Index insurance: What you need to know

Governments and some funders customarily set aside parts of their budgets as contingencies for disaster relief. At the same time, victims often wait too long for what may turn out to be inadequate assistance when that cash is deployed.

Small farmers usually rank high among those most severely hit by natural catastrophes. And there are some 2.5 billion of them scattered across the globe, according to World Bank Group estimates.

That helps explain why Ana Gonzalez Pelaez, co-author of a recent report from the University of Cambridge Institute for Sustainability Leadership, called insurance “an essential policy instrument” in efforts to meet the Sustainable Development Goals.

As a market mechanism, insurance provides a clear role for the private sector. And it can help taxpayers save money.

“Governments traditionally deal with [cataclysmic] events by paying for them after they occur,” said Gloria M. Grandolini, the World Bank Group’s senior director, finance and markets global practice, in an exclusive interview during a recent event on index insurance in Paris.

“Either the government or donor countries come up with the money. [Insurance] is not just risk management for the farmers, it is also a way for governments to deal with their contingent liabilities,” she said. “By creating a system whereby these risks are transferred to the market, you can have major fiscal implications.”

The extension of insurance to the world’s poor can create opportunities for partnerships between companies and other actors. Grandolini threw out a challenge to donors: “Why don’t you help pay the premiums?”

Insurance sounds like a great idea, but when disaster strikes it can be subject to bottlenecks. The prospect of deploying an army of claims adjusters in the aftermath of a catastrophe rings in on the far side of daunting — especially in hard-to-reach rural areas. Some microinsurance organizations are making valiant efforts, but the challenges of replication and scaling-up loom large.

Enter index insurance, which uses a statistically defined proxy instead of the confirmed loss of assets as a yardstick to determine the awarding of benefits.

Since it deals only with the benefits side of the equation, index insurance is not an alternative form of delivering access to insurance policies to the poor. Therefore it is not a competing model for microinsurance. Indeed, index insurance can be used just as easily by microinsurance outfits as it can by traditional insurance companies.

So how does it work in practice?

One obvious and easily understood index insurance metric is rainfall: under a certain level in a particular region, creating drought-like conditions, or over a certain amount, meaning probable flooding. Any agreed-upon deviation from average rainfall and the insurer pays out — no questions asked. No need to deploy a costly crew of claims adjusters. No reason to wait for their reports to approve payouts.

The concept can be traced back to India in the 1920s, when an economist named Chakravarti suggested the creation of insurance policies with payouts based on low rainfall. Since the 1950s, Sweden, the United States and, again, India have toyed with index insurance, but for the most part it has run under the radar. Almost a century later the World Bank still characterizes index insurance as “relatively new” and “innovative.”

To help encourage the spread of index insurance as a risk management tool, a World Bank multi-donor trust fund called the Global Index Insurance Facility is working with regional partners in developing countries, primarily sub-Saharan Africa, Latin America and the Caribbean, and Asia-Pacific. Over 1 million small farmers, pastoralists and small businesses have signed on — with over $130 million in sums insured.

Rainfall might be the classic example, but index insurance policies can theoretically be adapted to anything that is measurable. The GIIF’s work focuses on what Gilles Galludec, World Bank Group GIIF manager, called “climate-linked index insurance.” In practice, that can be translated as any natural condition or resulting phenomenon, including temperature, earthquake magnitude, wind speed, crop yield and livestock mortality rates.

Inevitably, the index is rooted in local conditions. “It’s linked to a region. It’s linked to a risk. It’s linked to a crop,” Galludec said.

With the emergence of new technologies, both measurements and client relations can work more quickly and reliably. “This index can be measured through weather stations or by satellites,” he said. “Information can be transmitted by mobile, as can payments. It is a revolution for clients in these remote locations.”

In Kenya, for example, three-quarters of the population is employed in agriculture. Over half of them are smallholders with less than five acres of land. Agriculture accounts for one-quarter of the country’s gross domestic product. Working with local outfit Agriculture and Climate Risk Enterprise Ltd, GIIF has managed to insure upwards of 340,000 farmers, with total premiums topping $2.5 million.

The World Bank’s role, said Galludec, is to forge partnerships with local insurance companies and help design products and create distribution channels — the latter increasingly involving telecommunications firms that run mobile phone networks. On the other side of the equation, it means pulling in international reinsurance companies, in Kenya’s case Swiss Re.

It also entails convincing people that insurance policies make sense in places where the industry’s market penetration might be less than 1 percent.

“We have to build the culture,” said Galludec. “We have to educate the clients. We also have to educate the intermediaries, up to the government. Through index insurance we educate them on risk management, and insurance. It opens doors to discussions about other risks: health, fire, and everything that can change people’s lives.”

To read additional content on land and property rights, go to Focus On: Land Matters in partnership with Thomson Reuters.