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Accounting For The Rain Gods: How Index-Based Crop Insurance Can Help Farmers

29/02/2016 8:25 AM IST | Updated 15/07/2016 8:26 AM IST
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PRAKASH SINGH via Getty Images
Indian farmers sow a paddy in a field in Goralhpur, Uttar Pradesh on June 27, 2012. Monsoon rains are a key factor for global commodities markets, strengthening the output of various crops in India, which could help bring relief to Asia's third-largest economy in its battle with high food prices. AFP PHOTO / Prakash SINGH (Photo credit should read PRAKASH SINGH/AFP/Getty Images)

There is a cruel joke about the Indian economy that goes around every year during budget season. "It is not the Finance Minister, but the rain gods that write India's Budget." This would be funny only if it weren't true! The Indian economy depends very heavily on the monsoons and weather conditions. Serious concerns arise annually when there are weather fluctuations in any part of India. The recent vagaries of nature have added to the growing agrarian distress in the country. While building better agriculture infrastructure like irrigation facilities and cold storage chains will go a long way in building resilience within Indian agriculture, there is an urgent need to provide insurance coverage to cultivators. Simple crop insurance coverage, however, is unlikely to succeed. A sensible public policy response to the looming distress in the agriculture sector is, therefore, to design and offer innovative insurance products which can address weather fluctuations and become sustainable financial instruments for India in the long run.

The simple strategy of rainfall insurance is to abandon trying to insure against bad crop yields and instead to insure against bad weather directly.

In a major policy outreach, Prime Minister Modi launched the Pradhan Mantri Fasal Bima Yojana in Bhopal a few days ago. There are expectations that this crop insurance scheme might be scaled up to other parts of the country in the forthcoming Budget. The effort of the government towards addressing agrarian distress must be lauded, yet the global data shows that simple crop insurance is very likely to fail due to acute problems of adverse selection, moral hazard, high transactions costs and weak enforcement of contracts. The data on state-supported crop insurance programs finds that for such government programs, costs exceeded revenues by 4.6 times in both Brazil and Japan, 3.7 times in Mexico and 2.4 times in United States. The question is: can India do better? And the simple answer is: Yes, if we index crop insurance to weather or rainfall, which is easily measured, unlike "crop loss" in simple crop insurance.

Globally, one of the most promising new insurance lines in recent years is rainfall insurance and other variants of so-called "index-insurance". The idea of rainfall insurance is to avoid the moral hazard and adverse selection problems associated with crop insurance. In simple crop insurance, these problems emerge when cultivators take on excessive risks or are not as careful since they are covered by an insurance scheme. The simple strategy of rainfall insurance is to abandon trying to insure against bad crop yields and instead to insure against bad weather directly. In a typical plan, tamper-proof rain gauges are installed in a region; contracts are then written that guarantees payouts in the event of specific events of bad weather, such as lack of rainfall by a certain date, or in other cases, too much rainfall. This simple innovative idea works well because farmers are powerless to change the weather, eliminating concerns of moral hazard and adverse selection. Costs are also cut since no one needs to verify crop losses on given plots of land; instead only the accuracy of the rainfall gauge is needed. The rainfall data can also be corroborated by data from the meteorological department.

Costs are also cut since no one needs to verify crop losses on given plots of land; instead only the accuracy of the rainfall gauge is needed.

There have been pilots of this product in Andhra Pradesh through a partnership of BASIX, an innovative microfinance institution and ICICI Lombard. The insurance contract divides the rainy season into three parts, corresponding to different parts of the crop cycle. At sowing time, the main risk is that the monsoon will arrive too late. At podding and flowering time, the risk is with insufficient rainfall. And at the harvest time, the fear is too much rain. The contract thus yields different kinds of payouts in different scenarios.

The idea appeals, but in practice farmers have not rushed to buy rainfall insurance. The reason is unlikely to simply be the price. It can be sufficiently low priced to be accessed by poor farmers. So the real reason is more likely to be low perceived value. One possibility is that farmers expect that if the season is a true disaster, the government will help or loans will be forgiven. This is very likely given past experience with state governments across India. A second possibility rests with the low value of rainfall insurance itself. The case for rainfall insurance relies on there being a high correlation between incomes and rainfall as measured at the local rain gauge or weather station. Such "basis risk" can be reduced through improving the locations of the rain gauges.

One limitation of rainfall insurance, relative to traditional crop insurance, is that it only covers rainfall-related losses. Index-based agricultural insurance can, therefore, perform much better. The idea is to base insurance payouts on the measured average yields in a region, eliminating concern with moral hazard and adverse selection as long as any given farmer can do little to affect the regional average. Here, the basis risk attached to measuring the yields and losses can be reduced through a randomized sample.

One of the under-exploited elements of index-based insurance is that villagers who are not farmers can also purchase contracts.

One of the under-exploited elements of index-based insurance is that villagers who are not farmers can also purchase contracts. For obvious reasons crop insurance in marketed only to farmers, but nothing stops the sale of weather insurance to others who want protection from the ups and downs of demand and supply fluctuations. Thus shopkeepers, craftsmen, traders and others whose livelihoods are conditioned by the weather will have a chance to gain added protection, even if they do not themselves work in the fields.

The Modi government has made a serious attempt to address agrarian distress in India by announcing the crop insurance scheme last week. It is imperative, however, that we learn from the mistakes of other countries and urgently fine-tune this simple product to make it financially viable in the long run. And the fine-tuning is easy -- instead of measuring the crop losses of farmers let us just measure the performance of the rain gods!

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