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Risk reduction for smallholder farmers: Making weather index insurance work Alain de Janvry and Elisabeth Sadoulet
University of California at Berkeley
IFPRI workshop on “Opportunities for the New PMFBY Agricultural Insurance
Program”, New Delhi, December 21, 2016
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1. Uninsured risk is a major cause of low investment in agriculture and high rural poverty • Agriculture is a risky business, especially due to extreme
weather events • Most investments in improved productivity (HYV, high
value crops, fertilizers) increase exposure to weather risks • Climate change makes exposure to extreme events more
likely and harder to predict • Such events lead to:
o Ex-post decapitalization to cope with shocks (e.g., sale of assets, dis-saving, use of liquidity for consumption): farmers are less able to plant the year after a shock
o Ex-ante self-insurance by reducing investment in higher risk-higher expected income options (such as high yielding varieties, fertilizers) and distorting asset portfolios (toward more liquid assets)
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2. Traditional approaches to risk-reduction do not work for smallholder farmers
o Informal risk pooling arrangements (mutual insurance) do
not help address weather risks as covariate (Townsend 1994)
o Traditional indemnity-based insurance does not work for smallholder farmers as too difficult to implement (lack of regulation) and excessively costly
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3. Weather index insurance (WII) is an appealing way of offering insurance to smallholder farmers o Payouts are triggered by an observable indicator/index falling
below a threshold. Indicator can be: o Weather events (rainfall) measured at meteorological
stations o Average small area yields measured by crop cuttings or
aerial/satellite observations o Payouts are not based on actual individual damages as assessed
by an insurance adjuster
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Index insurance: Role of threshold in triggering payments
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o Presumed advantages o Avoids lengthy and conflictual claims process, o Eliminates mis-behavior by client: no room for Moral
Hazard and Adverse Selection o Allows quick, automatic, and transparent disbursements o Cheap to implement for large numbers of smallholder
farmers o Ex-post protection from shocks (insurance payouts) should
induce ex-ante investment effects (production response)
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4. However, index insurance has met with low uptake unless heavily subsidized by government
Take-up of index insurance as a % of the market price: high take-up with high subsidy, but falls to only 1-18% at market price
Source: ATAI 2016
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o All large scale index insurance programs are heavily subsidized by government o India: 60% uptake with 75% subsidy (AICI) o China: 40% uptake with 60% subsidy (PICC)
o Interlinks between insurance and credit have not worked: o Low demand (Gine and Yang for Malawi) o Demand for interlinked loans lower than for standalone
loans: 2% uptake in Ethiopia (Ahmed et al.)
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5.Main reasons for low uptake are: o Basis risk: an incomplete/imperfect insurance
o No weather index is perfectly correlated with yields even with data collected at the farmer’s field
o Index measured at distant weather station or for average area § In UP, demand for WII declines by 6.4% for every
kilometer in distance to weather station o Basis risk creates ambiguity about the value of the
insurance product. Strong ambiguity aversion deters demand for index insurance.
This makes WII into a partial insurance, with eventually a double loss: pay the premium and do not get payout in bad year (Clarke, 2016). Hence insurance can make the worst that can happen eventually worse than without insurance.
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o High cost due to o High loading (40-60% premium in excess of fair price in
developing countries) o Data premium (lack of long data series prevents from
accurately calculating risk, and this ambiguity is charged as an extra premium)
o Lack of re-insurance (hence insurance provider bears extra risk)
o Behavior: index insurance difficult to understand for farmers o Lack of trust in insurance company that payouts will follow
triggering (opposite of microfinance)
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6. But index insurance works for shock-coping and risk management where up-taken: o In Mexico, insured farmers plant more the year after a shock
than non-insured farmers (de Janvry et al., 2016) o In Kenya, insurance helps pastoralists avoid reducing
consumption (poor) and decapitalizing livestock (rich) in response to a drought (Janzen and Carter, 2013)
o In Andra Pradesh, farmers who receive insurance are 6%pts more likely to plant cash crops rather than subsistence crops (Cole et al., 2014)
o In Andra Pradesh, Uttar Pradesh, and Tamil Nadu, insured farmers use riskier higher-yielding production methods (Mobarak and Rosenzweig, 2013)
o In Ghana, index insurance induces farmers to plant more maize and use more fertilizer (Karlan et al., 2013)
Hence, worth trying to induce more take-up at market prices
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7.Many opportunities exist to make index insurance into a better product
a.Better contract design i. Fail-safe contracts: combine area indexing with audits.
