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

After performing a risk assessment from a wide range of weather data in Peru, it became clear that El Nino events are the major source of catastrophic risk. The last two severe El Nino events (1983 and 1997) devastated a number of regions in Peru with above average rainfall and massive flooding. In the northern coastal department of Piura, a typically arid region, a strong El Nino can bring rainfall that is more than 40 times the average.

The risk from this type of event has affected the availability of agricultural credit. The volume of lending by MFIs in Peru grew 350% between 1998 and 2003 (de Janvry et al. 2003). However, during the same period, agricultural lending by the same MFIs had virtually no change in volume, and agricultural lending currently accounts for only about 10% of all MFI lending. At the extreme, one MFI has nearly stopped agricultural lending altogether--the predicted response from lending institutions when there is a correlated weather risk that is likely to increase default rates. Default rates for all MFIs operating in Piura prior to the 1998 El Nino were around 8% whereas after the event, default rates increased to about 18%. While not all of this increase can be attributed to El Nino, much of it was driven by the major disruptions created by El Nino flooding.

It was determined that the ENSO 1 + 2 index, which measures Pacific sea surface temperature immediately off the coast of Peru, was highly correlated with excess rainfall and flooding in Piura. Abnormal increases in sea surface temperature typically indicate an El Nino weather pattern. More detailed statistical work on these relationships can be found in Khalil et al. (2007).

Based on feedback from a major re-insurer, it became clear that writing a direct insurance contract on the ENSO 1 + 2 was both relatively easy to do and would provide for significant risk transfer for catastrophic events. For index insurance contracts, re-insurers are most receptive to a secure measure that has a long time series. ENSO indexes are measured, maintained, and published by the U.S. National Oceanographic and Atmospheric Administration. Daily records that use very similar technology exist for about 50 years. One basic contract would simply make linear payments when the ENSO 1 + 2 index during the January-March flooding period exceeds 2, with a maximum payout when the index reaches 3. In years of recent El Nino events, 1982-83 and 1997-98, the ENSO 1 + 2 index exceeded 2.5. Using an example, an MFI with a $100 million portfolio and an estimate that a severe El Nino could cause an increase in default rates of 10 percentage points, could purchase an ENSO 1 + 2 insurance contract with a maximum payout of $10 million. If the index value were 2.6, the payment rate would be 60% of the value insured, or $6 million. The Peruvian regulator approved ENSO insurance in the summer of 2006, based on the potential of this instrument to enable the transfer of a major catastrophic risk that has plagued Peru for centuries.

Vietnam: Leading the Market

In contrast to the experience in Peru, Vietnam faces a very different institutional environment but also one that is in flux. The Socialist Republic is currently transitioning many of its state-owned banking and financial services toward greater market orientation in a process referred to as "equitization," which includes the modernization of insurance regulation and other changes to improve conditions for general insurability and risk transfer.

There has been little success in offering agricultural insurance in Vietnam. For example, the state-owned insurance company BaoViet suffered actuarial losses in excess of Vietnamese Dong (VND) 5 billon (VND 16,000 = US$1) on insurance based on rice-yield loss offered over the 1993-97 time period, resulting in an aggregate loss ratio of 110%. A subsequent attempt in 1997-98 to offer traditional multiple peril crop insurance, principally for rice, was also terminated due to massive losses (Dufhues, Lemke, and Fischer 2005). At present, there is essentially no agricultural insurance activity in Vietnam.

The state agricultural bank, the Vietnam Bank for Agriculture and Rural Development (VBARD), has become the de facto risk aggregator and agricultural insurer through its lending practices. Characteristics of VBARD lending include: (a) nearly flat interest rates that are charged throughout the country, thus VBARD pools risk nationally; and (b) in the event of a natural disaster that impacts loan repayment ability, it performs a loss assessment to determine if loans should be rescheduled or forgiven. In the past the government periodically recapitalized the bank for loan forgiveness, but this practice has recently been discontinued. Loan rescheduling and some amount of commune-level loss adjustment continue to occur if the borrower qualifies. And like an insurer, VBARD now maintains local reserves to protect against losses created when debt is postponed. These recent regulatory changes with the movement towards commercialization are serving as an important catalyst for VBARD and other lenders to consider innovative options to protect their lending portfolio from natural disaster risk.

The work in Vietnam has focused on early flooding that impacts the second rice crop prior to harvest. While the Mekong Delta floods every year, Vietnam has made massive investments in infrastructure to manage the normal extent of the flood in its early stages to extend the growing season. River flow normally starts to increase in June, but significant river flows usually do not begin until mid- to late July, with the annual flood levels peaking in October. The problem occurs when flows increase significantly during the later part of June and early July, when farmers still have their summer-autumn rice crop in the fields. In the project area, approximately 200,000 hectares of summer-autumn rice valued at over US$150 million are vulnerable to this risk.

While flooding in the Mekong Delta is a function of multiple conditions, hydrological modeling performed by the Southern Institute of Water Resources Planning (2007) reveals that water coming across the Cambodian border is the dominant factor influencing flooding. Daily water level data obtained from Tan Chau hydrological station from 1977-2004 were used to examine levels exceeding 250 cm for dates between June 20 and July 10. At 250 cm, downstream flooding becomes a serious problem, while the June 20 to July 10 period coincides with greatest harvest activity. When this measure is used, 4 out of 27 years had excess water levels (greater than one-half meter) during this period. This threshold represents roughly a 1-in-7-year chance, which should be an acceptable level of frequency for most insurance providers.

Using this information, an aggregate IBRTP can be constructed that indexes the level of water at the Tan Chau station and provides indemnity payments directly to rural lenders. This targets the economic costs of flooding to creditors and is intended to cover business costs associated with default risk and restructuring the loan portfolio. Furthermore, a certain percentage of loans will never be repaid even after restructuring. The significant question is how these credit risks should be evaluated and to what extent the bank would want to establish reserves for these costs versus the purchase of an insurance product. The optimal strategy is likely a blend of these two mechanisms.

The most straightforward IBRTP for excess water levels during this time frame would be a linear payout. The payment rate for a contract that begins paying indemnities for water levels above 250 cm with maximum payout at 350 cm, would be 1% of liability for every 1 cm of water above 250. Any risk aggregator who purchased the contract would evaluate the amount of liability they require relative to the risk exposure of their portfolio. The liability selected would drive both the premium and the indemnity payments. For example, if the liability was VND 4 billion and the premium rate was 10%, the purchaser of the index insurance contract would pay VND 400 million (0.10 x 4 billion). If the water level reached 275 cm during the critical period, the indemnity payment would be 25% or VND 1 billion.

Conclusions and Extensions Emerging from Peru and Vietnam

The country case studies of Peru and Vietnam provide two very different institutional and market maturity examples illustrating how it may be possible to construct aggregate 1BRTPs that blend banking and insurance to remove a lender's correlated portfolio risk. However, such aggregate risk transfer is only a beginning step in the process of developing efficient credit markets in developing countries.