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ISSUES AND GOOD PRACTICES Peter Hazell | Independent Researcher Rachel Sberro-Kessler & Panos Varangis | Finance & Markets Global Practice | World Bank Group Table of Contents Acknowledgements..................................................................................................III Executive Summary................................................................................................. V 1. Introduction............................................................................................................ 1 2. Existing Types of Levels of Subsidies for Agricultural Insurance...................3 3. Reasons for Subsidizing Agricultural Insurance..............................................7 Subsidies to Correct Failures and Externalities in Insurance Markets..............7 Subsidies to Achieve Broader Social and Political Goals...................................... 9 4. Challenges in Subsidizing Agricultural Insurance.......................................... 11 5. Does Subsidizing Agricultural Insurance Pay?...............................................15 6. Principles And Good Practices in the Design of Subsidies for Agricultural Insurance..................................................................................................................21 Guidelines for Subsidizing Insurance for Commercial Farmers........................22 Guidelines for Subsidizing Agricultural Insurance for Poor Farmers...............24 Guidelines for Subsidizing Insurance to Improve or Replace Disaster Assistance.................................................................................................................... 27 7. Conclusions......................................................................................................... 35 References............................................................................................................... 39 Annex: The Choice Between Subsidizing an Insurer’s Costs Versus Providing Subsidized Reinsurance........................................................................................ 43 LIST OF BOXES Box 1: Ex Ante Cost-Benefit Evaluation of an Insurance Program in Bangladesh...............................................................................................................16 Box 2: The R4 Risk Resilience Initiative in Ethiopia.......................................... 26 Box 3: Early Recovery Vouchers (ERVOs)............................................................ 28 Box 4: Seguro Agricola Catastrófico (SAC) in Peru........................................... 30 Box 5: The CADENA Program in Mexico.............................................................. 33 TABLE OF CONTENTS I Box 6: Pros and Cons of Premiums Subsidies and Public Reinsurance of Extreme Risk Layers.......................................................................................... 44 Box 7: Some Examples of Public Reinsurance Arrangements Verses Direct Subsidies for Risk Loading Costs......................................................................... 45 LIST OF FIGURES Figure 1: Illustrative Comparison of Disaster Relief and 50 Percent Subsidized AYII Across Years With Different Levels of Shocks........................ 17 Figure 2: Overlap Between Agricultural Insurance and Disaster Assistance....22 Figure 3: Government of Mongolia is “Double Exposed” to Extreme Risks........46 Figure 4: Agricultural Insurance Program in Kenya...........................................47 LIST OF TABLES Table 1: Producer Claim Ratios for Seven Countries............................................5 Table 2: Cost to Government of Transferring Income to Farmers Through Subsidized Crop Insurance Programs in Four Countries ...................................18 WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES II Acknowledgements The authors are grateful to Joe Glauber, Ruth Hill, and Oliver Mahul for reviewing this paper. The authors also thank Carlos Arce, Ulrich Hess, Michal Matul, Roy Parizat, and Pranav Prashad for helpful comments on earlier drafts. Appreciation is also extended to Pavis Devahasadin and Joost Tijdink for coordinating the production process and Aichin Lim Jones for design and layout support. Global Index Insurance Facility The Global Index Insurance Facility (GIIF) is a multidonor program that supports the development and growth of local markets for indexed/catastrophic insurance in developing countries, primarily in Sub-Saharan Africa, Latin America and the Caribbean, and Asia Pacific. Funded by the European Union, Japan, and the Netherlands, the Global Index Insurance Facility is managed by the World Bank Group, as part of the Finance & Markets Global Practice. Impact Insurance Facility Housed at the International Labour Organization, the Impact Insurance Facility enables the insurance industry, governments, and their partners to realize the potential of insurance for social and economic development. The Facility was launched in 2008 with generous support from the Bill & Melinda Gates Foundation, and has received subsequent funding from several donors. ACKNOWLEDGEMENTS III WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES IV Executive Summary Agricultural insurance is subsidized in many countries, at a global cost to governments of well over $20 billion each year. There are many reasons behind these subsidies, some having to do with market failures and externalities that constrain the development of privately provided and unsubsidized insurance, and some having more overt political and social objectives such as helping specific segments of poorer farmers access insurance, protecting agricultural lending institutions, reducing the need for disaster assistance payments, or simply as a politically acceptable means of supporting farm incomes. Very little is really known about the effectiveness of insurance subsidies in achieving their intended purposes, or whether the impacts they generate justify their costs, and there is a real need for more evaluations and impact assessments of subsidized agricultural insurance programs. Much more is known about the challenges that can all too easily undermine the benefits from agricultural insurance subsidies. These include well known challenges with the design and operation of agricultural insurance programs themselves, poorly designed subsidies added to