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Weather index-based insurance: Concepts and characteristics

Weather index-based insurance: Concepts and characteristics

Weather index-based insurance: Principles
Conventional crop or livestock insurance relies on direct measurement of the loss or damage suffered by the farmer. However, field loss assessment is normally costly or not feasible, particularly where there are a large number of small-scale farmers or where insurance markets are undeveloped.

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The essential feature of WII is that the insurance contract responds to an objective parameter (e.g. measurement of rainfall or temperature) at a defined weather station during an agreed time period. The parameters of the contract are set so as to correlate, as accurately as possible, with the loss of a specific crop type suffered by the policyholder. All policyholders within a defined area receive payouts based on the same contract and measurement at the same station, eliminating the need for in-field assessment.
Typical features of a WII contract are:
• A specific meteorological station is named as the reference station.
• A trigger weather measurement is set (e.g. cumulative millimetres [mm] of rainfall), at which the contract starts to pay out.
• A lump sum or an incremental payment is made (e.g. a dollar amount per mm of rainfall above or below the trigger).
• A limit of the measured parameter is set (e.g. cumulative rainfall), at which a maximum payment is made.
• The period of insurance is stated in the contract and coincides with the crop growth period; it may be divided into phases (typically three), with each phase having its own trigger, increment and limit.

WII is not a panacea. It is best suited to weather hazards that are well-correlated over a widespread area and where there is a close correlation between weather and crop yield. The strongest relationships typically involve a single crop, a marked rainy season and no irrigation. To date, most WII efforts have focused on the risk of rainfall deficit (drought).
WII is less useful where more complex conditions exist. Localized risks, such as hail, or where microclimates exist (for example, in mountainous areas) are not suitable for WII. Similarly, the scope for WII is limited where crop production is impacted by many or complex causes of loss (as may be the case in the humid subtropics), or where pests and disease are major influences on yields. For a given
environment, other insurance products may be more appropriate (such as area-yield index insurance or named-peril crop insurance).

Introducing WII to an area requires willing stakeholders: insurers, national weather services and linkages for distribution and support, including FSPs, agri-chain participants and government, which provides the regulatory environment. WII is b0est introduced using market-based principles and business practices, but often with an important developmental and social agenda. As such, private/public-sector
partnerships are common. There are many opportunities for technical and organizational innovation in WII.

Advantages and disadvantages of index insurance

Advantages:

Transparency. Index insurance contracts usually allow the policyholder direct access to the information on which the payouts will be calculated. Trust is strengthened by transparency.
No on-farm loss adjustment. This is a primary advantage of index insurance, as on-farm loss adjustment is quite complex and costly and may not be credible in many low-income countries.
Lack of adverse selection. Adverse selection occurs when potential insured parties have hidden information about their risk exposure that is not available to the insurer, who then becomes more likely to erroneously assess the risk of the insured. Traditional insurance encourages high-risk producers to insure, while risk and premium are calculated on the average producer. Index insurance requires that all insured farmers within the defined area have the same insurance payout conditions, regardless of their specific risk exposure. Hence, insurers and clients benefit from reduced adverse selection.
Lack of moral hazard. Moral hazard occurs when individuals engage in hidden activities that increase their exposure to risk as a result of purchasing insurance, or attempt to influence the claims outcome. These hidden activities can leave the insurer exposed to higher levels of risk than had been anticipated when premium rates were established. With WII, there is no benefit in individual producers trying to influence claims. All producers in the defined area are treated equally.
Addresses correlated risks. Index products work best where there are correlated risks. With traditional products, perils such as drought are challenging to insure.
Low operational and transaction costs. Index insurance requires limited individual underwriting (client assessment). It can be distributed, and claims can be settled, at relatively lower cost. Education on the product remains important, both prior to product launch and as an ongoing process.
Rapid payout. Measurement of weather station data, with no field loss adjustment, allows rapid payouts.

Disadvantages:

Basis risk. Basis risk in WII is a key constraint. Basis risk is the difference between the loss experienced by the farmer and the payout triggered. It could result in a farmer experiencing yield loss, but not receiving a payout, or in a payout being triggered without any loss being
experienced. Index insurance works best where losses are homogeneous in the defined area and highly correlated with the indexed peril. There are various types of basis risk:
• Spatial basis risk. Local variations in the peril occurrence (e.g. rainfall) within the area surrounding a weather station.
• Temporal basis risk. Inter-annual variations in seasonal crop phases, meaning that theinsurance phases are not temporally aligned with the intended crop growth stage.
• Product basis risk. Crop losses can be caused by many factors. Where there is no clear-cut relationship between loss and the indexed weather peril, basis risk can be high. WII is most likely to work for rainfed crops and at severe levels of the event, when losses may be more widespread and homogeneous.
Limited perils. WII normally covers only one, or sometimes two, weather perils. Although this reduces the cost compared with MPCI, the product may not provide broad enough coverage to satisfy risk management needs.
Replication. The triggers, limits and increments of a specific product need to be adjusted to reflect the weather parameters of each weather station. Different product designs are required for different crop types (or at least generic crop types). WII requires considerable
technical work in its implementation and sustaining.
Technical capacity and expertise are required, particularly during the initial design phase for new products, in agro-meteorology and in operationalizing the products.

Lack of weather data. WII depends on the availability and quality of weather data, which can drastically vary from country to country. In developing countries, the shortage of historical and real-time weather data is often a major hurdle.

(Source – http://www.ifad.org/ruralfinance/pub/WII_tech_guide.pdf)

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