2007 Reports

Designing Weather Insurance Contracts For Farmers

Osgood, Daniel E.; McLaurin, Megan; Carriquiry, Miguel; Mishra, Ashok; Fiondella, Francesco; Hansen, James E.; Peterson, Nicole; Ward, Niel

This report presents project products to the Commodity Risk Management Group of the World Bank for the development and evaluation of index insurance contracts for smallholder farmers in Malawi, Tanzania, and Kenya. The development of some products we are providing was supported at no cost by the NSF-funded Center for Research on Environmental Decisions. Index insurance is a relatively new weather risk management tool. While traditional insurance insures against crop failure, index insurance insures for a specific event or risk, such as rainfall deficits. The index insurance can be more cost effective since there is no need for in-field assessment of damage because payouts are triggered by weather data directly. Index insurance addresses two problems associated with traditional crop insurance: moral hazard (incentives for a farmer to let a crop die in order to get an insurance payout) and adverse selection (in which insurance is priced based on the risks of the entire population but only the most vulnerable farmers purchase insurance). However, index insurance only provides partial protection and is therefore only one part of a complete risk management package. It is critical that the client have a comprehensive understanding of exactly what risks are covered (and what risks are not covered) by the index product so that clients can effectively use the insurance as a part of their risk management system. Products must be transparent and completely understandable to the client or they will not be able to play their proper role. We designed and evaluated contracts for Malawi, Kenya and Tanzania. Because some contracts existed for Malawi prior to this project, and since the insurance is in its second year of implementation in Malawi, the Malawi initial contracts and implementation are used as a starting point. Following the project specification, we have developed in depth analysis, such as process based crop simulations and quantitative analysis of historical data, for the Malawi case study. These additional analyses are unique to the Malawi case. In general, the contract development and evaluation process has led to a set of contracts that appear to perform extremely well. So much so, that demand in many places has overwhelmed administrative capacity to serve clients. As this is an unsubsidized product that is purchased by clients, some indication of its value can be seen in its market demand. In interviews, farmers have stated that their primary strategy for adaptation to climate change is enrollment in the insurance program. Much of this success is due to the outstanding input and support from project partners, including strong data and analysis support from the Malawi, Kenya, and Tanzania Meteorological services. Because of their wide range of competencies, it is likely that these Meteorological services could play a much expanded role in project scale up. There are several issues that we addressed in evaluating and improving the initial Malawi 2005 pilot contract design process for updated contracts in Malawi Kenya and Tanzania. First, the initial Malawi contracts had particular features in the formulas that we modified in order to increase robustness, performance, flexibility, and transparency. Second, we extended the design process to include more statistical analysis so that contracts addressed climate characteristics as well as agronomic features of crops. We evaluated and improved the crop water stress calculation techniques to more effectively represent drought related risk in the contract. We developed a systematic design methodology that could utilize the strengths of each source of imperfect information. Finally, we provided formal mechanisms to incorporate financial constraints in the contracts. There are several important issues that have yet to be addressed in the design of future contracts, in order to ensure that the product evolves into a fully sustainable and scalable product. It is important to build capacity for local design and adaptation of contracts as existing needs change and new needs are identified. It is critical that the pace of product upscaling does not exceed the pace of capacity development and project improvement. In addition, the design process must be updated in order to allow for information in seasonal precipitation forecasts to be utilized in the insurance strategy. Crop breeding programs can be integrated into this process. Contracts could be developed further to more elegantly address failed sowing issues and sporadic starts to the rainy season. Index contracts and reinsurance must be designed acknowledging regional and global climate features, since large scale climate processes can lead to negatively correlated seasonal rainfall between regions. Work should be done to more accurately and transparently characterize the distributions underlying historical precipitation that lead to losses and payouts beyond historical burn analysis we used for improved characterization of risk. Techniques must be developed to interpolate information between stations and to use satellite based products. These, and related techniques should be advanced to enable a quality product to be established when a new station is installed, to detect data tampering, to reduce basis risk, and perhaps enable the availability of index products where met stations are not available. Indexes should be explored to cover additional risks, such as excess rainfall. It is worthwhile to utilize economic contract theory to develop incentives that discourage tampering and encourage accurate farm reporting. Contracts could be designed to reveal the value of insurance through market transactions. It is important to develop communication tools for cooperative design, education of contract issues, and exercises to test for farmer understanding of products.