those programs, plus political dynamics that make it hard to terminate or contain the amount of the subsidy. Poorly designed subsidies can also inadvertently create disincentive problems that lead to significant economic costs and inefficiencies, and in some circumstances, to environmental degradation. To avoid these problems, any insurance subsidy needs to be carefully designed to be “smart”, in the sense that it is cost effective in achieving its underlying purpose, minimizes disincentive problems, and does not become a growing financial burden on the government. This paper discusses these issues in detail and draws upon available literature and case study experiences to propose some good practice guidelines for the design and implementation of subsidized agricultural insurance. EXECUTIVE SUMMARY V WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES VI 1. Introduction Agricultural insurance, defined here to include crop and livestock insurance, is an instrument of choice in many countries for helping farmers and rural communities cope with risk. Some insurance is private, sold by insurance companies to farmers on a purely commercial, non-subsidized basis, but, as will be seen, most agricultural insurance is provided on a subsidized basis as part of government efforts to further development, social or political goals. Many billions of dollars are spent each year on premium subsidies and other forms of financial support for agricultural insurance. A World Bank study estimated that in 2007, the total global cost to governments was about $20 billion (Mahul and Stutley, 2010). However, that figure seems low today given that just three countries - China, India and the US, are together spending about $17.7 billion each year. To put this in perspective, total OECD bilateral and multilateral support for agriculture in the developing world was about $11 billion in 20141. This paper explores the reasons why governments and donors subsidize agricultural insurance, and asks a) is this a worthwhile way to spend public money, and b) if insurance must be subsidized are there smarter ways of doing it that can achieve the same objectives, but at lower cost, and which avoid some of the economic and institutional pitfalls that have plagued subsidized agricultural insurance in the past. The paper is structured as follows. The next section reviews existing types and levels of subsidies for agricultural insurance, both globally and for the developing world. Section 3 reviews the various arguments that have been offered for subsidizing agricultural insurance, while section 4 discusses some of the key challenges that have arisen when insurance subsidies are poorly designed. Section 5 seeks to balance the benefits and costs of subsidized agricultural insurance, and asks whether this has proven to be a worthwhile way of spending public funds. Given that many governments and donors seem likely to continue to subsidize agricultural insurance, section 6 presents a set of guiding principles and best practices to be used in their design and implementation. Finally, section 7 concludes. 1 Calculated from OECD DAC data: http://www.oecd.org/dac/stats/documentupload/1%20World%20 -%20Development%20Aid%20at%20a%20Glance%202016.pdf 1. INTRODUCTION 1 WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 2 2. Existing Types and Levels of Subsidies for Agricultural Insurance The extent of agricultural insurance around the world was assessed in 2008 by researchers at the World Bank. They estimated that 104 countries had some form of agricultural insurance in 2007, and that the total premium collected that year, including premium subsidies, was an impressive $20 billion (Mahul and Stutley, 2010). More detailed insights were obtained for 65 countries that completed a questionnaire. The total premium collected in these countries in 2008 was $15.1 billion. Of this amount, 86% was collected in high-income countries and only 0.03% was collected in low income countries, showing that agricultural insurance is largely the preserve of the rich. Globally, about 90% of the total premium collected was for crop insurance and 10% was for livestock insurance. Multiple Peril Crop Insurance (MPCI) was available in two thirds of the countries, but was most popular in the middle- income countries. Named peril insurance was available in 69% of the countries, including half of the low-income countries. Area-yield insurance was available in 15% of the countries, and weather index insurance was available in 22% of the countries, but mostly on a pilot basis. There has been significant expansion of agricultural insurance since 2008, especially of index based schemes in the US, India and China. Based on a recent review of documented index-based agricultural insurance programs in the developing world, Hess and Hazell (2016) estimate that about 198 million farmers were insured in 2014, divided into approximately 650,000 in Africa, 3.3 million in Latin America and the Caribbean, and about 194.2 million in Asia - of which 160 million were in China and 33.2 million in India. Given that there are about 550 million farms in the developing world (Lowder et al., 2014), it would seem that about one third of them now have some kind of agricultural index insurance. Clearly IBI has achieved scale. Yet despite these impressive numbers, market penetration remains small, even in rich countries. In 2008, the total insurance premium collected (including subsidies) in the World Bank survey amounted to 0.9% of agricultural GDP, ranging from virtually zero in low-income countries to 2.3% in high-income countries (Mahul and Stutley 2010). One reason for this low coverage is that only a small part of the crop area and livestock population is insured. Another 2. EXISTING TYPES AND LEVELS OF SUBSIDIES FOR AGRICULTURAL INSURANCE 3 reason is that most programs only insure farmers Of all the IBI-like programs Hess, Hazell and Kuhn against losses for specific crops or livestock, or pay (2016) reviewed, the only programs with low or to replace purchased inputs or repay credit when no subsidies were for insurance coverage provided insured losses occur. As such, the insured coverage within contract farming arrangements, which also typically represents just a small fraction of a included access to modern inputs, markets and farmer’s total exposure to farm income and asset credit. Most other forms of IBI were subsidized: risks. the