Index Based Weather Insurance William Dick Commodity Risk Management Group

1. Managing Risk in Financing Agriculture - Expert Meeting Index Based Weather Insurance William Dick Commodity Risk Management Group Agriculture and Rural Development Department World Bank Johannesburg, April 2009

2. Global agricultural insurance market Source: Paris Re, 2008

3. Rural insurance constraints in developing countries Highly challenging environment for insurers Insurers lack rural networks, expertise, data Technically complex to insure crops and livestock Catastrophe risk exposures High transaction and loss assessment costs More profitable opportunities exist in commercial and urban areas Clients Small size, geographically spread Lack insurance awareness Lack capacity or willingness to pay premiums Lack incentives to insure if there is government disaster assistance Inadequate data and infrastructure Poor statistical base (crop production, risks, losses) Poor rural services including credit Difficult to establish distribution channels and linkages

4. Agricultural insurance – product range • Traditional crop and livestock indemnity products • Named peril crop insurance (e.g. hail) • Multiple peril crop insurance (yield guarantee) • Revenue insurance (yield and some price protection) • Livestock mortality insurance • Index-based products • Weather index products • Area yield index products • Livestock index products • Rural insurance products • Health, life, property, motor… • Microinsurance - a growing sector enabling rural households to access simplified policies

5. Risk assessment Senegal: Causes of Loss in Rain-fed and Irrigated Crops

6. Philippines - Rice Crop Insured Causes of Loss1981 to 2006 (26 years) (P.Pesos ’000) Total: P1,937,350 Source: Philippines Crop Insurance Corporation (Multi-Peril Crop Insurance)

7. What are index insurance contracts ? • An index insurance contract pays out based on the value of an “index”, not on losses measured in the field • An index is a variable that is highly correlated with losses and that cannot be influenced by the insured • Example indexes - rainfall, temperature, regional yield, river levels etc. • Key strengths • Index insurance overcome most of the supply side problems of MPCI • Objective and transparent • Provides timely payout • Reduce administrative costs • Facilitates international reinsurance • Constraints • Basis risk – the potential mismatch between losses and payouts • Provides single-risk protection • High inputs required during development phase • Weather data and networks • Requires local adaptation – slows the scaling up

8. Payout ($)  Payout ($)  Payout ($)  Deficit Rainfall (mm)  Deficit Rainfall (mm)  Deficit Rainfall (mm)  PHASE 1 Sowing & Establishment PHASE 2 Growth & Flowering PHASE 3 Yield Formation to Harvest Dekadal Cropping Calendar*  Sowing Window & Dynamic Start Date * Cumulative rainfall per dekad is capped to prevent excessive rainfall impacting the phase-wise total Simple Index Insurance Contract • Three-phase deficit rainfall weather insurance contract, indexed to a weather station • Pioneered by Indian insurance company ICICI Lombard in 2004 and subsequently in many CRMG pilots around the world (Malawi, Central America, Thailand)

9. Motivation/Benefits • Traditional crop insurance for smallholder economies is extremely challenging • Many constraints for traditional products based on individual loss assessments • Agricultural production suffers from covariant risks (e.g. drought) • Needs reinsurance • Risk management products adapted to developing countries could increase access to, and reduce cost of, agricultural credit • Index-based weather insurance: • Avoids the need for loss assessments • Lowers programme costs and technical complexity • Objective and timely • Works well for spatially correlated risks • Reinsurable

10. Product Limitations • Addresses only one aspect of production risk – deficit rainfall, excess rainfall, low temperatures etc. – amongst many – pests, poor inputs, farm management… • Similar to “named peril” insurance, but for systemic risk • “Basis Risk”, the potential mismatch of insurance payouts and actual losses on a farmer’s field, has two forms: • The inability of an index to faithfully capture the risk in question as effectively as individual field inspections • “Perceived” basis risk, another peril impacts a farmer’s crop production • New product, therefore training and capacity building required • For insurance sector, insured parties and distribution channels • Needs regulatory approval, adjustment to framework • Like all insurance, it is a commercial product • Presents limitations when dealing with non-commercial clients

11. Assess loss based on estimates of the area yield. Threshold is established less than the expected district yield Indemnities paid when area average yield is < than threshold. Requires sound official yield sampling Products date to the 1950s (Sweden) and has since been offered in Canada (since 1977) and the US (since 1992). India’s national crop insurance program (NAIS) is area yield Mixed social and market goals Actuarial performance is quite poor Assess loss based on the changes in a weather index over a pre-specified period of time at a particular weather station. Appropriate for highly correlated weather risks excess and deficit rainfall excess and deficit temperature. Strong, quantifiable relationship, must exist between weather risk and yield loss in order to establish the index on which the contract will be based. Relatively low administrative costs and does not face moral hazard issues. Index Based Products Area Yield Index Insurance Weather Index Insurance

12. Applications and experience Index insurance experience to date • Main application has been for drought risk at Micro level • Pilot scale implementation in several countries • Private sector scale-up of micro level only in India • Research to expand to other risks: flood, ENSO, cyclone

13. Micro level insurance program Meso/Macro insurance program Insurer Insurer Policies, premiums, claims Policies, premiums, claims Distributor Policyholder is Aggregator (e.g. processor, bank) Policies, premiums, claims Aggregator sets the payout rules Policyholder is Farmer Farmers Index insurance structures and entry points • Clear, well-defined, responsibilities are needed for stakeholders • Aggregator/Distributor is critical link

14. Stakeholders in rural insurance

15. Scope, limitations and lessons • Opportunity to embed weather insurance into larger development projects and lending • An integrated approach is needed linked to other rural services • Natural linkage to improved availability of agricultural credit • Climate adaptation and role of insurance • Insurance plays a supportive but not a leading role • Insurance is not a substitute for climate adaptation measures • Increased risk from climate change is a challenge to insurers • Lessons learned in agricultural insurance • Technically demanding and sometimes infeasible or costly • There is no universal insurance product • Public-private partnerships are needed for agricultural insurance • Devil is in the detail • Insurance is only one component of risk management • Insurance is not a panacea • Practice may differ from theory

16. Some issues for workshop consideration • Assessing the risks facing lenders • Understanding of reasons for loan performance • Risks – type, frequency, severity, client vulnerability • External, structural or political constraints in agricultural economy • Willingness and ability to repay • Systemic versus independent risk exposure • Insurance as collateral • Does index insurance meet lender requirements • Basis risk • Can risks not covered by an index be retained or managed elsewhere • Can index insurance be scaled up • Role of traditional versus index insurance • Role of credit guarantees • Smart structuring and delivery options • Improving entry points into the agri value chain • Meso versus micro solutions • Bundling/packaging • Public/private sector roles and donor involvement