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

One issue involves the challenge of providing a direct linkage between the aggregate IBRTP and financing and delivering some level of efficient insurance product to protect both smallholder borrowers and the lender from defaults. While the initial focus is on removing the big constraints for the lender, there is some question as to whether this alone will provide the desired level of "trickle down" benefit to drive an active credit market (Trivelli et al. 2006). Allowing lenders to pass on the benefits of the large indemnity payment from the IBRTP may be the most efficient way to deal with the large transaction costs associated with providing more complete financial services to small households. This does not mean that the lender would be underwriting the risks, but rather that the lender would link the benefits of the aggregate index payments to the small loans. Given special considerations from regulators about micro-insurance, this arrangement could evolve into more sophisticated products that would allow payments based on risk zones for group lending and group indemnity.

One promising area of research is the use of more advanced technology to make estimates of local losses, which would reduce the transaction costs of extending insurance products at a disaggregate level, while also controlling for moral hazard and adverse selection problems. For example, there is ongoing work in risk-zone modeling to develop accurate and reliable maps for the specific timing of catastrophic flooding events (Southern Institute for Water Resources Planning 2007). Technological innovations in satellite imagery may also offer potential in providing rapid and reliable methods for evaluating water inundation on small parcels. The institutional innovation associated with index-based insurance products can be a motivation for investing in technological advances that improve estimation of losses at the local level.

Finally, mitigation remains a critical component when designing any risk management strategy within a country. It is important to remember, however, that mitigation also comes at a real economic cost, and that overconfidence with engineering solutions can obscure serious residual risks. For example, Vietnam has invested extensively in dyke and canal systems to control flooding. Yet, experience and initial hydrological modeling both indicate that these systems can be overwhelmed. In Peru, there have been discussions about the potential for the construction of flood control structures, but these are estimated to be enormously expensive. The economic trade-off between engineered mitigation solutions relative to financial solutions for extreme catastrophic risk remains an important area of research.

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Jerry R. Skees is the H.B. Price Professor of Risk and Policy in the Department of Agricultural Economics at the University of Kentucky, and president of GlobalAgRisk, Inc. Jason Hartell is Ph.D. Candidate in the Department of Agricultural Economics at the University of Kentucky, and Anne G. Murphy is Vice President of GlobalAgRisk, Inc.

GlobalAgRisk, Inc. has been leading work in Peru under US-AID/DAI Prime Contract LAG-I-00-98-0026-00 BASIS Task Order 8, Rural Finance Market Development; and in Vietnam under contract with World Perspectives, Inc. for ADB TA-4480. The authors gratefully acknowledge the editorial assistance of Celeste Sullivan. This article is published under the University of Kentucky Agricultural Experiment Station Number 07-04-082.

This article was presented in a principal paper session at the AAEA annual meeting (Portland, OR, July 2007). The articles in these sessions are not subjected to the journal's standard refereeing process. Table 1. Key Characteristics of the Proposed Index-Based Risk Transfer Products in Peru and Vietnam

Peru Vietnam Natural disaster Severe flooding Extreme and early event during El Nino arrival of annual

event flood Event impact on Crop destruction, Interrupts harvest of

agriculture erosion summer-autumn rice

crop Event onset Excess rainfall Excess river flow

measurement Index for correlated Sea surface tempe- River depth at Tan

risk transfer rature, ENSO 1 + 2 Chau Station Index measurement January-March June 20 to July 10

period Producer response to Loan default Loan default

disaster Institutional res- Credit market Debt forgiveness; now

ponse (creditors) withdrawal debt restructuring Institutional moti- Indemnify lending Prepare for

vation for catas- portfolio to enable commercialization

trophic risk a return to rural by protecting

transfer market lending portfolio Impact of most 1998-Massive 2000--Extreme early