Question

Farmers in developing countries are vulnerable to shocks from climate change and in most cases have no access to agricultural insurance. One potential insurance product, weather index insurance, could reduce some of the problems associated with traditional multiperil insurance products.

Outline the process by which a weather index insurance product could be defined for a farmer in a developing country. In your answer also explain why an index insurance product might be more suitable for a developing country than a multi-peril insurance product.

Answer 1

Farmers in developing countries are vulnerable to shocks from climate change, thus a weather index insurance product could be useful in providing insurance cover during such times.

A weather index product could be defined as a tool which measures the amount of rainfall measured by the local monitoring station, so as per the station report which is based on collected data, if the amount of rainfall received in a particular area is below a certain threshold than the farmers in that area can avail insurance payout. So if the rainfall does not fall below the specific threshold, then the insurance company will not pay the amount. In this way based on the weather, the insurance cover can be generated. The premiums could be set in terms of the farm size so that the larger the farm, more is the insurance premium, which will prove beneficial for small scale farmers as their area will be small and their premiums also. Thus when there is a bad year, the farmer can be paid and compensated upon by the insurance company.

In the case of a multi peril insurance cover there are huge administrative costs as it tries to cover all sorts of risks faced by the farmer, this increases the size of premiums as more risk is covered, which is not suitable for small scale farmers. There is a also a case of moral hazard wherein after purchasing the insurance agent won't necessarily know that the yield was damaged because farmers might purposely seek repayment by destroying the yield, this leads to less number of insurance agents trusting and farmers unwilling to opt for insurance cover as they get the belief that they have been cheated upon. There might also be a problem of adverse selection wherein the farmer is not letting the insurance agent know all sorts of risks the farm faces on daily basis which would increase his chances of paying low premiums and seeking a greater payout.

Thus based on these disadvantages, a weather index product proves useful for a developing country as there is no moral hazard and adverse selection, the insurance agents and the farmers are on the same page.