Weather Index Insurance, Lending to Small Farmers, and Credit Risk Management Jerry Skees, President, GlobalAgRisk and HB Price Professor at the University of Kentucky

 Our Mission GlobalAgRisk, Inc. is committed to improving financial services for the rural poor through innovative approaches for transferring weather risk  Current projects in Mongolia, Peru, and Vietnam

Introduction  MFIs are contributing to economic development in lower income countries  Experienced fantastic growth  Empowered the poor  Effective sustainable solution  Focus on improving MFI business  Increasing access to credit for many segments  Increasing MFI solvency  Still agriculture and rural MFI access is limited  Innovations in risk transfer to ease constraints for Agricultural and Rural lending to small holders  Household insurance for livelihoods disruption due to catastrophic natural disaster risks  Business interruption insurance for rural lenders

High Concepts  Lenders can attempt to pool risk  May be possible when risks are independent  Can lead to very poor results if risks of borrowers are correlated  Agriculture still dominates the rural economies of many lower income countries  Financial markets are largely undeveloped in rural areas  Correlated Risk in agriculture remain a major reason

Consider 2 Villages  Both villages have 30 households  In an average year, each household expects to receive US$1,000  Three income earning activities are available 1. Crops 2. Livestock 3. Off-farm income

Village 1 versus 2  In Village 1 — All 3 outcomes of income will all occur in a single year (Independent Risk) 01/3 of households 1,0001/3 of households 2,0001/3 of households  In Village 2 — All households get the same income in the same year (Correlated Risk) 0 1 in 3 years 1,0001 in 3 years 2,0001 in 3 years  Goal — Assure that no household has less than $1,000 of income in any given year

Solutions for Village 1  Social solution – pre agreement for those 10 households with $2,000 income to transfer $1,000 to those with $0  Banking solution – pre agreement for those 10 households with $2,000 income to loan $1,000 to those with $0  Insurance solution – pre agreement for all 30 households to pay $333 to pre finance the outcome of 10 households receiving $0

More on the Insurance Solution Village 1 Insurance: (1/3 =.3333) Premium =.3333 x $1,000 = $333 Available: $333 x 30 households = $10,000  Remember in every year there will be 10 households with $0 Need: $1,000 x 10 households = $10,000  The pool works because exactly 10 households get $2,000 and can transfer $1,000 to the 10 households getting $0

Reaching the Goal in Village 2  Pooling risk is impossible since in any given year all 30 households can get 0 income, $1,000 income, or $2,000 income  If everyone in the community receives $0 income, everyone will starve and there is no opportunity to help one another Need: $1,000 x 30 households = $30,000 to protect against the $0 outcome (reserving)  In this scenario, microfinance and mutual insurance that are geographically limited will fail

Correlated Risk Affects Large Numbers  Regarding correlated risks, the local community will not be able to diversify their risk  A major weather shock (drought, flood, etc.) can affect  Crop income  Livestock  Off-farm jobs  In reality, household incomes tend to be neither completely independent nor completely correlated within a community  Microfinance and mutual insurance works for pooling independent risk  The challenge is still the correlated risk

Insurance for Correlated Risk  Goals for insuring correlated risk 1. Transfer risk out of local community 2. Offer affordable coverage  keep transaction costs low  Insuring correlated risk has been problematic  To make money selling insurance, premiums collected must cover 1. Expected indemnities (Price of risk) 2. Administrative costs

Return to Village 2  If we knew that the 0 outcome for everyone was clearly associated with lack of rainfall, an outside financial interest could write an insurance that would pay when there was a shortage of rainfall

Weather Index Insurance — Creating New Opportunities  Indemnities based on an objective, transparent measure that is important for livelihoods  Precipitation  Temperature  Flood levels  Does not require inspection of losses  Eliminates most asymmetric information problems  This is weather insurance, not crop insurance

Pricing Index Insurance Price of Index Insurance =  Increases opportunities for affordable coverage Price of Risk + Risk Financing + Delivery + Education/Marketing + Farm level/Asymmetric Information Problems  Adverse Selection  Moral Hazard  Loss Adjustment

Weather Index Insurance Limitations  Basis risk  Correlated risks only  Mostly single peril coverage  Weather data — Requires reliable historical and ongoing weather data

Example of an Excess Rainfall Insurance Product  Extreme rainfall in India — Payments would occur anytime rainfall exceeds 2000 mm  Client might buy US$1,000 liability

Payout Structure for an Example Excess Rainfall Contract  $1 for every 1 mm excess of 2000 mm  $1,000 limit at 3000 mm

