Moving into the XXI century, images of lives devastated by floods in Asia, droughts in Africa and cyclones in Central America are becoming increasingly familiar, reminding us of how vulnerable people in developing countries are to climate change. Considering the hardships these people face every time a catastrophe dawns on them, could they not perhaps be insured against the perils of climate?
Joel Wiramu Pauling, , 2007
Certains droits réservés.
Recent headlines of devastation caused by Cyclone Sidr in Bangladesh, displacing over half a million people, or the massive floods in southern Mexico, leaving vast stretches of land completely submerged, are just the visible face of a growing problem affecting developing countries. According to a recent Oxfam report1, the number of weather related disasters has quadrupled over the past 20 years, with an average of 500 disasters taking place each year compared to 120 in the 1980s. Vulnerability to adverse weather events occurs for several reasons, among them the geographic location, poor infra-structure, economies highly dependent on agriculture, high incidence of poverty and limited means of coping with risk, including access to formal insurance. Climate change is expected to make matters worse, raising the likelihood of more extreme events like the ones mentioned above and posing real risks to development2. So, considering that many instruments already exist for risk-sharing and transfer, can these also be provided to the poor in rural areas of developing countries? Can the poor be insured against adverse weather events and climate change more broadly?
Risks, vulnerability and poverty
The rural poor own very few assets and income generation is largely dependent on labour put into agricultural activities. The main threats to livelihoods are therefore those pertaining to loss of life, critical illness, old age, lower agricultural productivity and loss of assets. To counter these risks, and considering that formal protection mechanisms such as social security and formal insurance are wholly absent, these people have developed sophisticated strategies to “insure” against negative surprises. Ex ante, they may diversify their sources of income and make more conservative decisions on farm technologies and techniques. Although less risky, these forms of income smoothing tend to yield low returns and contribute to the vicious circle of poverty.
They may also resort to risk coping strategies following a shock, such as drawing down their savings or through mutual assistance arrangements. The downside is that these strategies are often insufficient in dealing with shocks that affect whole regions (i.e. covariate shocks). This is especially true if the savings are held in cattle or grain, and thus perishable, and if the social networks are based on close relatives and neighbours which may be equally affected by the shock. There is also significant evidence that when severe economy-wide shocks occur, certain survival strategies are used that divert spending away from investments in education and health, with serious implications on the well-being of future generations3-4. Transitory events can therefore have permanent effects on household welfare5.
The insurance problem in developing countries
To avert many of the problems of managing natural disasters in rural areas after these have occurred, many governments in developing countries have experimented with providing crop yield insurance, with full compensation paid out for all losses incurred. These experiences have been financially disastrous, with governments subsidizing not only part of the premiums but also most of the delivery and service costs6.
Multiple factors contribute to why such programs have been so onerous to the public purse. First, there is the difficulty in discriminating farmers by risk profiles, with only high risk types coming forward to purchase insurance (“adverse selection”). This has been partly addressed by mandatory insurance programs, but has nonetheless resulted in low risk farmers paying relatively high premiums while others are profiting from the system. Subsidized premiums have also lead to excessive risk taking (“moral hazard”), such as growing unsuitable crops in high risk regions, therefore increasing exposure to future disasters.
Second, servicing such programs entails high transaction costs. Assessing crop losses is both difficult and time consuming, since it requires on-site inspections and verification of claims on a case-by-case basis. Furthermore, loss assessment is required more frequently for crop insurance than for other lines of insurance. These costs are further inflated by limited transportation, communication and legal infrastructure in rural areas.
Last but not least, these insurance programmes are ill-suited to cope with region-wide shocks. Insurance is based on the statistical “law of large numbers”, which means that the larger the pool of contracts, the more closely the losses reported will match the underlying probability of loss. However, this only holds when the risk faced by each policy-holder is independent from the rest of the lot. With spatially correlated catastrophic losses, the benefits of “risk pooling” are largely reduced, potentially leaving the insurer insolvent and the policyholders unprotected. The absence of a well-diversified insurance portfolio, with most schemes too focused on specific crops, regions and type of farmers, has indeed been a major cause of bankruptcy following the occurrence of natural disasters7.
The weather microinsurance promise…
Index-based microinsurance are contingent claims contracts for which payouts are determined by an objective weather parameter or index (i.e. rainfall, temperature, soil moisture, etc) that is highly correlated with farm-level yields or revenue outcomes. Each contract has a threshold – the strike – defined in terms of the underlying parameter, and payouts are made once that threshold is exceeded. This type of product fits into the broader category of weather derivatives, a type of financial product that has been used for some time in western countries as a mechanism for sharing risks due to weather phenomena8.
