INNOVATIONS IN RISK MANAGEMENT

INDEX INSURANCEJERRY SKEES

H.B. Price Professor University of Kentucky

and President GlobalAgRisk, Inc.

OCTOBER 24, 2006

Development, Livelihoods, and Risk

Risks can impact the asset position, ability to generate income, and creditworthiness of households, businesses, and governments, slowing development.

High transaction costs limit access to financial services and global markets, resulting in suboptimal risk-coping strategies.

Agricultural activity still dominates the livelihoods of many rural poor in low income countries — agricultural activity is exposed to a wide range of risks.

MACRO

Market Intermediaries and Local and Regional Governments

MESO

Individual Households MICRO

Risk Experienced By . . .

Risk is experienced at different levels due to specific events such as low prices and adverse weather.

L

E

V

E

L

Agricultural Risk Identification

National Governments and International Organizations

Poverty Traps Created by Severe Events

A minimum asset base is necessary for households to invest in education, accumulate assets, and improve economic well-being.

Rapid onset shocks can knock households below this minimum asset threshold, resulting in a poverty trap.

Slow onset shocks can also result in poverty traps depending on the coping strategies available to and chosen by households.

Poverty Traps and Responses to Events

Households sell assets to maintain minimum levels of consumption — this in turn reduces future streams of income; or

Households reduce consumption to protect assets — this can impact the human capital needed to generate future income streams.

A Hurricane’s Impact on Asset Trajectory

shock recovery

better-off HH

poorer HH

poverty-trap

threshold

Time

Ass

ets

Source: Carter, Little, Mogues, and Negatu 2005

One Reason Poverty Traps Persist — Lack of Rural Finance Markets

Well-Developed Rural Financial Markets

Saving and Insurance occurs before the event occurs

Borrowing can be a response after the event occurs

Delivering banking and insurance services is expensive — cost is largely fixed making access to small and poor households even more difficult

Insurance

BorrowingSavings

Strategies for Risk Coping

TIME FRAMETIME FRAME

EX ANTEEX ANTE

Before the EventBefore the Event

Event OccursEvent Occurs

EX POSTEX POST

After the EventAfter the EventDROUGHTDROUGHT

STRATEGIESSTRATEGIES

INFORMALIndividual or

Community-based

FORMALMarket or

Policy-based

INFORMALIndividual or

Community-based

FORMALMarket or

Policy-based

Independent versus Correlated Risk

Independent risks are insurable because they are unrelated and generally impact different people at different points in time.

Correlated risk (i.e., commodity price risk) affects a group of people in a region or multiple regions at the same time to a similar extent.

Most weather-related events and natural disasters are “in-between” risks, neither perfectly correlated nor independent, resistant to traditional insurance pooling.

Markets for Different Types of Risk

0% 100% No Correlation In-between Risk Correlation

Auto Accidents Natural Disasters Commodity Prices

Rainfall / Crop Yields Insurance Markets Futures

Markets

0% 100% No Correlation In-between Risk Correlation

Auto Accidents Natural Disasters Commodity Prices

Rainfall / Crop Yields Insurance Markets Futures

Markets

High Probability Low Consequence versus Low Probability High Consequence Risks

Low ProbabilityHigh Consequence Risks Extreme weather events can result in low yields. The likelihood of such events is

normally ignored by producers. Insurers, on the other hand, adjust or “load” premium rates to capture uncertainty surrounding the occurrence of such events, producing a wedge between the

buyer’s willingness to pay and the seller’s price.

versusversus

High Probability

Low Consequence Risks

Yield-reducing events that generally

occur under mild to moderate

weather conditions often result in

losses which the individual farmer

can manage.

What Can be Done? — Risk Management

A major challenge for low income countries is to develop an appropriate risk management framework to address these concerns.

This framework must be designed to manage correlated risks that accompany many low-probability, high-consequence events.

An effective risk management strategy should mitigate risk at the micro, meso, and macro levels.

What are the Benefits of Risk Management?

An appropriate risk management framework

Avoids depletion of assets Encourages investment Enables more efficient use of resources Permits effective financial design Provides timely and efficient aid Improves the targeting of vulnerable households Clarifies the roles of the public and private sectors Enhances safety nets Facilitates more efficient country-level risk management

strategies

Examples of Support for Risk Management in High Income Countries

The United States and Canada have heavily subsidized crop and revenue insurance programs.

