Risk to Small Farmers

1. Risk to Small Farmers Shubhashis Gangopadhyay India Development Foundation (June 5, 2004) Prepared for the conference on Integrating the Rural Poor into Markets

2. Risk • Subsistence versus commercial farming • Why is risk critical? Inability to absorb losses

3. Role of Financial Markets • Reducing the cost of finance • Reducing the risk of farming • Insurance model Low probability, high losses High probability, crisis

4. Insuring Against Risk • Insurance 100 with probability p W 0 with probability 1-p L Coverage bought will be 100 W - L Independent of the probability Premium rate = 1-p If p = 0.8, premium = 100*0.2 = 20 If p = 0.7, premium = 100*0.3 = 30

5. Insuring Against Risk (contd.) • Payoff Good crop: 100 – 20 = 80 Bad crop: 0 – 20 +100 = 80 • Perfect consumption smoothing • 20 to be paid upfront

6. Feasibility? • The subsistence farmer Income of INR 24,600 Probability of loss (INR 0) 0.2 Poverty line INR 328 Annual subsistence need INR 19,680 Premium per year INR 4,920 • 2.4 months of household income

7. Some Other Problems • Incentive issues Adverse selection Moral hazard • Limited liability (5 for 1) • Correlated risk

8. An Alternative • with probability 0.8 0 with probability 0.2 Sell a ticket that pays 1 if good weather at a price of 0.8 Buyer gets 0.8*1 + 0.2*0 = 0.8 so buys the ticket

9. An Alternative (contd.) • Farmer sells 100 of these tickets • Gets 0.8*100 = 80 • In good weather has 100+80-100 = 80 • In bad weather has 0+80 = 80 • Exactly the same payoff as insurance

10. Alternative is Better……. • Collecting money upfront Solves the liquidity problem • Borrowing rate greater than lending rate Alternative makes money • Correlated risk • Credibility and unlimited liability

11. Market Solution • Not rainfall insurance • Who cross-subsidizes whom? • Who are the players? Could be anybody!

12. Getting the Systems • NGOs • Credibility of NGOs • Clearing house • Technology • Speculators!

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