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Index Insurance Could Reduce Social Inequity for Farmers

Barn Fire At Sunset

Almost two billion livelihoods around the world depend on agriculture, and many farming communities are susceptible to the devastating socioeconomic consequences of severe weather and climate change.  

Index (or parametric) insurance can be a powerful tool to help them. Index insurance is cheaper compared to traditional indemnity coverage and faster to issue payouts. Because it is triggered by a predefined peril intensity, such as the severity of a drought, index insurance offers vulnerable communities protection for their incomes.

It also presents a compelling opportunity for businesses to advance their environmental and social goals, especially those that work with agriculture supply chains, wholesale or retail credit providers and (re)insurers active in developing countries.  

However, thoughtful design and collaborative implementation are essential. 

Weather Index Insurance Is Taking Off

Unlike traditional indemnity insurance, index insurance does not require costly claims assessments because payouts are based on an unambiguous, objective scale. Index insurance also does not suffer from adverse selection, or moral hazard. This makes it well suited to microinsurance applications for weather risk management in poorer regions.

Weather index insurance is not new. It was first introduced in the early 2000s and has since been piloted dozens of times globally, ranging from large regional risk facilities to targeted local offerings.  

The more successful pilots are backed by public-private partnerships and structured as group covers, often with the insurance embedded in other services. Many development organizations have refined index insurance as a core element of “safety nets” against catastrophes that would otherwise perpetuate poverty cycles, including adverse weather events that cause food supply and income shocks.  

The capabilities of any one player are no match for the magnitude of these challenges, and all too many schemes fail to make it out of the pilot stage. Collaboration is key.

New entrepreneurs have enriched the enabling ecosystem through novel applications of remote sensing and payment technology and by taking advantage of better data sets bringing to bear progressively more refined risk models and ancillary digital services. Supervisors are also playing a role in creating friendlier microinsurance regulations.

So, while overall penetration rates among smallholder farmers remain disappointingly low — paltry even, in places like sub-Saharan Africa — a growing number are being reached alongside a rising volume of insured value and triggered payouts.

Showing the Social Value Is Essential

Why should we care? Frequently-cited impact metrics (number of insured customers, value protected, payouts made) are easy to track but do not tell the whole story. We need to look at more incisive indicators directly linked to longer-term economic empowerment and farmer welfare.

Social impact is difficult and expensive to prove. It is only in the last decade or so that the rise of field-based impact research, especially the use of randomized control trials, has helped to document evidence that comports with anecdotal experiences of the positive impact of weather index insurance.  

For example, an award-winning review by Harvard Business School citing independent studies across China, Ghana and India concluded:

Robust evidence suggests production-related microinsurance can increase economic output. Several studies show agricultural index insurance can improve farmers’ planting decisions, causing them to plant riskier, higher-yield crops … they show that insurance can not only facilitate consumption smoothing, but also increase expected [farmer] incomes.

This finding is all the more significant when juxtaposed against another finding in the same review that “there is almost no high-quality academic evidence that life or health microinsurance products improve welfare” (it may simply have been too challenging to prove).  

Embedding It In Smart Subsidies

Our experience at Blue Marble suggests there is a causal inference: Index insurance provides peace of mind, encouraging farmer policyholders to plant riskier, higher-income crops and also invest in farm infrastructure to improve yield productivity — thereby enhancing longer-term economic welfare, reducing inequality and, in turn, uplifting the entire community.  

In short, index insurance catalyzes a virtuous welfare cycle.  

It can also beget more far-reaching change. For example, an innovative index for hurricane protection on the Mexican coast uses part of the payout to restore coastal reefs that serve as a protective natural barrier.  

Similarly, the U.N. World Food Programme’s R4 initiative uses premium subsidies to help farmers access drought insurance in return for building small dams in the offseason, improving community resilience and reducing vulnerability over time.  

These examples inspire new uses of “smart” subsidies to encourage sustainable net zero and regenerative agriculture practices.

What Distinguishes the Good From the Bad?

Index insurance has many advantages over traditional indemnity-type covers and is the only tenable option for microinsurance purposes.

But not all index designs are the same.  

What separates a good one from a bad one is how “basis risk” is managed. In other words, how closely does the index payout performance match the actual loss experience?  

The question of managing basic risk continues to challenge many talented practitioners. Various solutions such as ex gratia basis risk funds, conditional audits and secondary indices have been proposed, but all add varying degrees of complexity, and none have proven satisfactory.   

At Blue Marble, we create locally optimized, customer-centric designs across large areas of geographically dispersed smallholders. This effectively breaks the tradeoff between depth and breadth — though a tradeoff between lower premiums and the possibility of an under-payout is unavoidable.

Given the importance of basis risk, it is vital to continually assess, among other things, how well the index tracks actual losses and whether it works well over large regions with variegated terrain and microclimates.

Collaboration Is Critical

Despite the immense benefits of weather index insurance, it continues to face stubborn challenges that afflict microinsurance in general: costly distribution, limited access to risk capacity, premium affordability, low trust, fixed transaction costs and poor financial literacy. 

The capabilities of any one player are no match for the magnitude of these challenges, and all too many schemes fail to make it out of the pilot stage. 

Collaboration is key.  

For example, our Café Seguro venture, protecting smallholder coffee growers in Colombia (now in its fourth year), is a shared-value ecosystem with Nespresso and others providing distribution access, premiums that are subsidized by the Colombian government and supported by Fairtrade funds, and reinsurance capacity that is provided by Blue Marble’s consortium of insurance industry owners. 

This all points to a natural entrée for ESG-minded private sector players into the space: Buyers, input suppliers and lenders can provide cost-effective access; (re)insurers can provide actuarial expertise and risk capacity; technology firms can provide the digital operational backbone; and the public sector and NGOs can enable premium support and capacity-building. 

The need for viable and enduring programs is urgent. The opportunity is clear, and on the eve of the 2021 U.N. Climate Change Conference (COP26), there is strong momentum for positive change. Now is the time to act.

Bilal Mughal

CEO of Blue Marble Microinsurance

Bilal Mughal is CEO of Blue Marble Microinsurance, an insurtech delivering affordable insurance protection programs to benefit low-income families and small businesses in emerging markets, and Head of Emerging Consumers, Zurich Insurance Company.

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