average subsidy was 37% for input supplier schemes, 40% for farmer group schemes, 63% for The majority of agricultural insurance programs credit-linked schemes, 67% for direct insurance, are subsidized. Mahul and Stutley (2010) found and 80% for safety net insurance schemes. that of the 65 countries that completed their questionnaire, one third had an unsubsidized crop The producer claims ratio (PCR), calculated as or livestock insurance program. However, the I/P, where I is total claim payments and P is total unsubsidized programs are at a much smaller scale, premium collected from farmers net of any subsidy, and of the total premium collected from farmers in is a direct measure of how much the farmer gets all 65 countries, only 15% was not matched by a back in claim payments on average for each dollar premium subsidy (Mahul and Stutley, 2010, Tables of premium he/she pays. Hazell (1992) reported 3.23 and 3.24). The premium subsidies added PCRs for 7 country programs in the 1980s, ranging up to $6.6 billion, or 44% of the total premium from 0.99 in Japan to 5.11 in India. This meant that collected. In addition, governments spent at least in India, for example, farmers on average received another $1.5 billion subsidizing administrative and payments worth $5.11 for every dollar of premium operational costs, and another $2.2 billion in the they paid. Remarkably, the insurance still had to form of direct payments to insurers to help settle be made compulsory for farmers who borrowed claims. When these additional costs are added in, credit. In their update, Mahul and Stutley (2010) the average subsidy equivalent increases from 44% found that PCRs were lower during 2003-07, as, for to 68%. The cost of insurance to governments has example, in the comparative numbers reported in since increased, largely because they have been Table 1. Yet still most farmers are getting back far scaled up. For example, each year the Chinese more than they pay on average (e.g., Indian farmers government now spends about $6 billion annually2 are getting back $3.36 for every dollar of premium on its insurance programs, the Indian government they pay) and still many farmers are choosing not to spends $ 2.75 billion3, and the US government is purchase insurance. programmed to spend $9 billion annually over the next 10 years4. 2 2014, source: CIRC, Chinese Regulatory Authority. 3 Proposed budget for the new PMFBY scheme, comprehensive agricultural insurance especially for farmers with loans. http:// pmjandhanyojana.co.in/pradhan-mantri-fasal-bima-crop-insurance-scheme/. 4 Joe Glaubner, personal communication. WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 4 Table 1: Producer Claim Ratios for Seven Countries Country Producer Loss Ratio Brazil 1975-81 4.29 2004-07 1.19 Costa Rica 1970-89 2.26 2003-07 1.75 India 1985-89 5.11 2003-07 3.36 Japan 1985-89 0.99 2003-05 1.84 Mexico 1980-89 3.18 2003-07 0.72 Philippines 1981-89 3.94 2003-07 1.42 US 1980-89 1.87 2003-07 1.70 Canada 2003-07 2.20 Iran 2003-07 4.05 Italy 2003-06 1.47 Russia 2003-06 1.23 Spain 2003-07 2.44 Note: Calculated as total claim payments divided by total premium paid by farmers. Source: Hazell (1992) and author’s calculations based on data in Mahul and Stutley (2010). 2. EXISTING TYPES AND LEVELS OF SUBSIDIES FOR AGRICULTURAL INSURANCE 5 WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 6 3. Reasons for Subsidizing Agricultural Insurance There are many reasons why governments and donors subsidize agricultural insurance. Some are based on narrow economic arguments like market failures, externalities and establishment problems that constrain the development of private sector insurance and insurance markets, or which systematically exclude certain segments of farmers from insurance, such as poor or women farmers, or farmers in high risk regions. Many governments also subsidize agricultural insurance as a way of achieving other social and political goals in addition to risk management, where insurance subsidies are seen as a more politically acceptable or cost efficient way of achieving those goals than other available policies. Despite their varying purposes, insurance subsidies all seek to reduce risk exposure for farmers, whether against catastrophic natural disasters or more normal agricultural production risks. Most often, subsidies also help scale up the demand for agricultural insurance. Subsidies to Correct Failures and Externalities in Insurance Markets. Several economic arguments have been made in the literature for subsidizing agricultural insurance programs to correct market failures and externalities (Hill et al., 2014; Clarke, 2011). These include: • Public spending in the form of subsidies or direct service provision for building and maintaining weather station infrastructure and data systems, supporting agro-meteorological research leading to product design, and educating farmers about the value of insurance. These services are needed to enable insurance markets to work. Private insurers are willing to make some of these investments themselves, but there is an inherent problem in that they may not be able to recoup their investment costs given the ease with which competitors can use the same knowledge and services once established. This is a classic ‘public goods’ problem that inevitably leads to insufficient investment, and hence a need for complementary public spending. There may also be spillover benefits for other types of financial and service sectors, including public relief or disaster assistance programs, which help justify such public spending; 3. REASONS FOR SUBSIDIZING AGRICULTURAL INSURANCE 7 • Temporary subsidies might be warranted for uncertain about how climate change will impact some types of farmers if there are positive on the risks they are insuring. Another view is externalities. A good example is when the that since many small farmers are the victims insurance enables poor farm households to of climate change, they should be entitled to access credit and game changing technologies a temporary premium subsidy that helps them that can lift them out of poverty. In this case adopt new climate smart technologies that have the underlying problem is often an inability of risk characteristics that are initially not well many poor farmers to bear the initial risk of known5. adopting such innovations without subsidized • Siamwalla and Valdes (1986) have argued