The World Bank has issued a new policy research working paper on the rainfall index insurance market in market along with information on contract design and history.
Rainfall index insurance provides a payout based on measured local rainfall during key phases of the agricultural season, and in principle can help rural households diversify a key source of idiosyncratic risk. This paper describes basic features of rainfall insurance contracts offered in India since 2003, and documents stylized facts about market demand and the distribution of payouts. The authors summarize the results of previous research on this market, which provides evidence that price, liquidity constraints, and trust all present significant barriers to increased take-up. They also discuss potential future prospects for rainfall insurance and other index insurance products.
Download World Bank Case Study on Indian Rainfall Index Insurance Market
at the link below.
Households in India and other developing nations are often critically exposed to extreme weather-related events, including drought, flood, tidal waves and hurricanes. For example, in a household survey that we conducted in Andhra Pradesh, 89% of surveyed rural landowners cite drought as the most important single risk faced by the household (Giné, Townsend and Vickery, 2008). Weather shocks often affect all households in a local geographic area, making some forms of risk-coping, such as seeking help from nearby family, friends and neighbors, relatively less effective. Globally, household exposure to extreme weather events is likely to increase over future decades, due to climate change as well as population growth in risk-sensitive areas.
Efforts have been made in India and other countries in recent years to develop formal insurance markets to improve diversification of weather-related income shocks. The goal of this paper is to survey the features of one of these markets, namely the Indian rainfall index insurance market. “Index insurance” refers to a contract whose payouts are linked to a publicly observable index; in this case, the index is cumulative rainfall recorded on a local rain gauge during different phases of the monsoon season.
This form of insurance is now available at a retail level in many parts of India, although these markets are still in their relative infancy in terms of product design and distribution.
Rainfall insurance is only one of a growing range of “micro-insurance” products gaining popularity in the developing world. Examples include policies relating to health, livestock, accidental death and disability, property, weather, and microenterprise risk. Lloyd’s (2009) estimates that around 135 million low income individuals around the world already make use of micro-insurance in some form, and estimates a potential final market size of 1.5bn to 3bn households. Growth in these markets reflects a broadening of efforts towards greater financial access for the poor to include insurance and savings products in addition to micro-credit.
As with other microfinance products, a key challenge for micro-insurance is to design products that minimize transaction costs and ameliorate incentive problems, frictions which can otherwise make financial services to the poor prohibitively expensive. The key feature of rainfall index insurance that assists in this regard is that payouts are calculated based on a publicly observed and exogenous variable, namely local rainfall.
This significantly reduces transaction costs, because the household does not need to formally file a claim, and the insurance company does not need to do an inspection to estimate the amount of loss. Since rainfall data is observed in close to real time, this also means that claims can in principle be calculated and disbursed quickly to households. The use of an index also greatly reduces incentive problems, because the household is unlikely to have significant private information about the distribution of future rainfall shocks, and because the household cannot misreport the size of its loss.
The main disadvantage of index insurance is potential basis risk between the rainfall
index and the actual income loss suffered by the household. This will be greater when the distance between the insured household and the rain gauge is larger, for example, or when actual yields correlate poorly with the rainfall index. In addition, while index insurance is in part designed to minimize transaction costs, these costs may still be significant relative to the modest value of insurance purchased by an average policyholder, making the product expensive, at least by comparison to insurance in the developed world. Finally, even if the insurance product is well designed, other frictions may prevent households from purchasing it. For example, households may be liquidity constrained, may not have a sufficient level of financial literacy to properly evaluate the product, or may not fully trust the insurance provider.
As part of this paper, we describe the basic structure of rainfall insurance contracts commonly sold in India, and present some stylized facts on the distribution of returns on the insurance. While aggregate data on market size and growth are difficult to come by, we do document changes in product demand over time, summarizing data generously provided by the microfinance institution BASIX. We also describe stylized facts regarding the types of households that buy insurance, and factors that inhibit demand for insurance, summarizing results of academic research conducted by three of us.
Amongst our findings, we show that product demand is quite price sensitive, suggesting that increased economies of scale and competition could lead via lower prices to significant increases in insurance take-up. Our previous research also shows that other frictions are also important for take-up, however, such as financial constraints and the level of trust of the household in the insurance provider. We conclude with a discussion of the future of rainfall insurance and other related index insurance products.