What can index insurance offer to development?

The World Bank Group’s foray into index insurance started in 2000 with a $117,000 Development Marketplace grant to pilot weather insurance in four countries. 

Since then the institution has worked with insurers, reinsurers, brokers, banks, agribusinesses and governments to develop index insurance programs through the Disaster Risk Financing and Insurance Program and the Global Index Insurance Facility, managed out of the Finance and Markets Global Practice.

Based on a statistical index developed to measure deviations from normal for such parameters as rainfall, temperature, seismic activity, wind speed, crop yield or livestock mortality rates, index insurance pays out benefits for loss of assets and investments resulting from weather and catastrophic events; thus it doesn’t require the services of insurance claims assessors.

In countries where agricultural insurance and disaster insurance are either unavailable or expensive, index insurance can provide an alternative and protect people from shocks without placing insurers at an informational disadvantage.

As climate change adaptation and disaster risk management have become mainstream in development work, focus on insurance has increased because uninsured losses keep vulnerable populations in poverty.

Below, Panos Varangis and Daniel Clarke reflect on their work on index insurance and its use as a development tool.

Varangis: In many ways index insurance has not lived up to original expectations. Why?

Clarke: A lot of effort has gone into trying to offer index insurance to farmers. There have been approximately 150 donor-supported weather index insurance pilots alone, spanning perhaps 50 countries. But we haven’t seen many pilots maturing into sustainable, large-scale programs. I think it boils down to two key problems:

First, many products don’t seem to have been reliable enough. If a car insurance policy let the insurer flip a coin to decide whether or not to reimburse you for your totaled car, most people wouldn’t buy it. Yet some of the analyses of index insurance products for individual farmers—in Kenya and India, for example—suggest just this sort of mismatch between what happens to the farmer and what the insurer pays.

Second, even when indexed products offer reliable protection, people tend not to buy them. This may be due to high prices, low trust or risk aversion. Whatever the explanation, there seem to be huge challenges with demand, even for products that are fundamentally sound.

Varangis: We sometimes hear of situations in which farmers suffer losses but are not paid. Are there ways to address this issue so that farmers who bought index insurance aren’t let down?

Clarke: With index insurance, there’s always going to be a risk of it misfiring. The only way to really reduce this is to invest in data systems for more reliable indexes.

Then, it’s a consumer education issue. Do people understand what they’re buying? Do they understand what it protects them against, and what it won’t cover? Have they thought through what they would do if it misfired?

Regulators and insurers have an important role in making index insurance safe for the mass market. But they need to rely on statistics, not anecdotes. If programs around the world collected and shared the right data, and if the appropriate statistical techniques were applied, we could learn quite quickly about particular typesof index insurance products. This could help to identify products that don’t seem to work well, and provide comfort to insurers and regulators about products that do. If we don’t monitor, we can’t improve.

It’s difficult, but possible. Last month, Andrew Mude won the 2016 Norman Borlaug Award for Field Research and Application from the World Food Prize for his work to make index insurance safe for pastoralists in northern Kenya.

Varangis: Index insurance products were originally sold to farmers or individuals directly (retail). Is this the best approach? Is index insurance more promising for some applications than for others?

Clarke: In many cases index insurance works well for governments, and it seems to offer a lot of potential for banks or other aggregators such as NGOs. As Stefan Dercon and I write in our book Dull Disasters, insurance principles and instruments are starting to fundamentally shift the way governments, banks, charities and families pay for disasters—and this is great for development.

Index insurance and index insurance principles can be used to support financial resilience, beyond door-to-door sales by insurance companies to individuals. In many circumstances, these other approaches may be a cheaper, safer way to increase individuals’ financial resilience.

Varangis: High premiums for index insurance are not uncommon. Why? What can be done about it?

Clarke: Sometimes a high price for insurance is a signal that you shouldn’t be buying insurance, but need to start reducing your risk. Beyond this, to get good prices, insurers need scale or, at least, a credible potential for scale. Few index insurance programs have reached scale without substantial, continuing financial support from government. Of course, governments have to decide whether they want to provide financial support to insurance products. For those that do, there are lots of options. For example, the Kenyan government has big ambitions for its agricultural insurance program, and in addition to premium subsidies, it provides financial support through investments in audited data, which are used to develop reliable insurance indexes, create risk awareness among farmers and build capacity within government.

Varangis: What are the biggest knowledge gaps in index insurance?

Clarke: We really don’t know which products to invest in and which to pull out of, because there hasn’t been enough of the right kind of monitoring. Another interesting knowledge gap concerns where index insurance fits in. Should governments buy it? What about banks or charities? What should these institutions seek to protect against, and how should insurance be linked to preparedness planning and institutional decision making? While we don’t know the answers yet, a lot of experimentation is going on.

And now it’s my turn to ask you a question. What do you see as the biggest challenges to index insurance meeting its potential for the developing world?

Varangis: Index insurance needs to be accompanied by measures to reduce risk and be bundled within systems that improve productivity, access to markets and access to credit. Such packages are increasingly popular, and they are being used in several emerging economies that are modernizing agriculture. Better data, improved modeling, greater capacity for local insurance companies, awareness-raising among policy makers and financial education among farmers will be critical to increase the penetration of index insurance. Also, solutions aiming at the macro level (governments) and meso level (agribusinesses, financial institutions, producer organizations/cooperatives, etc.) perhaps hold more promise than retail, individual-farmer sales. Finally, overall insurance penetration is low in emerging markets. So index insurance is constrained by the same issues that leave most people in emerging markets uninsured.