insurance, and/or an inability to access credit that a subsidy might be warranted in some without insurance because they are perceived to circumstances when region-wide agricultural be high-risk borrowers by financial institutions. losses impact on the nonfarm population by • Temporary subsidies might be justified when reducing farmers’ demand for the services and farmers or insurers are initially uncertain about outputs of small businesses in the rural nonfarm a new type of insurance product because they economy. In this case, the insurance subsidy have insufficient knowledge to assess its real might help by buffering reductions in farmers’ risks and benefits. For example, a premium spending, though it ought first to be established subsidy might encourage farmers to purchase that insuring farmers was more effective than and experiment with a new insurance product offering insurance products to the community about which they have no prior experience, at large. much as seed companies sometimes give out • A less credible argument is that insurance free trial seed packets. Another example is subsidies may be justified if they lead to positive when an insurer initially charges a high-risk benefits for consumers. For example, if the loading for a new line of insurance because introduction of an insurance subsidy leads to it has inadequate data to properly assess the greater production of food staples which lowers actuarial risks, and the risk loading is expected food prices and benefits consumers, then a to fall once the insurer has acquired additional subsidy would essentially transfer some of the data over time. In this case the government consumer benefit back to producers. The need might want to subsidize part of the risk loading for such a subsidy is perceived to be greater cost, or offer subsidized reinsurance, during an the more inelastic the demand for food staples, initial learning phase; since consumers then capture a larger share • Related to the previous point, temporary of the total benefits from an increased food subsidies might also be warranted as part of supply. Siamwalla and Valdes (1986) refute this a strategy to assist farmers adapt to climate argument by showing that if the subsidy lowers change. This might take the form of subsidizing the cost of the insurance to producers and shifts some of the high-risk loadings that insurers the supply function for food staples outwards build into premium rates when they are compared to unsubsidized insurance, the net 5 Some have argued, based on the principle of ‘polluter pays’, that there is a case for the industrialized countries (through green climate funds, for example), subsidizing the increase in the pure risk component of insurance premiums as a result of climate change in developing countries. WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 8 social gain from that shift will always be less people with subsidized insurance against than the cost of the subsidy. The effect is similar catastrophic losses, like droughts; to a subsidy on any other farm input (such as • Insure disaster assistance programs (DAPs) fertilizer or credit). The reduction in unit cost so that they have assured and quick access to is partly paid for by the subsidy, and the cost funds when disaster payments need to be made, of the subsidy is always greater than sum of the whilst also annualizing the cost of DAPs in the additional producer and consumer welfare that form of an insurance premium rather than lump it generates (Siamwalla and Valdes 1986). Only sum payments when disasters occur; if there are externality benefits beyond the gain to consumers could there conceivably be a net • Protect banks and agricultural credit programs social gain from a subsidy. from bad debt, especially against systemic losses that lead many farmers to default on their Subsidies to Achieve Broader Social loans at the same time. It is often hoped that and Political Goals this will also encourage banks to extend credit Governments are rarely constrained by narrow to riskier farmers. market failure arguments, and often choose to heavily subsidize agricultural insurance for broader Sometimes subsides are used to obtain multiple political and social purposes. Insurance subsidies goals. For example, in the US, the crop insurance are commonly used as a means to: program provides income support to farmers - an average PCR of 1.7 during 2003-07 (Table 1), and • To increase food production or agricultural since the major claim payments are tied to disaster exports for national purposes, even though the years, the insurance also helps substitute for disaster value of that production may be less than the assistance programs. In India, insurance subsidies cost of the subsidy (see previous section); are intended to expand agricultural lending, while also providing protection for the agricultural banks. • Improve equity of coverage by extending If the insurance also encourages farmers to adopt insurance access to previously excluded riskier but higher income earning strategies, the groups, such as low-income farmers or high- social and political goals may also be win-win with risk regions, on a more permanent basis. agricultural growth and higher farm incomes. • Support farm incomes more generally, as Of course, governments usually have alternative is done in many middle and high-income ways of achieving many of these social and political countries. This happens when the average goals, and using an insurance subsidy to achieve annual claim payment exceeds the unsubsidized them is only justified from an economic perspective part of the premium rate by farmers (i.e., PCRs if it is more cost effective and less distortionary for greater than 1.0), and which, as seen in Table markets and resource allocation decisions (see next 1, amounts to a substantial income transfer in section). some countries. • Substitute for safety net and disaster assistance spending by providing farmers and other rural 3. REASONS FOR SUBSIDIZING AGRICULTURAL INSURANCE 9 WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 10 4. Challenges in Subsidizing Agricultural Insurance Agricultural insurance faces challenges of its own when it comes to the design, delivery and administration of insurance contracts that farmers are willing to buy, and as reviewed elsewhere, important problems remain despite considerable progress over recent decades (Hazell, Hess and