Audit is provided if the index outcome is challenged (Elabed et al., 2013)
ii. Institutional-level contracts: producer organization, municipality, bank. Insured institution can in turn distribute the index-based payouts based on observed damages. Hence, focus on institutions with formal or informal risk-sharing capacity
b. Better data and measurement i. Better yield predictions at the plot level using remote
sensing (satellite) and crop modeling (Lobell, 2015) ii. IFPRI proposal: drones data, geo-referenced crowd-
sourcing photography
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c. Better marketing i. Regulation (like for seeds): Safe minimum quality
standards for index insurance. Guarantee that the market price is below the reservation price (max price that client can pay without being made worse off) (Carter)
ii. Pricing and smarter subsidies: Demand is highly price elastic. Subsidy is needed to promote adoption (learning) or to reach a given uptake (40% for PICC in China). If there is stochastic learning with recency bias and discouragement, subsidy needs to be adjusted every year based on past price (subsidy) and past payouts (Cai et al., 2015)
iii. Offer subsidized index insurance as a social safety net: avoid high fiscal cost of erratic relief expenditures (CADENA Mexico, China)
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d. Better delivery i. Financial literacy: extending the length of the
promotion session increases uptake from 30% to 50% in China (Cai et al., 2016). Diffusion of information through social networks help make financial literacy training cost effective.
ii. Trust in insurance provider: learning-from-others by witnessing insurance payouts increases own demand
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8.Combine index insurance with other risk-mitigating instruments
a. Incentives to precautionary savings: nudges more important than higher interest rates in motivating precautionary savings (Karlan)
b.Emergency loans: BRAC indexed emergency loans offered as an ex-ante credit line to good clients (minimum score based on credit history)
c. Risk-reducing technology: use resilient technology for small shocks; use index insurance for larger shocks when technology fails (drought and flood tolerant varieties)
i. Resilient technology has yield advantage in bad years: 45% yield advantage after 10 days submergence
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Shock-coping value of flood tolerant rice
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Flooded rice field in Odisha and yield resilience
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ii. Down-side risk reduction induces farmers to invest more in all years:
1.Cultivate more land, use more fertilizer, adopt more labor intensive planting methods, hold less precautionary savings, and take more credit.
2.Achieve higher yields in both flood and non-flood years, with expected gains in good years about equal to avoided losses in bad years.
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d.Managing risk with a portfolio of instruments: optimum combination of self-insurance, resilient technology, precautionary savings, emergency loans, and index insurance
Portfolio management of weather risk for smallholder farmers Based on concepts in Clarke and Dercon (2016) and Mahul (2016)
Frequency Severity Riskfinancing Ex-anteriskmanagement Ex-postshockcopingofevent ofimpact strategy (arrangedbeforeadisaster) (arrangedafteradisaster)Low Major Risktransfer Socialsafetynet Discretionaryaid
IndexinsuranceRiskretention Contingentpre-approvedcreditline Emergencycredit
Resilienttechnology AdjustedincomestrategyHigh Minor Precautionarysavings Expenditurereallocation
Risklayers
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Combining resilient technology, index insurance, and other financial products for
risk management
Traditionaltechnology(Swarna)
Farmergrossincome Resilienttechnology(Sub1)(%ofnormalyear)
Resilienttechnologyandindexinsurance100
Precautionarysavingsarea
Resilienttechnologyarea
Contingentcreditarea
Indexinsurancearea
Socialsafetynetarea
0 100 %yieldshortfallwithtraditionaltechnology
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9. Conclusion a. Weather index insurance can be uniquely effective for
smallholder farmers but has not worked commercially b.There are many ways of improving the product and
enhancing its take-up making it into a viable commercial product
c. Most important is to: i. Reduce basis risk: better contract design, better
indices, better data ii. Insure at the institutional level: banks, governments,
producer organizations, groups that already do risk smoothing (Dercon, Ethiopia; McIntosh et al., Guatemala)
iii. Combine insurance with other risk-management instruments (risk layering and portfolio approach):
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precautionary savings, resilient technology, contingent pre-approved credit line, social safety nets
iv. Embrace and optimize the use of smart subsidies: justified by social learning, externalities (better risk management induces investment), predictable public expenditures, better social safety nets, reduced clientelism in relief
