Index insurance for agricultural transformation in Africa

September 29, 2016
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The paper discusses the renewed focus in using index insurance to manage risks in agricultural production in order to promote technical transformation of agriculture. It then demonstrates that unlike conventional agricultural insurance, which indemnifies policyholders for verifiable production losses arising from multiple perils, index insurance pays policyholders based on the observed value of a specified “index” variable, such as rainfall, that is highly correlated with losses.

Index insurance is less susceptible to the structural problems that have rendered conventional agricultural insurance too expensive and financially unsustainable for the developing world. Index insurance, however, offers less effective individual risk protection than conventional insurance and faces non-trivial challenges for sustainable implementation. Most early index insurance products were micro products designed for farmers, who would receive the payouts provided by the contract. However, given uniformly disappointing results with micro insurance products, researchers are now paying increased attention to offering index insurance to lenders, input suppliers, processors, farmer based-organizations, and exporters to strengthen the agricultural value chain in general, with farmers benefiting indirectly. In general, the paper summarizes lessons learned from index insurance projects undertaken in sub-Saharan Africa since 2000.

According to the paper, the best way forward with index insurance is to use it to strategically to manage the portfolio risks borne by lenders, processors, and exporters. Only then can the basis-risk reduction benefits promised by meso index insurance products be fully realized. Index insurance has the potential to reduce loan defaults (or losses from such defaults) across many farmers simultaneously in the event of a widespread drought, flood, or other natural disaster. Thus, if properly integrated into a lender’s portfolio risk management and loan policies, index insurance could dramatically reduce the lender’s exposure to catastrophic risk and promote the expansion of credit supply to subsistence farmers at lower interest rates, which in turn should spur increased adoption of higher-yielding agricultural technologies.

However, proper use of index insurance by lenders in holistic portfolio risk management requires a deeper understanding of the cash-flow risks faced by lenders and the debt restructuring policies they employ to manage such risks. Although lenders arguably are more sophisticated than farmers and thus better able to implement complex risk management practices, it is also true that many rural lenders in developing countries lack a culture of active risk management practices that employ insurance, reinsurance, and derivative products. Operational cash-flow models and risk management practices can be intricate and opaque and can vary from one lender to the next. Efforts to develop lender portfolio risk management strategies that incorporate index insurance can encounter difficulties if lenders are reluctant to openly discuss their trade and internal cash-flow management practices with index insurance specialists. For meso index insurance products to gain wide acceptance from donors and international agencies, there is a very practical need to demonstrate that they can generate tangible benefits to poor farmers, either through lower interest rates on loans or through significant expansion of services offered to such farmers.

The paper also shows that most pilot projects have been developed around a specific crop or farmer group and typically with the involvement of one or a very small number of lenders or processors. Although many lessons have been learned from these efforts, questions remain as to whether index insurance can take root in Africa and support its agricultural transformation. These questions, however, can only be answered by attempting expansion of the most promising pilot programs so as to (1) include a larger number of poor farmers on the fringes of the agricultural marketing chain; (2) span a greater variety of crops and production practices over a wider geographical scope; (3) develop alternative institutional frameworks that includes wider stakeholder representation, including a combination of banks, input suppliers, processors, and exporters; and 4) promote chances in lender, processor, and exporter risk management strategies.

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