Kuhn, 2016). Additional challenges arise when the insurance is to be subsidized, and as discussed in this section, care is needed in the design and implementation of subsidies, otherwise they can prove unnecessarily expensive, worsen inequality, and create disincentive problems that undermine the insurance program, distort markets and resource allocation decisions. Poorly designed insurance subsidies can inadvertently create disincentive problems that lead to significant economic costs and inefficiencies. The main reason for this is that subsidizing insurance leads farmers to assume more risk in their resource allocation decisions than when the insurance is not subsidized. In some circumstances this may be desirable. For example, it might enable smallholders who were previously underinsured to adopt more risky crop mixes and technologies that increase their average incomes and help lift them out of poverty. However, premium subsidies that reduce the cost of insurance below its actuarially fair value may also encourage farmers to take on too much risk, such as growing unsuitable crops in risky environments, or growing more of them, adding to the future costs of insurance and possibly damaging the environment (Siamwalla and Valdes, 1986; Hess and Hazell, 2016; Goodwin and Smith, 2013). Of course, other types of policy interventions designed to help farmers manage risk also create disincentive problems. These problems can be particularly severe for some types of disaster assistance programs (DAPs) because DAPs are invariably fully funded by governments and/or donors given the difficulties of recovering costs from beneficiaries. In effect, a DAP provides what is equivalent to 100% subsidized insurance payouts. A classic example of the disincentive problems associated with DAPs is how publicly provided compensation to repair or rebuild houses after hurricane disasters in the US may have contributed to a net increase in the housing stock in vulnerable areas (Kunreuther et al., 1978). Another example was the negative impact of publicly subsidized barley feed and credit for herders in drought years in the 4. CHALLENGES IN SUBSIDIZING AGRICULTURAL INSURANCE 11 low-rainfall areas of the North Africa and Middle • Subsidies in the form of direct payments to East region. This intervention contributed to the insurers to help settle claims have the potential eventual overstocking of rangeland areas and crop to undermine efficiencies and incentives for expansion into drought prone rangelands, helping due diligence within the insurance industry, to undermine well established and sustainable especially if the government automatically rangeland management systems (Hazell, Oram and covers any claims that the insurer cannot pay Chaherli, 2003). One way to reduce the negative (Hazell, Pomareda and Valdes, 1986; Hazell, incentives associated with DAPs is to combine 1992). Direct payments to insurers need to them with compulsory insurance for some kinds be tied ex ante to specific formulas, such as of catastrophic losses, even if the premium has to reinsurance within agreed rules on the tail end be partially or fully subsidized for poorer people. risks to be covered. This is a common practice in many higher income • Subsidized insurance may raise WTO concerns countries for managing flood risks. Another way if the subsidies have more than a minimal is to provide insurance coverage as long as the impact on production and trade. beneficiaries take some prescribed actions to reduce risks. For example, in several countries earthquake • Without a clearly defined strategy, using insurance is conditioned on houses being built or insurance subsidies for some political and adapted to building codes that make them more social purposes can easily become more earthquake resistant expensive than planned, in part because the demand for insurance is typically inelastic, and Poorly designed insurance subsidies can also create premium subsidies have to be set at high levels other kinds of problems: to attract the kinds of participation rates that • When subsidized insurance is used to insure governments look for to achieve their social farmers’ credit, the claim payments need to and political purposes (Glauber, 2012; Hill et be tied to verifiable losses against specific and al., 2014). insured perils or index outcomes, otherwise • Insurance subsidies can also lead to undesired there is potential to reduce due diligence in distributional consequences. For example, the lending practices of banks. An egregious the benefits from proportional subsidies are example was the former Mexican insurer skewed towards those farmers who buy more ANAGSA, which insured the loans of an insurance, and they are unlikely to be poor. agricultural development bank (Banrural) with MPCI policies that repaid the bank for most Another difficulty with insurance subsidies is that sources of farmers’ crop losses. Not only did they can be difficult to phase out or remove once ANAGSA end up making large claim payments established. In fact, like most input subsidies, each year to offset loan defaults, but knowing experience shows that their cost to government that they could easily collude with farmers typically grows over time as more of the input is to obtain claim payments from ANAGSA, used, or in this case, larger crop areas are insured Banrural staff had limited incentive to perform (Hazell, 1992; Glauber, 2012). Recent examples are due diligence on loan applications or to attempt the rapid growth in public spending on subsidized to recover defaulted loans (Hazell, 1992). insurance in China, India, and the US. The problem WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 12 can be especially acute when the subsidies are control over insurance subsidies seems greater untargeted and paid on a proportional basis, since this when used for broader political and social purposes can benefit a clientele of larger and politically well- than when targeted at fixing specific market failure connected farmers who lobby for its continuation or externality problems. and expansion (e.g., in the US). Subsidies may also Of course, alternative policies for achieving some benefit the insurance and financial sectors, which of the same political and social objectives as are also effective lobbying groups. The dynamics of subsidized insurance (e.g. farm income or price the political support for subsidies can even be driven support policies) can also become politically by governments themselves, as, for example, when entrenched and distort incentives and markets. As subsidized insurance is seen as a way of influencing such, the indirect costs of subsidized insurance election outcomes, or writing down farm debt (the need to be evaluated relative to the indirect costs of former ANAGSA program in Mexico was a classic alternative policies, and not held to unrealistically example – Hazell 1992). The danger of losing high standards that eliminate it from consideration. 