For example, an individual can purchase $100 of liability that pays if rainfall drops below 60% of the average for the period. The full liability would be paid out for rainfall below the average. Given that such an event would occur 15% of the time, the farmer would be charged a pure premium of $15. In practise, more complex contracts would generally be offered, offering different levels of protection under different rainfall scenarios while lowering premium costs to well below $5. More than an academic possibility, these index-based weather insurance products have already started being tested with some degree of success in countries such as India9, Malawi and Ethiopia, as a tool to hedge the risks of uncertain rain patterns.
There is a range of advantages which makes weather microinsurance potentially very attractive. First and foremost, it can be easily tied to specific events or hazards which are associated with climate change, such as droughts, floods or hurricanes. “Adverse selection” is avoided because all buyers in a region pay the same premium and receive the same indemnity per unit of insurance, regardless of their risk profiles. Similarly, because the amount of compensation is tied to an objective index which cannot be influenced by the buyer, both insured and uninsured farmers will have the same incentives to produce a profitable crop. It should also discourage overproduction of crops likely to increase environmental problems, which in turn increase vulnerability to weather shocks10. Further, weather microinsurance is considerably less expensive to administer than traditional insurance, given that there are no individual contracts to write, no on-farm inspections and no individual loss assessments.
This type of insurance also poses significant advantages in terms of outreach to potential clients. The standardized and transparent structure makes them relatively easy for purchasers to understand. They provide effective income protection rather than protecting against the loss of a single crop, and payouts can be quick, unlike the drawn-out and uncertain claim settlement process of traditional insurance. As such, they can be made available to a wide variety of parties other than farmers, including lenders, traders, processors, input suppliers, shopkeepers, and agricultural workers, as long as their income is highly correlated with the insured event. Weather microinsurance can also be bundled into existing microfinance schemes, namely by tying them to credit provisions or to the purchase price of inputs like seeds and fertilizer.
From theory to practice
Although a promising new development, there are many underlying supply and demand issues which may ultimately hinder its viability on a grand scale in developing countries.
First, not only weather monitoring stations need to be in place but also a clean and consistent historical record is required, ideally encompassing at least thirty years of daily data, so that the underlying weather index can be derived and premiums set at “fair” rates11. These are often lacking in developing countries, especially in rural areas most vulnerable to extreme weather. As such, premiums are often loaded beyond the “fair” price to account for the added uncertainty pertaining to the poor and unreliable weather information12. This is likely to be further compounded by climate change. Past climate and disaster history may no longer be a good benchmark, and future changes could be non-linear and abrupt, resulting in higher premiums and reduced insurance availability.
Second, long-term sustainability requires financial robustness and this critically depends on the ability of insurers to find efficient and affordable mechanisms that reduce portfolio risk and avoid insolvency when a disaster strikes. This can be achieved either through regional diversification or through transfer of part of the risk to the international reinsurance and/or financial markets (i.e. bonds). Regional diversification is only possible in large and geographically diverse countries, which amounts to a minority of developing countries. International reinsurance requires scale and sophistication, not least in the models for pricing extreme/catastrophic risk. Indeed, unlike microcredit, where starting very small and slowly scaling-up is most practical, any local insurer must start big if they are to attract interest of an international reinsurer. Securitization of risk, through the transfer of risk to international financial markets in the form of catastrophe bonds, may prove more affordable and effective than reinsurance, but it is yet to attract the attention of global investors.
Demand-side issues related to effective risk-reduction, price and awareness, may also undermine the uptake of weather microinsurance. At the outset, any decision to purchase insurance is informed by its effective capacity to mitigate risks. However, unlike traditional insurance, with this product there is a risk of not receiving a payment sufficient to cover the loss should it occur. This is because compensation is not a function of actual losses but instead dependent on a “proxy” indicator like the amount of rainfall13. Furthermore, the farmer is no longer insured against the damage of crop failure, but only against a specific weather event (e.g. drought). If crops fail for a reason other than drought, then the farmer receives no compensation.
