INNOVATIONS IN RISK MANAGEMENT INDEX INSURANCE JERRY SKEES H.B. Price Professor OCTOBER 24, 2006 University of Kentucky and President GlobalAgRisk, Inc.
Development, Livelihoods, and Risk Risks can impact the asset position, ability to generate income, and creditworthiness of households, businesses, and governments, slowing development. High transaction costs limit access to financial services and global markets, resulting in suboptimal risk-coping strategies. Agricultural activity still dominates the livelihoods of many rural poor in low income countries — agricultural activity is exposed to a wide range of risks.
Agricultural Risk Identification Risk is experienced at different levels due to specific events such as low prices and adverse weather. Risk Experienced By . . . MICRO Individual Households L E MESO Market Intermediaries and V Local and Regional Governments E L MACRO National Governments and International Organizations
Poverty Traps Created by Severe Events A minimum asset base is necessary for households to invest in education, accumulate assets, and improve economic well-being. Rapid onset shocks can knock households below this minimum asset threshold, resulting in a poverty trap. Slow onset shocks can also result in poverty traps depending on the coping strategies available to and chosen by households.
Poverty Traps and Responses to Events Households sell assets to maintain minimum levels of consumption — this in turn reduces future streams of income; or Households reduce consumption to protect assets — this can impact the human capital needed to generate future income streams.
A Hurricane’s Impact on Asset Trajectory shock recovery better-off HH Assets poorer HH poverty-trap threshold Time Source: Carter, Little, Mogues, and Negatu 2005
One Reason Poverty Traps Persist — Lack of Rural Finance Markets Well-Developed Rural Financial Markets Saving and Insurance occurs before the event occurs Borrowing can be a response after the event occurs Delivering banking and insurance services is expensive — cost is largely fixed making access to small and poor households even more difficult Savings Borrowing Insurance
Strategies for Risk Coping TIME FRAME Event Occurs EX ANTE EX POST Before the Event After the Event DROUGHT STRATEGIES INFORMAL FORMAL INFORMAL FORMAL Individual or Market or Individual or Market or Community-based Policy-based Community-based Policy-based
Independent versus Correlated Risk Independent risks are insurable because they are unrelated and generally impact different people at different points in time. Correlated risk (i.e., commodity price risk) affects a group of people in a region or multiple regions at the same time to a similar extent. Most weather-related events and natural disasters are “in-between” risks, neither perfectly correlated nor independent, resistant to traditional insurance pooling.
Markets for Different Types of Risk 0% 0% 100% 100% No Correlation No Correlation Correlation Correlation In-between Risk In-between Risk Auto Accidents Auto Accidents Natural Disasters Commodity Prices Natural Disasters Commodity Prices Rainfall / Crop Yields Rainfall / Crop Yields Insurance Markets Insurance Markets Futures Markets Futures Markets
High Probability Low Consequence versus Low Probability High Consequence Risks versus
What Can be Done? — Risk Management A major challenge for low income countries is to develop an appropriate risk management framework to address these concerns. This framework must be designed to manage correlated risks that accompany many low-probability, high-consequence events. An effective risk management strategy should mitigate risk at the micro, meso, and macro levels.
What are the Benefits of Risk Management? An appropriate risk management framework Avoids depletion of assets Encourages investment Enables more efficient use of resources Permits effective financial design Provides timely and efficient aid Improves the targeting of vulnerable households Clarifies the roles of the public and private sectors Enhances safety nets Facilitates more efficient country-level risk management strategies
Examples of Support for Risk Management in High Income Countries The United States and Canada have heavily subsidized crop and revenue insurance programs. Spain also provides government-supported crop insurance using a different model
Income Support and Risk Management in High Income Countries Government-supported risk management programs of high income countries are expensive and not sustainable distort production decisions may be inconsistent with WTO agreements are difficult to implement favor large farms
Examples of Government-Supported Crop Insurance Presently there are few examples of successful models Financial performance of crop insurance Condition for sustainability Country Period (A+I)/P (A+I)/ P < 1 Brazil 1975–81 4.57 Where A = average administ rat ive cost Costa Rica 1970–89 2.80 I = average indemnit ies paid Japan 1985–89 2.60 P = average premiums paid Mexico 1980–89 3.65 Philippines 1981–89 5.74 USA current 4.00 Source: Hazell, 1992
Traditional Problems Adverse selection The most risky farmers buy Less risky farmers stay out Moral hazard People change their behavior after they are insured: their risk is greater
Pricing Insurance Price of insurance = Cost of the risk + Cost of information to control adverse selection + Cost of monitoring to control moral hazard + Cost of loss adjustment + Cost of delivery + Cost of ambiguity of risk 0 500 1000 2000 3000 4000 + Cost of ready access to capital to pay for all losses Index insurance should have lower administrative, lower ambiguity risk, and lower adverse selection and moral hazard than traditional insurance
Challenges for Insurance Markets Fiscal constraints Limited government resources High opportunity costs of government funds Structural constraints Smaller farm size High administrative costs Market constraints Underdeveloped financial and insurance sectors Lack of access to international financial markets Small volume of business Informational constraints Data Education Institutional constraints Weak regulatory environment Lack of contract enforcement
Yield, and Disaster Risk Management in Low Income Countries — The Challenge To develop cost-effective risk transfer instruments that do not distort incentives and that address the needs of participants at the micro, meso, and macro levels, while recognizing the country’s unique constraints.
Framework for an Innovative Risk Management Approach — Use of Market-based Instruments 1. Understand existing risk-coping strategies 2. Emphasize ex ante rather than ex post solutions 3. Focus on risk layering risk retention risk transfer 4. Focus on risk assessment at the micro (households) meso (intermediaries) and macro (national and global participants) levels
Index Insurance Pays for losses based on an independent and objective measure that is highly correlated with losses Extreme rainfall events Freeze Crop yields by area (US – GRP county) Mortality rates by county (Mongolia)
Index Insurance for Extreme Rainfall Extreme Rainfall in India Payments would occur anytime rainfall exceeds 2000 mm A Bank might buy US$1 million liability For every 1 mm = pay $1,000 4000 0 500 1000 2000 3000
Pre-conditions for Index Insurance For Weather Risk Weather event must create correlated losses Index must be a good proxy for loss Event must be observable and easily measured Third party should be involved in the measurement System must be objective and transparent Historic data must exist to price the risk
Traditional Crop Insurance versus Weather Index Insurance — A Cost Comparison versus
Applications of Index Insurance Index insurance can be sold to: Individual farmers (US, Canada, India, Brazil – area yield insurance / India – rainfall insurance (250,000) Microfinance / rural banks (Peru – COPEME) Importers for famine relief (WFP – Food security) Governments for disaster aid (Mexico- Fonden) Herders based on livestock deaths in an area (Mongolia – 2,400 herders purchased) Irrigators in a irrigation valley (Mexico IDB project) Agribusinesses (who are at risk- when their farmers have cash flow problems) Traditional crop insurance providers to serve as localized reinsurance
The Importance of Risk Aggregation When Using Market-based Risk Transfer Instruments Small households may not be able to use risk transfer instruments directly. Weather insurance relies on proxies that do not eliminate basis risk. Intermediaries may be needed to aggregate the risk to: Mitigate basis risk Reduce transaction costs Strengthen the negotiation position
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