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Weather Index Insurance, Lending to Small Farmers, and Credit Risk Management
Jerry Skees, President, GlobalAgRisk and HB Price Professor at the University of Kentucky
Our MissionGlobalAgRisk, Inc. is committed to improving financial services for the rural poor through innovative approaches for transferring weather risk
Current projects in Mongolia, Peru, and Vietnam
www.globalagrisk.com
Introduction MFIs are contributing to economic development in lower
income countries Experienced fantastic growth Empowered the poor Effective sustainable solution
Focus on improving MFI business Increasing access to credit for many segments Increasing MFI solvency Still agriculture and rural MFI access is limited
Innovations in risk transfer to ease constraints for Agricultural and Rural lending to small holders Household insurance for livelihoods disruption due to
catastrophic natural disaster risks Business interruption insurance for rural lenders
High Concepts
Lenders can attempt to pool risk May be possible when risks are independent Can lead to very poor results if risks of borrowers
are correlated
Agriculture still dominates the rural economies of many lower income countries
Financial markets are largely undeveloped in rural areas
Correlated Risk in agriculture remain a major reason
Consider 2 Villages Both villages have 30 households In an average year, each household expects
to receive US$1,000 Three income earning activities are available
1. Crops2. Livestock3. Off-farm income
Village 1 versus 2 In Village 1 — All 3 outcomes of income will all
occur in a single year (Independent Risk)0 1/3 of households1,000 1/3 of households2,000 1/3 of households
In Village 2 — All households get the same income in the same year (Correlated Risk) 0 1 in 3 years
1,000 1 in 3 years2,000 1 in 3 years
Goal — Assure that no household has less than $1,000 of income in any given year
Solutions for Village 1 Social solution – pre agreement for those 10 households with
$2,000 income to transfer $1,000 to those with $0
Banking solution – pre agreement for those 10 households with
$2,000 income to loan $1,000 to those with $0 Insurance solution – pre agreement for all 30 households to pay
$333 to pre finance the outcome of 10 households receiving $0
More on the Insurance Solution Village 1
Insurance: (1/3 = .3333)
Premium = .3333 x $1,000 = $333
Available: $333 x 30 households = $10,000 Remember in every year there will be 10
households with $0
Need: $1,000 x 10 households = $10,000 The pool works because exactly 10
households get $2,000 and can transfer $1,000 to the 10 households getting $0
Reaching the Goal in Village 2 Pooling risk is impossible since in any given
year all 30 households can get 0 income, $1,000 income, or $2,000 income
If everyone in the community receives $0 income, everyone will starve and there is no opportunity to help one anotherNeed: $1,000 x 30 households = $30,000 to protect against the $0 outcome (reserving)
In this scenario, microfinance and mutual insurance that are geographically limited will fail
Correlated Risk Affects Large Numbers Regarding correlated risks, the local community will
not be able to diversify their risk A major weather shock (drought, flood, etc.) can
affect Crop income Livestock Off-farm jobs
In reality, household incomes tend to be neither completely independent nor completely correlated within a community
Microfinance and mutual insurance works for pooling independent risk
The challenge is still the correlated risk
Insurance for Correlated Risk Goals for insuring correlated risk
1. Transfer risk out of local community2. Offer affordable coverage keep transaction
costs low
Insuring correlated risk has been problematic To make money selling insurance, premiums
collected must cover1. Expected indemnities (Price of risk)2. Administrative costs
Return to Village 2 If we knew that the 0 outcome for everyone
was clearly associated with lack of rainfall, an outside financial interest could write an insurance that would pay when there was a shortage of rainfall
Weather Index Insurance —Creating New Opportunities Indemnities based on an objective,
transparent measure that is important for livelihoods Precipitation Temperature Flood levels
Does not require inspection of losses Eliminates most asymmetric information
problems This is weather insurance, not crop insurance
Pricing Index Insurance
Price of Index Insurance =
Increases opportunities for affordable coverage
Weather Index Insurance Limitations Basis risk
Correlated risks only
Mostly single peril coverage
Weather data — Requires reliable historical and ongoing weather data
Example of an Excess Rainfall Insurance Product Extreme rainfall in India — Payments would
occur anytime rainfall exceeds 2000 mm Client might buy US$1,000 liability
500 1000 2000 3000 40000
Payout Structure for an Example Excess Rainfall Contract
$1 for every 1 mm excess of 2000 mm $1,000 limit at 3000 mm
Some Examples of Index Insurance Mongolia – Index on soum (county-level) mortality to
protect against dzuds (winter events that kill millions of animals) 14 percent of herders insured in year 2
India – Rainfall index insurance mostly against drought – nearly 1 million farmers purchased this is 2007
Malawi – Rainfall index insurance against drought – tied to lending and purchased of improved seeds
Peru and Vietnam – Index insurance products designed to protect the portfolio of agricultural lenders
Mexico – Macro index insurance to pre finance public expenditures after a natural disaster
Lessons Learned from Experience with Weather Index Insurance
1. Works best for CAT risks Household risk coping approaches cannot
manage these risks These are the most disruptive events Reduces basis risk Better for low-quality data Most not be sold as crop insurance Can be used to protect against many livelihood
strategies
Maintaining Household Interest inCAT Coverage How do you keep households interested in
CAT risk coverage? Cognitive failure Limited resources — High opportunity cost for
purchasing insurance In the best interest of rural lenders that
households address CAT risk rural lenders dependent upon household cash flow
Two options1. Micro product — Livelihoods disruption for
households2. Meso product — Business interruption for credit
risk of rural lenders
1. Micro Level — Livelihoods Disruption Households involved in many livelihoods
(crop, livestock, off-farm) Disaster can affect all of them Income shocks can endanger lives of
household members Weather insurance for livelihoods disruption —
Provides risk management for all activities affected by that weather shock (e.g., drought affecting crops, livestock, etc.)