4. CHALLENGES IN SUBSIDIZING AGRICULTURAL INSURANCE 13 WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 14 5. Does Subsidizing Agricultural Insurance Pay? Although there may be sound economic reasons for subsidizing agricultural insurance in some contexts, it is not guaranteed that it is a worthwhile way to spend public money. That depends on more than the just the size of the hoped for benefits. In the first place, an insurance program that is being subsidized may have problems of its own in designing, delivering and administering insurance contracts that farmers want to buy. Problems have been widespread in the past (Hazell, 1992), and challenges remain despite recent progress in the use of public-private partnerships and new forms of IBI (Mahul and Stutley, 2010; Hazell, Hess and Kuhn, 2016; Jensen and Barrett, 2017). Problems with underlying insurance programs are not necessarily resolved by adding a subsidy (e.g., a subsidy would not solve a basis risk problem), and in some circumstances a subsidy could compound existing problems (e.g., by crowding out alternative insurance programs). Then there are the potential disincentive problems that arise from adding a subsidy, and which could lead to additional economic costs and inefficiencies. So whether or not it pays to subsidize agricultural insurance is an empirical matter that requires careful collection and analysis of data about the performance of insurance programs. Unfortunately, there have been only a few quantitative studies of whether or not subsidized agricultural insurance leads to favorable net social returns for a country. These include ex post cost-benefit studies of the Japanese and Mexican programs, where it was found that the social returns were negligible in relation to the programs’ high costs (Tsujii, 1986; Bassoco, Cartas and Norton, 1986). However, these were evaluations of old style MPCI programs, and there have been significant improvements in the design and implementation of agricultural insurance programs since then (Hess, Hazell and Kuhn, 2016). At present, we simply do not know if subsidizing agricultural insurance is economically worthwhile, or how the net benefit might vary with the type of insurance subsidy and the context in which it is introduced. This does not mean that subsidizing agricultural insurance is not economically worthwhile - the lack of evidence does not prove the case one way or the other, but it does highlight the urgent need for ex post cost-benefit evaluations of more recent types of subsidized crop insurance programs, including IBI products. 5. DOES SUBSIDIZING AGRICULTURAL INSURANCE PAY? 15 There is a growing body of experimental data insurance program for Bangladesh shows how this showing how subsidized insurance can help can be done (World Bank, 2015 – Box 1). Although immediate beneficiaries (Cole et al, 2012; de the ex ante benefits look favorable in this case, the Janvry; Jensen and Barrett, 2017), but these gains analysis did not go so far as to sum all the benefits have not been valued and compared to the costs and compare them to the projected cost of the of the insurance programs, nor have they been program to the Government of Bangladesh, so it is tested and evaluated at scale. A good starting point not entirely clear that the program would be socially would be more ex ante evaluations of subsidized worthwhile. Ex ante evaluations would not only insurance programs before they are launched, help screen out less promising proposals, but also and a recent World Bank analysis of a proposed provide a basis for subsequent ex post evaluations. Box 1: Ex Ante Cost-Benefit Evaluation of an Insurance Program in Bangladesh Agriculture is a key sector in Bangladesh, but it is highly exposed to risks. Indeed, Bangladesh is commonly ranked as one of the most vulnerable countries in the world to natural disasters with agriculture heavily exposed to floods, cyclones, and drought. In 2007, for instance, Cyclone Sidr destroyed 0.69 million ha of cultivated crop lands and killed over 460,000 head of livestock and poultry. In the past, the government of Bangladesh and development partners have provided substantial support to farmers in the aftermath of large disasters, but this approach has disadvantages in that support is not guaranteed to farmers and may be slow. In the aftermath of Cyclone Sidr, recovery and reconstruction needs were estimated at US$1.3 billion, or 28 percent of government expenditures. Agricultural insurance offers the government a planned, fast, ex ante alternative to ad hoc disaster response, one that (1) reduces the ex post fiscal burden on the government, (2) improves farmers’ resilience to shocks, and (3) supports the expansion of agricultural credit. To assist the government, the World Bank undertook an ex ante evaluation of a proposed agricultural insurance scheme, which is now being implemented. Key findings from the evaluation follow. Annual fiscal costs to be borne by the government for supporting the development of a national area yield index insurance (AYII program) for aman and boro paddy are estimated at between US$6 million and US$9 million in 2020, when about 10 percent of the area cultivated with aman and boro paddy would be insured. This fiscal costing exercise is based on the assumption that the government will provide financial support to the AYII scheme through 50 percent premium subsidies as well as investment in data market infrastructure and support to awareness-raising activities. As a reference, this amounts to about 0.05 percent of the government of Bangladesh’s 2014 budget, and 1 percent of the Ministry of Agriculture’s budget for the same year. Welfare impact analysis shows that commercial insurance could help small- and medium-scale farmers stabilize and increase their crop income by up to 41 percent if insurance unlocks credit and adoption