19 November 2012

Africa: Index Insurance - a Free Lunch for African Farmers


An intriguing, private sector solution is emerging to help farmers manage rainfall risk

While only the most severe African droughts make headlines in the west, farmers in Africa constantly face the risk of poor rainfall, and the subsequent loss of livelihood and food security. Drought is the most common cause of severe food shortages in Africa and around the world.

In developed markets, the standard solution to yield risk is to provide crop insurance to farmers. This is impractical in Africa and many emerging markets, for a variety of reasons. First, the transaction costs associated with assessing the risk, pricing the policy, and servicing the policy are quite high relative to the premium a farmer with just a few acres of land could afford to pay.

The labour cost alone for an insurance company to send an incorruptible agent to verify losses could well exceed the price of a policy targeted at a small-holder farmer. Even if transaction costs were not an issue, the standard challenges of insurance, such as moral hazard (would a farmer spend the last of their savings to pay for costly irrigation if the plot were insured?) and adverse selection (will only the riskiest farmers sign up for a policy?) may cause the market to unravel.

Yet, an intriguing, new, private sector solution is emerging to help farmers manage rainfall risk: index insurance.These policies pay farmers if total rainfall during the growing season falls below a pre-specified level. In contrast to yield, insurance companies are happy to write contracts on rainfall, which is objectively measured, often with years of historical data that facilitate pricing.

Dismal scientists are famously reticent to admit the existence of a free lunch, but insurance is one area that can clearly be win-win for everyone involved. In fact, if you own a reinsurance company such as Swiss Re in your portfolio, you are helping poor farmers in Africa and India manage rainfall risk - and they are returning the favor by contributing to Swiss Re's bottom line.

A simplified example may help. Since rainfall insurance is a small part of Swiss Re's business, and Swiss Re is likely a small fraction of your investment portfolio, you would be happy for Swiss Re to take a bet that collects $10 from a farmer each year, with a 10% chance of paying out $90 at the end of the growing season. Swiss Re shareholders earn an expected profit of $1 over a three-month period for each policy sold. Of course, the farmer loses $1 on average, but that is a small price to pay for the security that comes in knowing a $90 payout will be delivered in case of a terrible drought.

Why rainfall insurance? Research suggests informal and semi-formal insurance networks developed by the poor enable them to smooth some shocks, such as illness or loss of a cow. But these informal mechanisms can break down in the face of a terrible drought, when everyone needs help. International capital markets can help.

Insurance can help raise incomes, not just smooth consumption. A rigorous research study in Ghana shows that farmers who are insured plant more land, and use more chemical fertilizer, than those without insurance.

At the Harvard Business School, we teach a case on index insurance to first-year MBA students as part of the required finance class. We see it as an important example of financial innovation that emerged in developing countries.

Yet, important barriers to widespread adoption remain. The details of policies may be difficult to understand, and it is hard to imagine a competitive market, as valuing the policies typically requires technical skills. Millimeters of rainfall do not map automatically to yields, as crops are subject to temperature, pest attack, and a host of other risks.

In Tanzania, the Dutch government is supporting efforts to tie payouts to satellite measures of yield, rather than rainfall, creating a true multi-peril insurance. In Kenya, the Syngenta Foundation is promoting the sale of index insurance via mobile payments, which dramatically lowers transactions costs. In Ethiopia, Oxfam is working with the government to enable cash-poor farmers to work in exchange for insurance.

African financial engineers may draw inspiration from India, where, in part thanks to the government, index insurance has grown to covers seven million farmers. Indeed, with over half of the worlds' poor engaged in agriculture, it could in time dramatically change the lives of African farmers, having a greater impact than its older sibling, micro-credit.

Shawn Cole is Associate Professor of Business Administration at Harvard University.

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