Benefits of Insurance forLivelihoods Disruption Household benefits of improved risk
management Protects many livelihoods, not just one household
crop More likely to specialize in higher-return activities
e.g., Improved seed varieties or inputs for higher-expected returns
For rural lenders this reduces the risk of borrowers Can use indemnities to repay loans Reduces need to ration credit Can lead to lower interest rates as correlated risks
must be built into interest rate charges
Increasing Uptake of Insurance for Livelihoods Disruption Households may still need incentives to purchase
Households need immediate benefits to overcome opportunity cost and cognitive failure
Linking insurance to services — Providing household benefits now Linking insurance to credit
Improved access to credit Credit at lower rates Reduced delivery costs for both products
Linking insurance to savings Improved access to savings Insurance for CAT risks complements savings for
small/moderate risks Linking insurance to inputs (Improved seeds, fertilizer)
Can protect loans to cover inputs Increases investments/use of credit
Household Products Are Difficult to Create Household products to address CAT risk
directly is ideal, but can be difficult to create Problem of household interest Problem of delivery Need appropriate insurance company
Instead, a business interruption product for firms may be an important first step
Framing this as business interruption insurance should have a strong appeal to insurance regulators
2. Meso Level — Business Interruption Portfolio risk is a major problem when lending
for production has correlated risks in the region MFIs could purchase product to insure its
lending portfolio Low basis risk — Idiosyncratic effects are
smoothed across portfolio Benefits
Increases lending for MFI Provides cash when debt restructuring/defaults are
leading to cash flow problems Helps ensure solvency of MFI Pass-through to households?
Peru — Proposed Business Interruption A severe El Niño adversely impacts farmers, processors,
transporters, and retailers A severe El Niño raises default rates for loans for agriculture
(as much as 12-20 percentage point increase in current rates)
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
Risk Is Loaded into Interest Rate Charges Cost of capital 10 Administrative cost +18 Cost of risk loading? +12
percentage points Cost of Loans to farmers 40
Challenge — Could Risk Transfer of El Niño Risk take even ½ of the 12 percentage points out of this equation?
Peru — Proposed Business Interruption Payouts based on NOAA measure of sea
surface temperature To be sold to MFIs for business interruption Provided by local insurer Global reinsurer providing risk transfer Regulator has approved El Niño product
Measuring El Niño
Positive ENSO 1.2 Sea Surface Temperature Anomalies 1950-2005(Three-month moving average)
1998
Designing an Index Contract Extreme values of the ENSO 1+2 Index during the
January–April growing season are strongly correlated to catastrophic rains in Piura
1998
Vietnam — Proposed Business Interruption Vietnam State Bank to purchase business
interruption for early flooding in Mekong Delta Early flooding affects summer rice crop Much of the bank’s lending is tied to rice
production at this time When early flooding occurs, default rates/loan
restructuring increase at the state bank Contract details
Based on water levels at a trusted river station Covers a portion of bank portfolio risk Contract provided by local insurer Global reinsurer providing risk transfer for insurer Approved by regulator
Summary and Conclusion
Managing correlated weather risk has been a major constraint financial services for agriculture in many regions
Weather index insurance is creating new opportunities to manage correlated risk in lower income countries
For households, weather index insurance may be most effective for protecting all livelihood strategies fromCAT risk
Catastrophic business or livelihoods interruption insurance for small holders or business interruption insurance for rural lenders exposed to correlated weather risk offers some promise for expanding rural lending