Periods of drought have the ability to devastate crops. A lack of rainfall can leave subsistence farmers, who are reliant on a successful harvest, in desperate situations. Coupled with the uncertainty which climate change is now making a reality, there is an urgent need to consider how to increase the resilience of subsistence farmers.
A particular type of insurance – index based insurance – has evolved to address the needs of smallholders in regions most at risk from drought.
By offering the ability to protect investments against disaster, farmers may be encouraged to invest more in agricultural inputs and new farming technologies. The availability of insurance may also result in lenders becoming more willing to provide finance to farmers, with the risk of crop failure now further detached from the risk of default.
Index based insurance may pave the way for subsistence farmers, allowing them access to previously unavailable technologies to secure their development and escape the poverty traps which have so far hindered their growth.
Under traditional indemnity insurance, pay-outs are based on a client’s loss. With index based insurance, pay-outs occur when an index falls below a predetermined threshold. By using rainfall as this index and setting an appropriate threshold, farmers can take out policies to insulate themselves against the effects of drought.
As the pay-out under index based insurance is determined by an objective index, the need to verify losses through individual farm visits is eliminated. The requirement for verification of loss has previously limited the feasibility of traditional indemnity insurance.
The objective nature of the pay-out also means the policy is more resilient to moral hazard; with the pay-out no longer dependent on the crop, farmers remain incentivized to ensure its success in otherwise difficult conditions.
As the policy is determined by climate data only, there is no field loss adjustment. In theory, this should result in prompt policy pay-outs, allowing farmers to reinvest the proceeds into establishing next year’s crop.
Prior to implementing a policy, the climate data needs to be analyzed. A lack of reliable weather data in sub- Saharan regions may limit the ability of an insurer to set an appropriate threshold for an index based policy.
The issue of “basis risk” has also been identified as a particular limitation. This is the difference between the loss experienced by a policyholder and the insurance pay-out received. With an index based policy, a policyholder may receive a pay-out even though their crops have been successful. Conversely, and more concerning, it is possible for a policyholder to experience crop failure despite the threshold for pay-out not being exceeded.
Example: Ethiopian insurance
Following pilot studies, the government of Ethiopia introduced index based insurance with the aim of supporting the nation’s smallholders. The policy was initially offered to around 200,000 farmers, however, this looks set to increase as awareness spreads.
In October 2015, farmers in four regions of Ethiopia received their first pay-out under the policy, to cover the loss of the previous years’ harvest caused by an El Nino event.
Weather shocks can trap farmers in poverty, but the risk of these shocks also limits the willingness of farmers to invest in measures that might increase their productivity and improve their economic status. The International Finance Corporation found those insured under the Global Index Insurance Facility generated 16 per cent more in earnings and invested 19 per cent more in their farms when compared to uninsured neighbors.
Studies are showing that index based insurance is having a positive impact. Whilst not designed to protect against every peril, it is able to protect farmers where there is a well-defined environmental hazard.