What is index insurance?
Index insurance is a relatively new but innovative approach to insurance provision that pays out benefits on the basis of a predetermined index (e.g. rainfall level) for loss of assets and investments, primarily working capital, resulting from weather and catastrophic events. Because index insurance does not necessarily require the traditional services of insurance claims assessors, it allows for the claims settlement processes to be quicker and more objective.
Before the start of the insurance period, a statistical index is developed. The index measures deviations from the normal level of parameters such as rainfall, temperature, earthquake magnitude, wind speed, crop yield, or livestock mortality rates.
What is the link between index insurance and microinsurance?
Microinsurance is the protection of low-income population against specific perils in exchange for regular premium payments proportionate to the likelihood and cost of the risks involved. This definition is exactly the same as one might use for regular insurance except for the clearly prescribed target market: low-income population. Given its focus on the low-income, microinsurance usually differs from regular insurance in terms of types of risks covered, types of delivery channels, premiums level, and types of claims documentation requirements.
Microinsurance can cover a variety of risks, including death, illness, property, or crop loss. When index insurance is sold to the low-income such as smallholder farmers or micro-entrepreneurs, it often takes the form of microinsurance with business models explicitly targeting the low-income population. Sometimes, index insurance regulations are part of the microinsurance legal and regulatory framework.
Why does the design of a high-quality agricultural index product require a good understanding of the agricultural cycle?
Historically, the first index insurance design dates back to 1920 when Indian economist Chakravarti envisaged a rainfall insurance product in which claim payments would be due if the total rainfall during a season was less than a given threshold. However, indices today are highly tailored to reflect the phenological stages of crop growth and therefore require a deep understanding of the agricultural cycle. For instance, an index needs to capture crop growth even if total seasonal rainfall is high; a short dry spell at a particular moment of the crop growth can trigger large crop losses. Building a high quality index allows an insurer to reduce basis risk.
What is basis risk?
Basis risk in index insurance arises when the index measurements do not match an individual insured’s actual losses. There are two major sources of basis risk in index insurance. One source of basis risk stems from poorly designed products, and the other from geographical elements. Product design basis risk is minimized through robust product design and back testing of contract parameters. Geographical basis risk is a factor of the distance between the index measurement location and the production field. The greater the distance between the measurement instrument and the field, the greater the basis risk. Some households that experience loss may not receive compensation while others that experience no loss may receive payments. Basis risk is reduced when the area covered by the index is homogeneous both in terms of weather and in terms of farming techniques. Therefore, as the density of weather stations and satellite pixels is increased, basis risk is minimized.