INNOVATIONS IN RISK MANAGEMENT INDEX INSURANCE JERRY SKEES H.B. Price Professor University of Kentucky and President GlobalAgRisk, Inc. OCTOBER 24, 2006
Jan 19, 2016
INNOVATIONS IN RISK MANAGEMENT
INDEX INSURANCEJERRY SKEES
H.B. Price Professor University of Kentucky
and President GlobalAgRisk, Inc.
OCTOBER 24, 2006
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.
MACRO
Market Intermediaries and Local and Regional Governments
MESO
Individual Households MICRO
Risk Experienced By . . .
Risk is experienced at different levels due to specific events such as low prices and adverse weather.
L
E
V
E
L
Agricultural Risk Identification
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
poorer HH
poverty-trap
threshold
Time
Ass
ets
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
Insurance
BorrowingSavings
Strategies for Risk Coping
TIME FRAMETIME FRAME
EX ANTEEX ANTE
Before the EventBefore the Event
Event OccursEvent Occurs
EX POSTEX POST
After the EventAfter the EventDROUGHTDROUGHT
STRATEGIESSTRATEGIES
INFORMALIndividual or
Community-based
FORMALMarket or
Policy-based
INFORMALIndividual or
Community-based
FORMALMarket or
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% 100% No Correlation In-between Risk Correlation
Auto Accidents Natural Disasters Commodity Prices
Rainfall / Crop Yields Insurance Markets Futures
Markets
0% 100% No Correlation In-between Risk Correlation
Auto Accidents Natural Disasters Commodity Prices
Rainfall / Crop Yields Insurance Markets Futures
Markets
High Probability Low Consequence versus Low Probability High Consequence Risks
Low ProbabilityHigh Consequence Risks Extreme weather events can result in low yields. The likelihood of such events is
normally ignored by producers. Insurers, on the other hand, adjust or “load” premium rates to capture uncertainty surrounding the occurrence of such events, producing a wedge between the
buyer’s willingness to pay and the seller’s price.
versusversus
High Probability
Low Consequence Risks
Yield-reducing events that generally
occur under mild to moderate
weather conditions often result in
losses which the individual farmer
can manage.
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
Country Period (A+I)/P
Brazil 1975–81 4.57
Costa Rica 1970–89 2.80
Japan 1985–89 2.60
Mexico 1980–89 3.65
Philippines 1981–89 5.74
USA current 4.00
Financial performance of crop insurance
Condition for sustainability
(A+I)/P < 1 Where A = average administrative
cost I = average indemnities paid P = average premiums paid
Presently there are few examples of successful models
Source: Hazell, 1992
Traditional Problems
Adverse selection
The most risky farmers buyLess 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
+ 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
500 1000 2000 3000 40000
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 IndiaPayments would occur anytime rainfall exceeds 2000 mm
A Bank might buy US$1 million liability
For every 1 mm = pay $1,000
500 1000 2000 3000 40000
Pre-conditions for Index Insurance
For Weather Risk
Weather event must create correlated losses Index must be a good proxy for lossEvent must be observable and easily
measuredThird party should be involved in the
measurementSystem must be objective and transparentHistoric data must exist to price the risk
Traditional Crop Insurance versus Weather Index Insurance — A Cost Comparison
Index-based Weather InsuranceLower Costs Measurable weather event is a proxy for crop losses, e.g., rainfall
Limits moral hazard and adverse selection
Objective triggers and structured rules for payouts Faster claims settlement Suitable for correlated risks More sustainable because of market financing
versusversus
Traditional Crop Insurance
Higher Costs
Compensation for actual
farm-level losses
Moral hazard and adverse selection
Asymmetric information —
Producers have superior
knowledge about farm-level risks
Payout process is protracted and
subjective
Suitable for Independent Risks
Relies on government
financial support
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
Benefits of Ex Ante Market-based Risk Management
Opens the way for innovation at the micro, meso, and macro levels
Improves access to risk transfer by the rural poor
Mitigates the impact of shocks that thrust the poor back into poverty traps
Strengthens locally based intermediaries offering market access to households of different income levels in low income countries
Allows for more efficient risk transfer at the macro level through greater risk retention at the country level
Creates a better environment for investment
For frequent and low consequence risk, those exposed should absorb the risk using savings and loans.
