Using index-based risk transfer products to facilitate micro lending in Peru and Vietnam.

This article focuses on two technical assistance projects that use aggregate index-based risk transfer products (IBRTPs) to transfer significant natural disaster risks affecting agricultural production over wide regions. In Peru, the issue is El Nino events that cause flooding in the northern regions, and in Vietnam, early flooding in the Mekong Delta. These and other countries constantly face major natural disasters. When considering how the costs of natural disasters are internalized, it is important to examine institutional arrangements, particularly in the financial sector.

A common problem for banks, microfinance entities, and other rural lenders with geographically limited loan portfolios is the threat of correlated risks that hinder the development of rural financial services and in particular, the provision of credit. The presence of correlated risk poses a dual problem for lenders: (a) a disaster event implies the potential for much higher default rates among agricultural clients; and (b) additional liquidity problems as clients simultaneously draw down savings and increase demand for borrowing to cope with the disaster (Skees and Barnett 2006).

Countries respond to natural disaster risk in different ways, but the costs are always present, and regardless of the institutional and market arrangements, are always internalized in one form or other. In addition to presenting the details of IBRTP design, this article shows how two countries at nearly opposite ends of the institutional spectrum with respect to natural catastrophe response have internalized natural disaster risk into agricultural lending systems and how, in both cases, an insurance mechanism to transfer these risks could lead to improvements.

Financial institutions failing to cope with natural disaster risks represent a common story the world over, underscoring the importance of making the costs of natural disaster risk more explicit and of considering new ways to mix market mechanisms and government initiatives to transfer this risk. An approach that places greater emphasis on ex ante rules and procedures than on ex post responses imposes discipline, transparency, and efficiency to influence the broader financial markets of insurance, credit, and savings. IBRTPs that focus on removing the big risks of correlated events for financial institutions can clear the way for the development of more robust and resilient rural financial markets.

Barnett and Mahul (2007) explain the background, applicability, and relative advantages of index-based risk transfer approaches. Index-based risk transfer uses a proxy measurement to pay for significant economic loss. For example, if it is known that extreme rainfall is highly correlated with production losses, then these measures can be used as a proxy for the loss. This design mitigates problems associated with the usual public-sector response to catastrophic risk and to credit constraints in developed countries, namely traditional forms of agricultural insurance and ad hoc disaster aid.

The first section of this article follows the link between the benefits of risk transfer and rural lending on economic growth and then considers the impact of, and a possible solution to, correlated weather risk on credit market functioning. The experiences with catastrophic weather risk in selected locations of Peru and Vietnam are then reviewed, and the IBRTPs specifically customized to address the risk for lending activity in each country are compared. We conclude by offering lessons and extensions regarding the use of IBRTPs.

Complete Financial Markets Hasten Economic Growth

There is increasing evidence that access to advanced financial services by rural people is linked to accelerated economic development. When farmers have access to a variety of financial services, they are better able to make productivity-enhancing investments, to accept the risk of greater specialization and technology adoption, and to accumulate wealth in formal savings vehicles that can be reinvested in the local economy (Hardaker, Huirne, and Anderson 2004; Skees and Barnett 2006; US-AID 2006a). However, some risks are too large to be easily mitigated or self-insured at the farm/household level. When insurance services are available to transfer such non-diversifiable risks, farmers are able to avoid other more costly risk management strategies and have recovery resources available should the insured event occur without the need to liquidate productive assets for consumption smoothing (Dercon 2005; Zimmerman and Carter 2003). The presence of insurance services also facilitates the more accurate consideration and pricing of risk, which increases the efficiency of credit markets and resource allocation between different investment decisions (Trivelli et al. 2006; USAID 2006a). When both insurance and banking services develop together, access to credit at favorable rates and economic growth are generally higher. However, insurance is often missing in the market, particularly for catastrophic weather events. Correlated risks are considered uninsurable in the strict sense in part because traditional risk pooling is ineffective (Anderson 1976; Harwood et al. 1999).

In a market-based economy, the inability to effectively hedge against correlated weather risk generates less activity in the credit market among both lenders and borrowers. Lenders respond by curtailing the volume of credit available, offering credit at less favorable terms, and sometimes by withdrawing credit services entirely following a catastrophic weather event (USAID 2006a). This response can be pronounced when creditors lack traditional forms of collateral, as is common in developing countries. Demand for credit simultaneously falls as the cost of borrowing increases and from fear of the consequences of loan default (Varangis, Hess, and Bryla 2003; Trivelli et al. 2006). When insurance markets are lacking, credit markets fail to work effectively. This restricts economic growth and increases the vulnerability of the poor to poverty traps (Dercon 2005; Skees and Barnett 2006).

The development of IBTRPs can remove a portion of the correlated risk that hinders development of financial services by offering banks, microfinance entities and other credit providers with the means to transfer the cost of catastrophic weather shocks that induce loan default and liquidity problems (Miranda and Vedenov 2001; Varangis, Hess, and Bryla 2003; Skees and Barnett 2006). A risk transfer mechanism for correlated weather risks that carefully blends markets with some degree of government effort to facilitate market development can remove a major constraint to rural financial markets (Skees and Barnett 1999; Skees and Hartell 2006; Skees, Hartell, and Hao 2006).

Case Examples: Flood Risk Transfer in Peru and Vietnam

While the source of risk is different, natural disasters in Peru and Vietnam have similar characteristics and impacts--the correlated risk of flooding creates problems with default among borrowers. The IBRTPs that we propose to manage these risks are similar. Each is designed to deal with the major correlated risks as a first step to improving banking and insurance services.

However, Peru and Vietnam each have very different political and economic institutions that internalize these risks in different ways and generate distinct experiences. Table 1 summarizes the key characteristics of the natural disaster risk, institutional response, and proposed risk transfer instrument for Peru and Vietnam. In Peru, loan defaults following catastrophic flood risk are internalized by the market economy into interest rates and severe credit rationing. In the Socialist Republic of Vietnam, the response has been to share the risk by charging roughly the same interest rate to all borrowers from the State bank, while forgiving and rescheduling loan defaults that were created by natural disasters.

Flood insurance is unavailable in developing countries for many good reasons. In addition to difficulties of managing correlated risk, loss adjustment for small farms is prohibitively expensive, and moral hazard and adverse selection are pervasive. Each of these problems poses a significant barrier to developing insurance markets that offer products for individuals. To address these constraints, the approaches taken in Peru and Vietnam focus on transferring the correlated risk through natural aggregators first. Banks and MFIs pool the risk exposure of their clients, but are unable to effectively diversify this risk. By indemnifying lenders at the outset to remove the large correlated risks, constraints to further financial market development are loosened. Focusing on existing risk aggregators is likely more feasible than attempting to create an explicit structure to provide the benefits of risk transfer directly to individual farm households. Nonetheless, effective internal policies to deal with default risk remain a challenge for agricultural lenders.

Peru: Growing the Market

The overall objective of the project in Peru was to provide microfinance institutions (MFIs) access to innovations in weather index insurance. The initiative was to contribute to the expansion and sustainability of rural finance in Peru by providing new index insurance instruments that would reduce both the portfolio risk for the MFIs and the risk to individual farm loans. In both cases the focus was on reducing exposure to correlated risk.