Spain also provides government-supported crop insurance using a different model

Income Support and Risk Management in High Income Countries

Government-supported risk management

programs of high income countries

are expensive and not sustainable

distort production decisions

may be inconsistent with WTO agreements

are difficult to implement

favor large farms

Examples of Government-Supported Crop Insurance

Country Period (A+I)/P

Brazil 1975–81 4.57

Costa Rica 1970–89 2.80

Japan 1985–89 2.60

Mexico 1980–89 3.65

Philippines 1981–89 5.74

USA current 4.00

Financial performance of crop insurance

Condition for sustainability

(A+I)/P < 1 Where A = average administrative

cost I = average indemnities paid P = average premiums paid

Presently there are few examples of successful models

Source: Hazell, 1992

Traditional Problems

Adverse selection

The most risky farmers buyLess risky farmers stay out

Moral hazard

People change their behavior after they are insured: their risk is greater

Pricing Insurance

Price of insurance = Cost of the risk

+ Cost of information to control adverse selection

+ Cost of monitoring to control moral hazard

+ Cost of loss adjustment

+ Cost of delivery

+ Cost of ambiguity of risk

+ Cost of ready access to capital to pay for all losses

Index insurance should have lower administrative, lower ambiguity risk, and lower adverse selection and moral hazard

than traditional insurance

500 1000 2000 3000 40000

Challenges for Insurance Markets

Fiscal constraints Limited government resources High opportunity costs of government funds

Structural constraints Smaller farm size High administrative costs

Market constraints Underdeveloped financial and insurance sectors Lack of access to international financial markets Small volume of business

Informational constraints Data Education

Institutional constraints Weak regulatory environment Lack of contract enforcement

Yield, and Disaster Risk Management in Low Income Countries — The Challenge

To develop cost-effective risk transfer instruments

that do not distort incentives and

that address the needs of participants at the

micro, meso, and macro levels, while

recognizing the country’s unique constraints.

Framework for an Innovative Risk Management Approach — Use of Market-based Instruments

1. Understand existing risk-coping strategies

2. Emphasize ex ante rather than ex post solutions

3. Focus on risk layering

risk retention

risk transfer

4. Focus on risk assessment at the

micro (households)

meso (intermediaries) and

macro (national and global participants) levels

Index Insurance

Pays for losses based on an independent and objective measure that is highly correlated with losses

Extreme rainfall events

Freeze

Crop yields by area (US – GRP county)

Mortality rates by county (Mongolia)

Index Insurance for Extreme Rainfall

Extreme Rainfall in IndiaPayments would occur anytime rainfall exceeds 2000 mm

A Bank might buy US$1 million liability

For every 1 mm = pay $1,000

500 1000 2000 3000 40000

Pre-conditions for Index Insurance

For Weather Risk

Weather event must create correlated losses Index must be a good proxy for lossEvent must be observable and easily

measuredThird party should be involved in the

measurementSystem must be objective and transparentHistoric data must exist to price the risk

Traditional Crop Insurance versus Weather Index Insurance — A Cost Comparison

Index-based Weather InsuranceLower Costs Measurable weather event is a proxy for crop losses, e.g., rainfall

Limits moral hazard and adverse selection

Objective triggers and structured rules for payouts Faster claims settlement Suitable for correlated risks More sustainable because of market financing

versusversus

Traditional Crop Insurance

Higher Costs

Compensation for actual

farm-level losses

Moral hazard and adverse selection

Asymmetric information —

Producers have superior

knowledge about farm-level risks

Payout process is protracted and

subjective

Suitable for Independent Risks

Relies on government

financial support

Applications of Index Insurance

Index insurance can be sold to: Individual farmers (US, Canada, India, Brazil – area

yield insurance / India – rainfall insurance (250,000) Microfinance / rural banks (Peru – COPEME) Importers for famine relief (WFP – Food security) Governments for disaster aid (Mexico- Fonden) Herders based on livestock deaths in an area

(Mongolia – 2,400 herders purchased) Irrigators in a irrigation valley (Mexico IDB project) Agribusinesses (who are at risk- when their farmers

have cash flow problems) Traditional crop insurance providers to serve as

localized reinsurance

The Importance of Risk Aggregation When Using Market-based Risk Transfer Instruments

Small households may not be able to use risk transfer instruments directly.

