Index Insurance and Climate Risk

For poor people, a variable and unpredictable climate can critically restrict options and limit economic development. For example, banks are unlikely to lend to farmers if they think a drought will cause widespread defaults, even if the farmers could easily pay back loans in most years. The farmers' lack of access to credit limits their access to improved seeds, fertilizers and other necessities.

Now, if the farmers could insure their crops against loss, then they could persuade the banks to give them loans. But traditional insurance is generally too expensive to implement in rural parts of developing countries. Enter index insurance: it uses a weather index, such as rainfall, to determine payouts, and this resolves a number of problems that makes traditional insurance unworkable in many poor rural areas. For example, with index insurance contracts, an insurance company doesn't need to visit a farmer's fields to determine premiums or to assess damages in the case of crop loss. Instead, if the rainfall recorded by gauges is below an earlier, agreed-upon threshold, the insurance pays out. Such a system significantly lowers transaction costs and allows insurance companies to sell to small farmers, which means they can then apply for bank loans and other types of credit previously unavailable to them.

To be sure, institutions need to overcome some major challenges before they can scale up the use of index insurance to cover significant percentages of an at-risk population. The new report, called Index Insurance and Climate Risk: Prospects for development and disaster management, discusses all these technical and operational hurdles, and presents a number of case studies on the use of index insurance around world thus far. You can read more here, or watch a 5-minute audio slideshow on why many are excited about index insurance as a means to help reduce climate risks to farmers and others: http://www.vimeo.com/5295491

For more information please get in contact with Francesco Fiondella at francesco@iri.columbia.edu