For less frequent, but moderate consequence risks, market instruments should be used.
For less frequent, but high consequence risks, the government and broader international community may have a role.
Layering Risks for More Efficient Transfer
Risk Segmentation — Sample Rainfall Distribution Showing Layering of Excess Rainfall Risk by Rainfall Levels
0 500 1000 1500 2000 2500 3000 3500
Frequent Less Severe Risk, Independent Losses Self-Retention Layer
Less Frequent, Moderate RiskMarket Risk-Transfer Layer
Correlated Losses from Excess RainfallMarket Failure Layer
Easing Financial Constraints
Market-based risk transfer — using insurance and reinsurance
Pooling and transfer of risk whereby government facilitates risk pooling among companies within the country and then sells the tail risk to the global reinsurance markets
Government packaged risk transfer — government contracts that can be auctioned or sold to insurers of reinsurers
Government subsidies on only the most extreme risks Premium subsidies — to be avoided due to cost and
poor incentives
Linking Index Insurance to Loans
Informal — farmers who get payments that they don’t need could loan to farmers having more serious loss
Formal but with simple structure —Rural finance entity will lower interest rates with the index insurance
Formal with contractual structure and loan officer involvement
Peru Project
To develop a risk transfer contract that would
allow MFIs in Peru to insure their
agriculture-related loan portfolios against the
risk of financial losses associated with
catastrophic weather events
Operational Considerations
End User
Operational
Financing
Technical
Regulatory
MFIs
Primary in Peru
Global Reinsurer
USAID project
SBS — Banking and Insurance
ENSO Insurance in Peru
MFIs are growing in Peru MFIs pool risk by the nature of their business Correlated losses from El Niño are an
obstacle to the development of sustainable insurance and financial markets
Major weather events will increase the default rate of loans made by MFIs
This source of risk reduces agricultural lending
ENSO Insurance in Peru
Severe rains and floods associated with El Niño are the economically most significant catastrophic risk in Piura
Index insurance based on rainfall measured at local weather stations is sensible, but has some problems
Available rainfall data are limited and incompleteRainfall stations must be secure and reliableRainfall stations should comply with World
Meteorological Organization standards to attract private sector insurers
Impact of El Niño
MFIs reduced agricultural lending after 97/98 El Niño
MFIs continue to restrict agricultural lending if El Niño is expected (or suspected)
97/98 El Niño brought an end to the agricultural insurance program and insurance premiums
Portfolio Risk in Piura Increased Due to El Niño
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Year
De
fau
lt R
ate
s
ENSO
RFA High Rice Prices
Benefits of Risk Transfer
Real cost associated with debt restructuring
Real cost associated with regulatory requirements for provisioning when repayment is in the arrears
Real liquidity problem as depositors also withdraw savings during this harsh time
ENSO Insurance Pilot in Piura
Prototype insurance based on El Niño Southern Oscillation (ENSO) 1.2 index
ENSO 1.2 measures sea-surface temperatures off the coast of Peru as deviations from normal – index is positive if temperatures are above normal, negative otherwise
ENSO 1.2 indices are normally between -2 and 2
Values above 2 are an indicator of a strong El Niño
Progress on ENSO Insurance
Support from the regulator (SBS) to classify this as ENSO Insurance.
There is a willing global reinsurer that is ready to underwrite the ENSO Insurance
Discussions with MFIs in Piura have advanced a good deal to enhance their understanding of how to use the ENSO Insurance
Linking reduction of provisions to index insurance as a form of ‘warranty’ BASEL II
THANK YOU
Please visit www.microlinks.org/afterhours for seminar presentations and papers
Jerry [email protected]