Academic journal article Agricultural and Resource Economics Review

Innovations in Index Insurance for the Poor in Lower Income Countries

Academic journal article Agricultural and Resource Economics Review

Innovations in Index Insurance for the Poor in Lower Income Countries

Article excerpt

This article focuses on innovation in weather insurance designed to fit the special circumstances of the poor in lower income countries where rural and agricultural financial markets are largely underdeveloped. Index insurance is an innovation that circumvents many of the fundamental problems that hamper the development of insurance for weather risks in lower income countries. With index insurance, payments are made based upon an objective and independent index that serves as a proxy for significant losses to crops, livestock, or other property. For example, the index can be based upon extreme rainfall measures that create either drought or flooding. Weather stations or even satellite imagery coupled with computer models can be used to create reliable "indexes" as the basis of payments. This article reviews this innovation by providing the background for its development and the motivation for using the innovation for the poor.

Key Words: index insurance, financial innovation for the poor, weather insurance, correlated risk, poverty trap, ex ante risk management

This article examines an innovation in risk mitigation-index insurance for weather risk. To establish the context and justification for insurance interventions, the article first explores the nature of risk and, specifically, the impact of weather risk on agricultural enterprises and rural house-holds. Agriculture remains a dominant economic activity for the poor in many lower income countries, comprising more than 40 percent of the work force on average. Furthermore, some 60 countries had more than 20 percent of their gross domestic product tied to agriculture in 2004 (World Bank data set). In the economic development literature, there is increasing recognition that the lack of rural financial markets for the poor is one reason so many poor are locked into poverty [Anderson 2002, Barnett, Barrett, and Skees (forthcoming), Barrett and McPeak 2005, and Carter et al. 2005].

This article first examines the effects of weather on income, behavior, and economic activity, and why weather-based agricultural insurance is needed in lower income countries. To provide background to the need for innovation in agricultural insurance, the article also provides a brief review of traditional agricultural insurance mechanisms used in higher and middle income countries, and the limitations to using those mechanisms in lower income countries. Next, the article explores how index insurance works, the advantages, constraints, and preconditions to developing these products, and the role of government and donors in supporting development of index insurance. The article closes with a discussion of the applications for index insurance and a look to the future.

For simplicity, the products discussed in this article are referred to as index "insurance." Nevertheless, as explained later, national regulatory agencies differ in how they define the term "insurance." Thus, these products may not be considered insurance products under every system (Hazell and Skees 2006).

Effects of Weather Risk in Lower Income Countries

In agriculturally dependent economies, weather is a significant factor for economic well-being. Particularly in areas of rainfed agriculture, variations in the weather are a major determinant of agricultural production. While variations are expected, natural disasters such as torrential rain, flooding, and prolonged drought can devastate a rural economy by damaging the major source of household, regional, or national income. Where there are no mechanisms in place to protect against large losses from extreme weather events, income and economic activities are likely to be depressed. Unmanaged weather risk can contribute to poverty and inhibit development. Beyond the immediate effects of a disaster, the chance, or risk, that a disastrous event will occur influences behavior and economic activity in the following ways:

* agricultural households can experience loss of income and assets,

* agricultural households will choose low-risk, low-return activities, and will not risk investing in technology,

* financial institutions may restrict lending to farm households, and

* overall investment in the rural sector may be deterred. …

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