How can micro-insurance programmes reduce developing countries’ vulnerability to climate change? This paper examines a micro-insurance pilot project in Malawi. The project provides a loan guarantee that enables farmers to access higher-yield seeds. By raising productivity, it decreases their vulnerability to droughts. Findings also show that micro-insurance in Malawi can directly promote adaptation by actually reducing crop losses from drought. This is possible by incorporating into insurance pricing seasonal rainfall forecasts, which are strongly related to El Niño-Southern Oscillation (ENSO).
In July 2005, the World Bank Commodity Risk Management Group collaborated with Malawian farmer organisations, bankers, insurers, and other stakeholders to explore the potential of insurance mechanisms for reducing loan default risk and thus breaking the barriers faced by local banks in extending high-risk credit. After examining several crop options, groundnut was selected for a pilot scheme (2005-2006) because of its sensitivity to drought, relatively high market value, and marketing possibilities.
Before the rainy season, participating farmers receive improved agricultural inputs through a contract that specifies (1) an index-based weather insurance component, with the premium based on the probability of a payout, and (2) a loan component. At the end of the season, the farmer owes the lending institutions the cost of agricultural inputs plus the insurance premium, interest, and taxes. If rains are good (as measured by a nearby weather station), then the insurance company keeps the premium and farmers pay back the loan with proceeds from the (presumably good) harvest. If measured rains are below certain trigger values (based on critical stages of the groundnut growing season), then the insurance company pays part, or all, of the loan to the bank.
The Malawi micro-insurance scheme contributes to both development and climate change adaptation. It reduces vulnerability by improving productivity in good seasons, and decreases crop losses by offering incentives for better crop management. An index-based insurance system provides farmers with incentives to change cultivation practices to become more resistant to drought. Findings from the scheme’s first operational year include the following:
- In a stakeholder survey, the overwhelming majority (86 per cent) of sampled farmers said they would participate in the scheme again.
- A win-win situation is created for the parties involved. For example, banks can diversify their lending portfolio into smallholding agriculture without taking on large systemic risks.
- If market prices are higher than the price offered by the intermediary, there is a risk of side selling to outside traders.
- There was a lack of understanding of the index-based system among farmers, with only 55 per cent of survey respondents understanding the scheme before joining it.
- The incentive effect of index insurance can be made more powerful if premiums are tailored to reflect the risks of the upcoming planting season.
Donors and international financial organisations (IFIs) have a role to play in ensuring the success of micro-insurance as an adaptation tool. The difficulties of scaling up micro-insurance schemes means that donors and IFIs can subsidise schemes that aim to provide more comprehensive insurance coverage.
- There are valid arguments that such subsidisation can lead to price and incentive distortion. However, some types of support can help to correct market failures, as in areas where the market will not provide insurance cover.
- Micro-insurance programmes suggest an important role for financial risk-sharing and transfer within an international climate adaptation strategy.
- Schemes such as the Munich Climate Insurance Initiative aim to support micro-insurance schemes in developing countries by providing technical assistance, capacity building and by absorbing insurance costs.
