asymmetric information, high transaction costs, and high exposure to spatially covariate risks (Skees and Barnett 2006). These problems are particularly acute for crop insurance.

Weather Index Insurance

In recent years, researchers and development organizations have been exploring the potential for using weather index insurance to provide risk management opportunities for the rural poor. Weather index insurance pays indemnities based not on actual losses experienced by the policyholder but rather on realizations of a weather index that is highly correlated with actual losses. In its simplest form a weather index measures a specific weather variable (e.g., rainfall or temperature) at a specific weather station over a defined period of time. Weather index insurance policies specify a threshold and a limit that establish the range of values over which indemnity payments will be made. If the insurance policy is protecting against unusually high realizations of the weather variable (e.g., excess rainfall or extremely hot temperatures), an indemnity is paid whenever the realized value of the index exceeds the threshold. The limit is set higher than the threshold, and the indemnity increases as the realized value of the index approaches the limit. No additional indemnity is paid for realized values of the index that exceed the limit. Conversely, if the policy is protecting against unusually low realizations of the weather variable (e.g., drought or extremely cold temperatures) an indemnity is made whenever the realized value of the index is less than the threshold, and the limit is set lower than the threshold.

To illustrate how weather index insurance works, consider the following example of an index insurance policy that protects against insufficient rainfall over a three-month period, with rainfall being measured at a specific weather station. The threshold is set at 100 millimeters of rainfall and the limit at 50 millimeters. Assume the policyholder purchases $1,000 of insurance protection. If the realized rainfall at the weather station is less than 100 millimeters, the policyholder will receive an indemnity equal to $20 for each millimeter less than 100 millimeters, up to a maximum of $1,000 for rainfall realizations of 50 millimeters or less. The indemnity does not depend on losses incurred by the policyholder but is based strictly on rainfall measured at the weather station.

Relative to traditional insurance products, weather index insurance has several advantages:

* The insurance contract is relatively straightforward, simplifying the sales process.

* Indemnities are paid based solely on the realized value of the underlying index. There is no need to estimate the actual loss experienced by the policyholder.

* Unlike traditional insurance products, there is no need to classify individual policyholders according to their risk exposure.

* There is little reason to believe that the policyholder has better information than the insurer about the underlying index. Thus, there is little potential for adverse selection. Also, there is little potential for ex ante moral hazard since the policyholder cannot influence the realization of the underlying weather index.

* Operating costs are low relative to traditional insurance products due to the simplicity of sales and loss adjustment; the fact that policyholders do not have to be classified according to their risk exposure; and the lack of asymmetric information. However, start-up costs can be quite significant. Reliable weather and agricultural production data and highly skilled agro-meteorological expertise are all critical for the successful design and pricing of weather index insurance products.

* Since no farm-level risk assessment or loss adjustment is required, the insurance products can be sold and serviced by insurance companies that do not have extensive agricultural expertise.

An important limitation of index insurance is that policyholders are exposed to basis risk. In this context basis risk refers to the imperfect correlation between the index and the losses experienced by the policyholder. It is possible for the policyholder to experience a loss and yet receive no index insurance indemnity. Likewise, it is possible for the policyholder to receive an index insurance indemnity and experience no loss. There are two potential sources of basis risk. First, losses may be caused by disease, insect infestation, or any number of factors other than the weather variable on which the index is based. Unless the index is based on a weather variable that is the dominant cause of loss in the region, basis risk will be unacceptably high. Second, the weather variable used to drive the index may not be highly spatially covariate. Thus, the measure of the weather variable at the farm or household may be quite different than the measure at the weather station. Basis risk can be reduced by offering weather index insurance only in areas where a particular, highly covariate weather variable (e.g., drought or extreme temperatures) is the dominant cause of loss.

Finally, it is important to recognize that in many cases the appropriate target market for weather index insurance may not be individual households. Instead, the appropriate markets may be various local-level risk aggregators--that is, organizations that do business with many households in the local area and thus are highly exposed to covariate weather risks. Examples would include microfinance entities and other formal or informal lenders, mutual-aid associations, farmers' cooperatives, input suppliers, output processors, and even local governments or disaster relief providers (Skees and Barnett 2006). Since these organizations aggregate risks from multiple households, they can effectively pool idiosyncratic risks; however, they remain highly vulnerable to extreme covariate weather events.

Requirements for Weather Index Insurance