The boon and bane of index-based weather insurance

The boon and bane of index-based weather insurance

Authored by Marius Ehrlinspiel, Associated Expert at Endeva

After the enthusiasm on microcredit has somewhat faded over the past few years, the next microfinance revolution in the form of index-based microinsurance is well underway. In this blogpost we will take a closer look at the index-based approach to insurance and highlight some of its advantages as well as some of its challenges.

Insuring smallholders is difficult, but we need to do better

Insuring agricultural smallholders in developing countries against adverse weather events has been tried many times in many different regional, socio-economic and cultural contexts. Unfortunately though, as different as these attempts may have been, the one thing they have in common is: None of them has really taken off! High administration costs, moral hazard and adverse selection while encountering little prospect of profits, have caused many to believe that agricultural smallholders in developing countries are simply uninsurable. To date more than 90 percent of smallholders in developing countries remain without insurance coverage – a fact that speaks for itself. At the same time, with BoP communities all over the world already feeling the impact of climate change on a daily basis, the need for effective risk protection has never been greater.

Can index-based insurance make a difference?

By linking payouts to objectively verifiable data such as rainfall rather than farmers’ individual losses, index-based weather insurance holds the promise of truly changing the face of agricultural microinsurance as we know it. The way it works is pretty straightforward: if a predefined threshold is met, a payout is triggered disregarding actual losses. Hence, index-based insurance, by design, swipes away many of the challenges posed by traditional agricultural insurance for both insurance suppliers and BoP clients. As for insurance providers, client behaviour no longer has the power to jeopardize the business model and time and cost-intensive on- farm visits to assess claims are a thing of the past.

Agricultural smallholders benefit for similar reasons. Lower administration costs on the part of the provider will ultimately be reflected in lower premiums for the target group. Research shows low willingness to pay and high price sensitivity substantially hinder the up-take of micro insurance products. Also, as a smallholder you’d have some sort of predictability: Since you know the terms of your policy, ideally you’d know right after the occurrence of an insured event whether you are entitled to a payout and if so to which amount. Most importantly, you’d receive your payout within a short period of time without having to go through complicated claims processing that can last for months. The time it takes to settle a claim and the uncertainty of not knowing whether you’ll actually be reimbursed can already have drastic consequences. You might have to cut down on meals, take your children out of school or sell productive assets you need to keep your agricultural production going. Timely payouts thus help cushion the effects adverse weather events have on smallholders’ livelihoods.

Protecting smallholders' livelihoods in the Caribbean

In the Caribbean - one of the climate change hotspots - for example, Hurricane Tomas (2010), a low-level trough system (2013) and a devastating drought (2015) have severely affected agricultural production and gradually depleted smallholders’ resources over the past few years. Unfortunately, prospects don’t look good! Against this backdrop, the Livelihood Protection Policy (LPP) was developed. The LPP is based entirely on rainfall and wind speed data and is one of many schemes in the developing world piloting index-based weather insurance. Farmers can purchase one policy for an annual premium of as little as 30 USD (8 percent of the sum insured). In case adverse weather triggers a payout, policyholders receive 370 USD within two weeks. While this is unlikely to cover all losses, a payout can be a start that allows farmers to swiftly get back on their feet! Thus far, the LPP has been implemented in Saint Lucia, Jamaica and Grenada.

Storage room at cooperative (left) and farmer’s pepper field (right) in Saint Lucia - One of the Small Islands Developing States (SIDS), that due to their size and location at the sea and in the hurricane belt are particularly prone to suffer from the adverse effects of climate change. Credit: Marius Ehrlinspiel

The challenges of index-based insurance

As always though, the index-based insurance model comes with a set of challenges of its own. The alleged advantage of disrupting the connection between actual losses and payouts, can equally be viewed as a major bottleneck. It means that farmers are at risk of incurring a loss without receiving a payout and insurers may have to pay even though there were no losses. This discrepancy is called basis risk. As a rule of thumb basis risk increases with the distance between the location of data collection and the insured farm.

This already hints to the second major challenge that lies in the lack of data availability and high initial investment costs. The design of robust indices that adequately reflect smallholders’ as well as the insurer’s risk is vital to both the impact and the financial viability of the model. For example, in order to design an insurance product against drought, the insurer relies on historical rainfall data as well as the density of weather stations. In many developing countries, however, reliable meteorological data can be hard to come by and weather station networks are often substantially proliferated.

Bearing these challenges in mind, index-based weather insurance might after all not be the silver bullet one would like for it to be. However, its potential to -by design- make risk protection affordable and available to millions of smallholders certainly deserves credit. Moreover, constant technological advancements and social innovations have already improved index-based insurance products. Using satellite technology, for example, provides spatially continuous data as compared to merely ground measured data and thus offers more reliable indices. Also, including farmers’ knowledge by employing participatory methods in the index-design process has shown promising results in terms of both acceptance and quality of the product. If research continues, who knows, maybe some of the outlined teething problems will, too, be a thing of the past soon.

This blog is a part of this month's theme on climate change and inclusive business. Read our December series for an overview of the blogs on the topic then post your own experiences, news and comments.