Index insurance, which relies on an observed value of a specified “index” or some other closely related variable that is highly correlated with losses to determine payouts, could significantly help those uninsured against environmental disasters in the developing world by providing an attainable safety net for crop protection.
New research from Mario Javier Miranda, AEDE Andersons Professor of Finance and Risk Management, and Katie Farrin, AEDE Ph.D. candidate, published in the Autumn 2012 edition of the journal Applied Economics Perspectives and Policy, provides a review of recent theoretical and empirical research on index insurance for developing countries and summarizes lessons learned from index insurance projects implemented in the developing world since 2000.
In low-income countries, especially in rural areas, traditional insurance options are often not feasible due to a number of capacity restraints. Index insurance offers a real work-around for these types of problems. For example, in the case of weather-related insurance that uses a rainfall index, insurance providers do not need to visit affected policyholders to assess damages or determine premiums in the event of a rainfall payout. Instead, under an index insurance contract, if earlier agreed upon thresholds are not met (for example, if the amount of recorded rainfall in a coverage area falls below the required amount for crop production) the insurance provider will pay the policyholder to cover his losses from lack of rain. Indemnities are thus determined by a pre-specified payment schedule and not by actual farm-level losses.
This type of setup drastically lowers the transactions costs associated with traditional insurance options, which makes index insurance affordable to those in the developing world. Additionally, having access to insurance often enables policyholders to apply for loans and other lines of credit from which they were previously cut off. However, one downfall to this insurance type is that it offers less effective individual risk protection.
In the article “Index Insurance for Developing Countries”, Miranda and Farrin offer a simple, dynamic model to explain an important aspect of observed low demand for farm-level index insurance: poor individuals value current consumption over the purchase of insurance. This is especially the case where future payments aren’t guaranteed to match actual losses.
After using case studies of index insurance programs in India, Peru, Kenya, Mongolia and Vietnam to highlight some of the challenges faced by development practitioners, the authors offer direction for future research and index insurance pilots. Theoretical and empirical findings suggest that upcoming work in the field should focus on (i) developing contracts for sale to larger entities, such as banks and input suppliers, who aggregate risk by lending to farmers; (ii) performing impact evaluations to assess whether farmers have benefitted from the purchase of index insurance; (iii) improving the quality, quantity and availability of collected data that would help to evaluate the risk-reduction benefits of index insurance; and (iv) attempting to scale up existing pilot programs, as well as widening the scope of coverage of crop varieties, production practices, and regions.
To access the journal article, please visit the Applied Economics Perspectives and Policy website.
October 19, 2012