Weather insurance relies on proxies that do not eliminate basis risk.

Intermediaries may be needed to aggregate the risk to:

Mitigate basis risk

Reduce transaction costs

Strengthen the negotiation position

Benefits of Ex Ante Market-based Risk Management

Opens the way for innovation at the micro, meso, and macro levels

Improves access to risk transfer by the rural poor

Mitigates the impact of shocks that thrust the poor back into poverty traps

Strengthens locally based intermediaries offering market access to households of different income levels in low income countries

Allows for more efficient risk transfer at the macro level through greater risk retention at the country level

Creates a better environment for investment

For frequent and low consequence risk, those exposed should absorb the risk using savings and loans.

For less frequent, but moderate consequence risks, market instruments should be used.

For less frequent, but high consequence risks, the government and broader international community may have a role.

Layering Risks for More Efficient Transfer

Risk Segmentation — Sample Rainfall Distribution Showing Layering of Excess Rainfall Risk by Rainfall Levels

0 500 1000 1500 2000 2500 3000 3500

Frequent Less Severe Risk, Independent Losses Self-Retention Layer

Less Frequent, Moderate RiskMarket Risk-Transfer Layer

Correlated Losses from Excess RainfallMarket Failure Layer

Easing Financial Constraints

Market-based risk transfer — using insurance and reinsurance

Pooling and transfer of risk whereby government facilitates risk pooling among companies within the country and then sells the tail risk to the global reinsurance markets

Government packaged risk transfer — government contracts that can be auctioned or sold to insurers of reinsurers

Government subsidies on only the most extreme risks Premium subsidies — to be avoided due to cost and

poor incentives

Linking Index Insurance to Loans

Informal — farmers who get payments that they don’t need could loan to farmers having more serious loss

Formal but with simple structure —Rural finance entity will lower interest rates with the index insurance

Formal with contractual structure and loan officer involvement

Peru Project

To develop a risk transfer contract that would

allow MFIs in Peru to insure their

agriculture-related loan portfolios against the

risk of financial losses associated with

catastrophic weather events

Operational Considerations

End User

Operational

Financing

Technical

Regulatory

MFIs

Primary in Peru

Global Reinsurer

USAID project

SBS — Banking and Insurance

ENSO Insurance in Peru

MFIs are growing in Peru MFIs pool risk by the nature of their business Correlated losses from El Niño are an

obstacle to the development of sustainable insurance and financial markets

Major weather events will increase the default rate of loans made by MFIs

This source of risk reduces agricultural lending

ENSO Insurance in Peru

Severe rains and floods associated with El Niño are the economically most significant catastrophic risk in Piura

Index insurance based on rainfall measured at local weather stations is sensible, but has some problems

Available rainfall data are limited and incompleteRainfall stations must be secure and reliableRainfall stations should comply with World

Meteorological Organization standards to attract private sector insurers

Impact of El Niño

MFIs reduced agricultural lending after 97/98 El Niño

MFIs continue to restrict agricultural lending if El Niño is expected (or suspected)

97/98 El Niño brought an end to the agricultural insurance program and insurance premiums

Portfolio Risk in Piura Increased Due to El Niño

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year

De

fau

lt R

ate

s

ENSO

RFA High Rice Prices

Benefits of Risk Transfer

Real cost associated with debt restructuring

Real cost associated with regulatory requirements for provisioning when repayment is in the arrears

Real liquidity problem as depositors also withdraw savings during this harsh time

ENSO Insurance Pilot in Piura

Prototype insurance based on El Niño Southern Oscillation (ENSO) 1.2 index

ENSO 1.2 measures sea-surface temperatures off the coast of Peru as deviations from normal – index is positive if temperatures are above normal, negative otherwise

ENSO 1.2 indices are normally between -2 and 2

Values above 2 are an indicator of a strong El Niño

Progress on ENSO Insurance

Support from the regulator (SBS) to classify this as ENSO Insurance.

There is a willing global reinsurer that is ready to underwrite the ENSO Insurance

Discussions with MFIs in Piura have advanced a good deal to enhance their understanding of how to use the ENSO Insurance

Linking reduction of provisions to index insurance as a form of ‘warranty’ BASEL II

THANK YOU

Please visit www.microlinks.org/afterhours for seminar presentations and papers

Jerry Skeesjerry@globalagrisk.com