of high-yielding varieties. Indeed, if farmers currently growing aman local or boro HYV switched to higher- yielding varieties (aman HYV or boro hybrid respectively), the increase in expected yield would largely compensate for the increase in input costs. Given that AYII could increase loan repayment by up to 35 percent in bad (1-in 10) years, insurance could unlock these productive investments through enhanced access to WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 16 cheaper credit. For large-scale farmers, the impact of AYII on access to credit and adoption of technologies would be more moderate. Subsidized AYII could also result in a 100 percent increase in small- and medium-scale farmers’ crop income in bad (1-in-10) years, compared to pure disaster relief. This positive impact of insurance is expected to result from two combined effects. On the one hand, AYII could crowd in credit and adoption of high-yielding varieties, thus increasing crop income in bad years by 83 percent. On the other hand, insurance could mobilize larger compensation to farmers following catastrophic shocks than can existing disaster relief programs, thus increasing crop income by 17 percent in bad years relative to disaster relief program (see figure 1).  Figure 1. Illustrative Comparison of Disaster Relief and 50 percent Subsidized AYII Across Years with Different Levels of Shocks Transfers to Beneficiaries Each farmer receives 80% of input costs +17% in crop income for Each farmers farmer receives No insurance 30% payouts when of input stocks are costs moderate Expenditures Moderate Large shock shock Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Disaster relief Disaster relief Premium paid Premium paid Insurance expense transfer (Gvt) (beneficiaries) payouts Source: World Bank (2015). There have also been only a few studies that compare bank’s lending portfolio. Even a subsidy to cover the the relative costs and benefits of subsidized insurance extra 2% interest charge would have been more cost with alternative policy approaches for achieving the effective for the government than funding many of same political and social goals. Pomareda (1986) the costs of the insurance agency. showed that for the Agricultural Development Bank Using subsidized insurance as a means to transfer of Panama during the 1980s, a 2% increase in the income, either as a safety net or a farm income interest rate it was allowed to charge on farm loans support measure can be expensive. As shown in would have been equally as effective as the entire Table 2, it cost governments about $0.50 to transfer crop credit insurance program in protecting the each $1 to farmers through subsidized insurance in 5. DOES SUBSIDIZING AGRICULTURAL INSURANCE PAY? 17 four major insurance programs during the 1980s, Table 2: Cost to Government of and the transfer cost had increased from $0.63 to Transferring Income to Farmers $0.95 in more recent years in the US program, Through Subsidized Crop Insurance despite improvements to the design of the program6. Programs in Four Countries This is expensive compared to an average 2009-13 transfer cost of between $0.12 and $0.19 per $1 Country Total government spending in dollars to delivered for the Ethiopian Productive Safety Net transfer $1 to farmers* Program (World Bank, 2016, pp. 57-58). It is also expensive compared to a cost of $0.20 to transfer USA 1.63 a dollar of food under Mexico’s Oportunidades 1981-90 1.95 program, which itself is ten times higher than the 2000-11 cost of transferring one dollar of cash (Gentilini, Mexico (1980-89) 1.22 2016). In richer countries with well developed income tax systems, it may also be less costly to Costa Rica (1970- 1.43 allow farmers to offset weather related losses in 89) any one year through income tax averaging over several subsequent years (as in the US). Subsidized Philippines (1981- 1.61 insurance does have an advantage over some 89) alternative income transfer mechanisms in that it Source: Hazell (1992) and author’s calculations based on data in pays out during years of insured losses, and hence Glauber (2012). *Calculated as total cost to government (premium subsidies also helps to stabilize incomes. But so do programs plus A&O subsidies and reinsurance payments) divided by net like the Ethiopian Productive Safety Net Program indemnities received by farmers. and Mexico’s Oportunidades program. rigorous studies have shown significant impact On the other hand, as an income support measure, of agricultural insurance on farmers’ risk-taking insurance subsidies might be less costly than behavior (Karlan et al., 2012; Elabed and Carter, payment schemes for environmental services, given 2015), evidence of the impact of insurance on the high administrative costs incurred in selecting, credit is still missing. There is virtually no credible monitoring and enforcing environmental projects at evidence available to show that subsidized credit farm and landscape levels. It may also be less costly insurance has any impact on the lending practices than price support mechanisms, which can lead to of agricultural lenders. Even with large scale and costly public storage schemes and distortions in well-established agricultural insurance programs commodity markets. such as in India or Mexico, there is no credible One of the key expected benefits of agriculture evidence to show whether the insurance has helped insurance is to unlock credit for agricultural activities to protect agricultural lending ex post (e.g. through exposed to risks such as drought, floods or pests a reduction in non-performing loans in bad years), and diseases. Indeed by absorbing large covariate or has been used by financial institutions to expand agriculture production risks, subsidized insurance agricultural lending ex ante (e.g. larger volumes has the potential to help financial institutions offer of credit, a broader segment of borrowers reached, larger loans and to more farmers. While several cheaper rates, longer maturities). To the contrary, 6 According to Joe Glauber (personal communication) this is in part because of the severe drought in 2012 when the government had to pick up a substantial part of the producers’ claim payments. WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 18 many financial institutions in India are finding ways experiences agricultural losses but does not receive to avoid the requirement of bundling rural