Some Examples of Index Insurance  Mongolia – Index on soum (county-level) mortality to protect against dzuds (winter events that kill millions of animals) 14 percent of herders insured in year 2  India – Rainfall index insurance mostly against drought – nearly 1 million farmers purchased this is 2007  Malawi – Rainfall index insurance against drought – tied to lending and purchased of improved seeds  Peru and Vietnam – Index insurance products designed to protect the portfolio of agricultural lenders  Mexico – Macro index insurance to pre finance public expenditures after a natural disaster

Lessons Learned from Experience with Weather Index Insurance 1. Works best for CAT risks  Household risk coping approaches cannot manage these risks  These are the most disruptive events  Reduces basis risk  Better for low-quality data  Most not be sold as crop insurance  Can be used to protect against many livelihood strategies

Maintaining Household Interest in CAT Coverage  How do you keep households interested in CAT risk coverage?  Cognitive failure  Limited resources — High opportunity cost for purchasing insurance  In the best interest of rural lenders that households address CAT risk  rural lenders dependent upon household cash flow  Two options 1. Micro product — Livelihoods disruption for households 2. Meso product — Business interruption for credit risk of rural lenders

1. Micro Level — Livelihoods Disruption  Households involved in many livelihoods (crop, livestock, off-farm)  Disaster can affect all of them  Income shocks can endanger lives of household members  Weather insurance for livelihoods disruption — Provides risk management for all activities affected by that weather shock (e.g., drought affecting crops, livestock, etc.)

Benefits of Insurance for Livelihoods Disruption  Household benefits of improved risk management  Protects many livelihoods, not just one household crop  More likely to specialize in higher-return activities  e.g., Improved seed varieties or inputs for higher-expected returns  For rural lenders this reduces the risk of borrowers  Can use indemnities to repay loans  Reduces need to ration credit  Can lead to lower interest rates as correlated risks must be built into interest rate charges

Increasing Uptake of Insurance for Livelihoods Disruption  Households may still need incentives to purchase  Households need immediate benefits to overcome opportunity cost and cognitive failure  Linking insurance to services — Providing household benefits now  Linking insurance to credit  Improved access to credit  Credit at lower rates  Reduced delivery costs for both products  Linking insurance to savings  Improved access to savings  Insurance for CAT risks complements savings for small/moderate risks  Linking insurance to inputs (Improved seeds, fertilizer)  Can protect loans to cover inputs  Increases investments/use of credit

Household Products Are Difficult to Create  Household products to address CAT risk directly is ideal, but can be difficult to create  Problem of household interest  Problem of delivery  Need appropriate insurance company  Instead, a business interruption product for firms may be an important first step  Framing this as business interruption insurance should have a strong appeal to insurance regulators

2. Meso Level — Business Interruption  Portfolio risk is a major problem when lending for production has correlated risks in the region  MFIs could purchase product to insure its lending portfolio  Low basis risk — Idiosyncratic effects are smoothed across portfolio  Benefits  Increases lending for MFI  Provides cash when debt restructuring/defaults are leading to cash flow problems  Helps ensure solvency of MFI  Pass-through to households?

Peru — Proposed Business Interruption  A severe El Niño adversely impacts farmers, processors, transporters, and retailers  A severe El Niño raises default rates for loans for agriculture (as much as percentage point increase in current rates)

Risk Is Loaded into Interest Rate Charges  Cost of capital  10  Administrative cost  +18  Cost of risk loading?  +12 percentage points  Cost of Loans to farmers  40  Challenge — Could Risk Transfer of El Niño Risk take even ½ of the 12 percentage points out of this equation?

Peru — Proposed Business Interruption  Payouts based on NOAA measure of sea surface temperature  To be sold to MFIs for business interruption  Provided by local insurer  Global reinsurer providing risk transfer  Regulator has approved El Niño product

Measuring El Niño Positive ENSO 1.2 Sea Surface Temperature Anomalies (Three-month moving average) 1998

Designing an Index Contract  Extreme values of the ENSO 1+2 Index during the January–April growing season are strongly correlated to catastrophic rains in Piura 1998

Vietnam — Proposed Business Interruption  Vietnam State Bank to purchase business interruption for early flooding in Mekong Delta  Early flooding affects summer rice crop  Much of the bank’s lending is tied to rice production at this time  When early flooding occurs, default rates/loan restructuring increase at the state bank  Contract details  Based on water levels at a trusted river station  Covers a portion of bank portfolio risk  Contract provided by local insurer  Global reinsurer providing risk transfer for insurer  Approved by regulator

Summary and Conclusion  Managing correlated weather risk has been a major constraint financial services for agriculture in many regions  Weather index insurance is creating new opportunities to manage correlated risk in lower income countries  For households, weather index insurance may be most effective for protecting all livelihood strategies from CAT risk  Catastrophic business or livelihoods interruption insurance for small holders or business interruption insurance for rural lenders exposed to correlated weather risk offers some promise for expanding rural lending