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

While the basic concept is simple, effective implementation of weather index insurance is not at all simple. The continuing availability of accurate historical weather data is critical. It is also necessary to determine whether any of the available weather variables are in fact highly correlated with realized losses and if so, the time periods in which losses are most likely to occur. International experience has also shown that effective implementation requires careful attention to the services currently being provided by local risk aggregators as well as legal and regulatory constraints.

Governments, donors, and international financial institutions can facilitate the offering of weather index insurance by assisting with demand assessment; establishing an appropriate legal and regulatory framework; collecting and managing the required data; training insurance suppliers and providing objective information to potential users of weather index insurance; developing and pilot-testing potential weather index insurance products; and possibly providing some level of catastrophic risk-sharing. Each of these is discussed below.

Demand Assessment

Before investing in data collection and product development, it is important to assess the potential demand for weather index insurance in a particular area. Personal interviews, focus groups, and surveys can be used to determine answers to the following questions: What are the key weather perils of concern? How frequently do the perils occur and how significant is the impact? Who is affected by these perils? What mitigation or informal risk transfer strategies are currently being employed? What is the (opportunity) cost of those strategies? How much are end users willing and able to pay for an insurance product?

Legal and Regulatory Framework

To facilitate the offer of weather index insurance, governments must establish an appropriate legal and regulatory framework. The legal framework should address not only the proper regulation of insurance sales but also contract enforcement. In many lower-income countries insurance is so poorly understood that courts often force insurance providers to pay indemnities for losses that were clearly not covered under the contract provisions. Conversely, insurance providers may refuse to pay claims to poor policyholders because they know that the policyholders cannot afford to have an attorney represent them in court. Thus, to protect the interests of small-scale policyholders, some sort of binding arbitration procedure is typically desirable.

Even in countries where the legal and regulatory system is more highly developed, the existing regulatory standards for traditional insurance products may not be appropriate for index insurance products. Index insurance creates unique regulatory challenges because the indemnities are not based on the actual loss incurred. Also, index insurance is highly exposed to spatially covariate losses; so the minimum capital (or contingent capital) requirements need to be higher than those for traditional insurance.

Data Collection and Management

For weather index insurance to be successful, both the insurer and the policyholder must have confidence that the index is being measured accurately and the data are secure from tampering. To build this confidence, the underlying index should be measured by a trusted government or private source of publicly available weather data.

In addition, a sufficient amount of historical (normally daily) data on the underlying weather variable must be available for the insurer to estimate premium rates. The amount of historical data required depends on the frequency of occurrence of the risk. Twenty years of data may be sufficient to set initial premium rates for relatively frequent weather events. Thirty or forty years of data may not be sufficient for infrequent but potentially catastrophic weather events. Without sufficient data on which to base premium rates, the insurer will either refuse to sell the insurance or add a large premium load to account for uncertainty.

Since weather data have public goods characteristics, they are unlikely to be collected, cleaned, archived, and made publicly available by private-sector companies. Government meteorological bureaus usually provide these services. However, many lower-income countries find it difficult to adequately fund meteorological bureaus or sustain a sufficient network of weather stations. To facilitate the availability of weather index insurance, some donor organizations have provided funding for expanded meteorological services in lower-income countries.

Training of Insurance Suppliers and Consumer Education

Insurance suppliers in lower-income countries are unlikely to be familiar with weather index insurance. Thus, they require training and capacity building opportunities to build the expertise needed to offer these unique insurance instruments.

Similarly, in rural areas of many lower-income countries, insurance products are not widely available. Even if potential policyholders are familiar with other types of insurance products, they will almost certainly not be familiar with weather index insurance. To make an informed purchase decision, it is critically important that potential policyholders understand the basis risk inherent with weather index insurance. That is, they need to understand that they may experience a loss but not receive an indemnity. Thus, the successful introduction of weather index insurance will require a significant educational effort. While insurance suppliers will provide some information as part of their sales efforts, potential policyholders also need information from objective sources.

Government entities and donor organizations can provide training on weather index insurance to insurance suppliers. They can also serve as an objective source of information and educational materials for potential policyholders.

Product Development

Once a weather index insurance product is developed and offered for sale by an insurance supplier, it can easily be copied by competitors, since the underlying index is based on publicly available data. This "free rider" problem makes it very unlikely that private-sector insurance suppliers will invest in the research and development required to bring a weather index insurance product to the market. For this reason governments and donors have tended to fund feasibility studies and pilot tests of new weather index insurance products.

Catastrophic Risk-Sharing

Local suppliers of weather index insurance policies must be able to transfer their loss exposure outside of the local area. Traditional lines of insurance (e.g., automobile, life, property and casualty) are offered on loss events that are largely uncorrelated, so the law of large numbers reduces the variance in indemnities for local insurance providers. But weather index insurance protects against spatially covariate loss events. When a policyholder collects an indemnity on a weather index insurance product, all other holders of that same policy will be collecting indemnities as well. This implies that, in any given year, indemnities can be very high relative to premiums collected. While in principle it may be possible for insurance suppliers to set aside adequate liquid reserves to cover the potential for large indemnities, in practice this is highly unlikely. There is a high opportunity cost associated with keeping such large amounts of capital in investments that can be readily liquidated. Further, in many countries there are tax disincentives for holding large reserves. Thus, index insurance suppliers generally obtain contingent capital via reinsurance. Catastrophe bonds and contingent loan mechanisms can also be used as sources of contingent capital.

Governments and donors may also assist with providing contingent capital to suppliers of weather index insurance. Some evidence suggests that those at risk tend to ignore the probability of the most extreme and infrequent loss events (Kunreuther 1996; Kunreuther and Slovic 1978). But insurers and reinsurers of weather index insurance cannot afford to ignore the potential for such events. They must load premium rates to reflect the potential for highly infrequent weather events, including events that are more extreme than any in the available historical data. Since there are no data from which to calculate the frequency and magnitude of such extreme events, insurers and reinsurers tend to be extremely conservative when calculating the premium load. This creates a gap between what buyers are willing to pay and what sellers are willing to accept for protection against extreme weather events.

To address this market failure, governments or donors can provide contingent financing (e.g., reinsurance or contingent loans) for extreme realizations of the weather variable underlying the weather index insurance product. To keep from crowding-out private sector risk transfer markets, any government or donor contingent financing should be carefully structured so that it covers only the most extreme weather events. If insurance suppliers can obtain contingent financing for this extreme tail risk at a reasonable cost, they can pass along the benefits in lower premium costs to policyholders. This will increase the number of policies sold, thus increasing market opportunities for reinsurers to provide contingent financing against all but the most extreme weather events.

International Experience