The cost of the product also plays a crucial role. Microinsurance clients are generally poorer than those served by standard insurance and depend on income flows that can fluctuate considerably throughout the year. Premiums ranging from 3% of insured assets in India to somewhere between 6% and 10% in Malawi may still prove unaffordable to many and clearly out of reach for the poorest and most vulnerable who are living at or below subsistence levels.
Finally, demand is also contingent on good awareness of both the product and the risks at stake. Preliminary evidence from India highlights that the poor understanding of the insurance concept and the conditions underlying a derivative-type contract make up the top reason for not purchasing insurance14. There is also evidence that farmers underestimate their exposure to low-frequency, high-consequence losses15. They may therefore be unwilling to pay to insure against something which they perceive not to be a real threat.
The way forward
Despite the many challenges briefly discussed above, there is plenty of room for government and donor intervention in supporting microinsurance, especially in light of the generally ineffective and costly alternative – disaster aid. Microinsurance could be made more affordable by way of premium subsidies, although this would lead to the distortions observed in traditional insurance. Still, the benefits may outweigh the costs when considering the adverse medium- and long-term poverty impacts of imperfect risk mitigation. Other types of intervention that would greatly increase the feasibility and success of microinsurance include subsidization of research on weather and risk modelling, provision of monitoring infra-structure, participation in reinsurance and securitization arrangements through co-finance and awareness-raising at all levels, from the poor farmer to the international investor.
However, one must be aware that “viability” does not entail “effectiveness”. Providing weather insurance alone is unlikely to result in significant benefits if other constraints in the rural sector are not addressed simultaneously, including poor infrastructure, rudimentary technology, high prevalence of disease, access to land, seeds, fertilizer and knowledge, all factors which drive much of the vulnerability to climate change. With so many of these issues contingent on “grand development plans” which often fail to deliver, weather microinsurance may still be one of the best bets to provide some degree of protection, empowering poor people to adapt and withstand the stress of a changing climate instead of waiting for assistance that may never arrive.
References
1. Oxfam International (2007) Climate Alarm: Disasters increase as climate change bites
2. IPCC (2007) Summary for Policymakers. In: Climate Change 2007: Impacts, Adaptation and Vulnerability. Contribution of Working Group II to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change, M.L. Parry, O.F. Canziani, J.P. Palutikof, P.J. van der Linden and C.E. Hanson, Eds., Cambridge University Press, Cambridge, UK, 7-22.
3. Jacoby, H. and Skoufias, E. (1997) “Risk, Financial Markets, and Human Capital in a Developing Country.” Review of Economic Studies 64, pp311-335.
4. Foster, A. (1995) “Prices, Credit Markets and Child Growth in Low-Income Rural Areas.” Economic Journal 105, pp 551-570.
5. Carter, M., Little, D., Mogues, T. and W. Negatu (2005) “The Long-Term Impacts of Short-Term Shocks: Poverty Traps and Environmental Disasters in Ethiopia and Honduras.” BASIS Brief 28, May 2005, Madison: University of Wisconsin.
6. Hazell, P. (1992) “The Appropriate Role of Agricultural Insurance in Developing Countries.” Journal of International Development 4: 567-581.
7. Brown, W., C. Green and G. Lindquist (2000). A Cautionary Note for Microfinance Institutions and Donors Considering Developing Microinsurance Products. Microentreprise Best Practice.
8. Since early 1997, market participants in the electricity and natural gas sectors in the United States have used temperature-based derivatives to offset their exposure, in terms of variability of firm’s revenues and costs, to extreme temperatures (Martin et al, 2001).
9. One example would be deforestation to increase cultivated areas. Cutting down trees generally leads to soil erosion and increased run-off from rain, resulting in bigger losses from both floods, droughts or hurricanes. Given its carbon sink potential, deforestation can also increase vulnerability by adding directly to the climate change problem.
10. In insurance jargon, a (actuarially) fair rate basically means that it accurately reflects the probability and severity of the underlying accident.
11. Hogarth, R., Kunreuther, H. (1992) Pricing insurance and warranties: ambiguity and correlated risks. The Geneva Papers on Risk and Insurance Theory 17, 35–60.
12. More formally, this is called basis risk, and it arises because index insurance indemnities are triggered by a weather event, which may not be perfectly correlated with the loss function.
13. Gine, X., Townsend, R. and J. Vickery (2006) “Rainfall Insurance Participation in Rural India”, working paper, unpublished.
14. Kunreuther, H. (1996) “Mitigating disaster losses through insurance” Journal of Risk and Uncertainty 12 (2/3), 171–187.