‘Parametric’ insurance could offer farmers quicker relief when they lose their crops to floods, storms and other climate-driven calamities.
Climate change is causing frequent heat waves, erratic rainfall, flooding and other extreme weather events that have a devastating impact on Asia’s agriculture. Disaster-related damage to crops and livestock in Asia is estimated at more than $49 billion since 2010, the highest among all regions.
In the People’s Republic of China, about 40 million hectares of crops have experienced yield loss from extreme weather events every year since 2000. The most recent flash flood in May 2022 in Bangladesh caused about $6 million crop loss, impacting the livelihoods of 24,000 farmers in the two affected districts. The agriculture sector in Asia, which supports more than 350 million small farmers, is suffering.
Climate crop insurance offers an opportunity for small farmers to mitigate these risks by pooling and transferring them to those better capable of managing them. Traditionally, crop insurance compensates farmers based on their production loss caused by adverse weather incidents. This type of indemnity insurance is often time-consuming and costly, given that an assessment of actual damages by a certified loss adjuster is required for payout.
To address this, governments are increasingly considering “parametric” insurance options, which rely on pre-defined parameters to trigger payout. This helps overcome the shortcomings of indemnity-based insurance by directly linking the compensation to specific parameters rather than farmers’ actual loss. The results are reduced transaction costs, greater transparency, and a faster processing time.
For example, in the case of flooding, parametric insurance policy holders would receive a pre-determined payout immediately as the flood occurs. This serves as an emergency source of finance that helps farmers to cope with unexpected losses. However, payout for farmers who participate in indemnity-based insurance would be delayed for a longer time to assess the actual crop loss from the flood and determine the payout.
Parametric insurance can be designed to cover the probability of extreme weather events using weather parameters such as rainfall, temperature, and drought. This is also called weather-based index insurance.
Weather-based index insurance is a powerful tool for stabilizing farmers’ income.
How does weather-based index insurance work?
Weather-based index insurance can rely on remotely sensed weather data to determine a threshold level of weather variables. Previous extreme weather events and their impact on agricultural production loss are used to estimate the pay-out rates for policyholders. As soon as the weather parameters exceed the predetermined threshold, policyholders are paid the amount in the insurance policy contract. Premiums are normally defined based on payout which is related to the expected income loss or cost of production.
Studies have documented the benefits of weather-based index insurance products to mitigate the negative impacts caused by extreme weather events, through improved risk management and improved income for the farmer. For example, by providing cash payment immediately after a drought in a drought-index insurance scheme, Kenyan farmers were able to better cope with livestock mortality and reduce their demand for food aid.
Thanks to a rainfall-index, farmers in India can diversify their crop production while increasing their ability to manage risk. Weather-based index insurance can also encourage farmers’ adoption of climate change adaptation technologies by bundling the insurance policy with a specific set of farming practices or technologies. This has been done in Malawi, where weather-based index insurance was bundled with loans for specific crops, which increased farmers’ incomes. In Indonesia, insured rice farmers were found to increase their profit by 26%.
A large group of farmers is also beneficial to pool the risks and diversity of the payouts across larger areas or for different events to provide greater financial stability of the insurance provider.
However, experience with weather index insurance shows that developing these markets involves high start-up costs. In addition to designing and marketing products, educating local insurance agents, government officials and consumers is also needed. These efforts help address a lack of trust in insurance providers, lack of suppliers, and limited knowledge about potential risks and role of insurance options.
One of the main challenges is to define an appropriate payout rate that corresponds to actual loss experienced by the farmers. Lower payout rates than expected will result in a low demand for the coverage. Careful research and climate risks assessments from scientists are essential to design an appropriate weather-based index insurance product that meets farmers’ demand.
Another challenge is the premium cost of the insurance that farmers may need to pay in advance. The premium cost of weather-based index insurance, even though lower than the traditional insurance, continues to rise due to increased frequency of catastrophic and extreme weather events. This challenge could be addressed with the help of government subsidies, international development organization support and private sector investment. For example, ECOM, a global coffee company, offered partial premium payments for the farmers to encourage their participation into the piloted rainfall-index insurance scheme in Viet Nam.
While weather-based index insurance is still developing, interest in the approach is increasing and programs are expected to expand significantly, with strong support from development agencies and governments. This is one part of the broader momentum for climate insurance which has garnered support from multilateral institutions and many governments, with nearly forty countries mentioning climate risk insurance in their Nationally Determined Contributions for climate change.
Weather-based index insurance is a powerful tool for stabilizing farmers’ income. However, challenges related to design, inappropriate risk assessment, and insufficient payouts to create a robust market remain to be addressed.
This requires concerted efforts and collaboration of governments, development partners, climate scientists and the wider insurance sector. Such efforts are particularly crucial in lower- and middle-income countries where large shares of the population depend on agriculture for livelihood and subsistence. An appropriate insurance scheme is an important foundation of improved agricultural practices, food security and stability, and economic development.