Institutional support of weather index insurance for smallholder integration

By Christopher Au, PhD candidate, Imperial College London, and 2016 Next Generation Delegate

Originally posted by The Chicago Council on Global Affairs, July 21st 2016

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Credit: Flore de Preneuf/World Bank

Growing Food for Growing Cities, by the Chicago Council on Global Affairs, delivers prescient conclusions on the future manifestation of supply chains, as urbanization and wealth generation influence the structure and orientation of social activities. Currently, the quantity of smallholder produced food to meet domestic demand is underwhelming, primarily caused by lagging productivity rates. From a social welfare perspective, smallholder agricultural underperformance constitutes a drain on economic activity.

Stagnant productivity rates are in part due to sparse use of improved inputs, where uncertain crop performance and risk of lost income deters investment, locking smallholders into a low risk, low return production strategy. Uninsured risk prompts costly self-insurance strategies, stunting economic development, hindering poverty alleviation efforts, and preventing a meaningful contribution from smallholders to food security.

Agricultural insurance is commonplace across the developed world, which can enhance individual and societal resilience through an increase in risk awareness, contractual obligations that require the reduction of exposure, the transfer of risk onto a third party expert and timely payments that facilitate a rapid recovery. Insurance protects households from deviations to income by maintaining overall asset levels and enabling farmers to remain in synchronization with crop cycles.

Provision of indemnity-based agricultural insurance is plagued by actuarial concerns of correlated risk (where many farmers are vulnerable to the same exposures such as insufficient rainfall) and information asymmetry (where farmers have greater knowledge of crop performance than the insurer). Weather index insurance is a recent innovation that lowers transaction and monitoring costs by use of external parameters that closely correlate crop performance.  Instead of individual assessments, remote monitoring and satellite observations of soil moisture, quantity and timing of rainfall help overcome the aforementioned chronic problems of insurance provision.

Yet despite these theoretical benefits and diverse testing within a range of well-funded pilot schemes, free market uptake is virtually non-existent. Such innovation strains existing infrastructural systems, both physical and institutional, which typically have not formalized index insurance products or demarcated best practice. The lack of risk data, poor financial literacy and weak financial infrastructure highlight the case for government intervention. As identified at the Symposium, it is the wider socioeconomic environment, regulatory landscape and enabling infrastructure that cumulatively determine smallholder access to credit, technology and markets by influencing the decision making process.  Thus, the burden rests with the state to curate the provision of socially and economically beneficial programs. The widespread welfare losses from large scale weather risks heightens the urgency of such involvement.

In the long term, a well-regulated insurance industry contributes to a widening of access to financial services and incentivizes disaster risk reduction. Insurance is a complex product and must be carefully managed to deliver the promised benefits; a poorly structured product may act as a disincentive for risk reduction by providing an unconditional safety blanket.  Targeted, institutional support can entice private sector participation, incorporate lessons from neighbouring vicinities and foster holistic governance which appreciates the diversity of stakeholders that accompany innovation towards financial sector inclusion.

The growing enthusiasm over high-level support for insurance is best illustrated through the G7 InsuResilience Initiative which targets 400 million policyholders in developing contexts by 2020.  Backed up by the Sendai Framework, the World Humanitarian Summit and the G20 Universal Financial Inclusion agenda, insurance is increasingly identified as a tool to assist in resilience building.  Those countries with a favourable environment for insurance development tend to create an institutional architecture to meet other financial sector needs, leveraging the provision of such services.  Institutional support and development are complementary processes and it is a sound regulatory and policy framework that is the starting point to entice a more resilient and food secure future, delivered by smallholder farmers.

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