loans payouts (or “basis risk”); and banks cherry picking with insurance. An estimated 30-40% of rural loans and only asking for insurance for riskier loans/ are actually insured, which suggests that financial clients. Research is too scarce to fully understand institutions are not strictly enforcing mandatory the mechanisms involved, but it seems clear that, bundling even though it ought to be in their self- regardless of the potential benefits to small farms, interest. A series of factors could explain this bundling insurance with credit for individual farm relatively low penetration: burdensome paperwork loans is not necessarily seen by financial institutions for insurance enrollment; borrowers unwilling to as a way to protect and expand their agriculture pay additional charges for insurance; reputation lending. risk faced by financial institutions if a customer 5. DOES SUBSIDIZING AGRICULTURAL INSURANCE PAY? 19 WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 20 6. Principles and Good Practices in the Design of Subsidies for Agricultural Insurance As seen in earlier sections, there are contexts in which subsidized agricultural insurance has the potential to offer private and social benefits, but experience shows that once introduced, challenges in the design and operation of insurance programs, poor design of subsidies, plus political dynamics can lead to disappointing results, an expensive draw on the public purse, and the creation of disincentive problems that lead to significant economic costs and inefficiencies, and in some circumstances, to environmental degradation. To avoid these problems, any insurance subsidy needs to be carefully designed and implemented so that it is cost effective in achieving its underlying purpose, minimizes disincentive problems, and does not become a growing financial burden on the government. Some useful good practice guidelines have been proposed in the literature, and we draw on these and our own work in proposing the guidelines set out below (e.g., Hill et al., 2014; Clark, 2011; Hess, Hazell and Kuhn, 2016). In developing guidelines, it is useful to distinguish between agricultural production insurance for farmers (including yield and credit insurance), and catastrophe insurance against natural hazards that is intended to complement or replace disaster assistance programs for farmers. While both types of insurance should be limited to objective and verifiable risks using index based or special peril contracts, a key difference between the two is that agricultural production insurance is designed to cover a range of crop and livestock production risks, while disaster insurance covers extreme natural hazards that can lead to loss of lives, assets and livelihoods, not just seasonal losses in agricultural production. Another difference is that disaster assistance is nearly always provided free of charge to beneficiaries, whereas agricultural insurance typically requires at least a co-payment. Within agricultural insurance, it is also useful to separate out insurance that is targeted specifically to poor farm households, as this requires additional care in setting guidelines. Agricultural insurance and disaster assistance (or insurance) programs are not necessarily mutually exclusive, and often coexist in many disaster prone regions (Figure 2). When this happens, special care is needed in their design to avoid a) undermining each other (e.g., farmers have less incentive to buy agricultural 6. PRINCIPLES AND GOOD PRACTICES IN THE DESIGN OF SUBSIDIES FOR AGRICULTURAL INSURANCE 21 insurance if they can rely on free disaster assistance), Since a primary purpose of most agricultural and b) to exploit possible complementarities (e.g., insurance subsidies is to reduce the risk exposure if disaster assistance removes extreme covariate of farmers, a good place to start is to ask if risks, then this can facilitate the development of insurable farm risks are the main problem in more flexible forms of agricultural insurance). terms of their severity and frequency compared One advantage of replacing part or all of disaster to other risks that farmers face. In some contexts, assistance program with disaster insurance is that it market, natural disaster, and security risks are more opens up the possibility of bundling the insurance important than agricultural production risks, in with other forms of agricultural insurance. which case subsidized agricultural insurance may not be effective. Even where production risks are Figure 2. Overlap Between dominant, subsidized insurance is not necessarily Agricultural Insurance and Disaster the best solution. Some production risks can be Assistance reduced by taking preventative actions, such as investing in irrigation, plant breeding, and flood control. Some of these preventative investments also contribute to higher productivity over time, Agricultural Disaster and may offer more attractive ‘win-win’ solutions Insurance Assistance to the risk problem than spending public money on insurance subsidies. Governments may be able to make their own investments in risk reduction or use policies to create incentives for farmers and local communities to make investments. Other risks may be more difficult or costly to prevent, Guidelines for Subsidizing Insurance but farmers can often reduce their exposure by using risk-avoiding strategies like crop and for Commercial Farmers income diversification. Such risk avoidance Assuming governments supply the basic public generally comes at a cost in terms of average goods needed to create an enabling environment income forgone, in which case insurance should for insurance markets to work (e.g., maintaining be explored to see if it is more cost effective. In weather station infrastructure and data systems), short, subsidized insurance is best seen as a way then agricultural insurance for commercial farmers to handle some of the residual risk after other and ought in principle to be financially viable without more cost effective measures have been taken to subsidies, except perhaps on a temporary basis reduce farmers’ exposure to production risks. The because of some externality or establishment World Bank, amongst others, works with countries problem that constrains the development of the in undertaking broad risk assessments, and this is insurance market. However, as seen in section 3, a useful first step before setting up an insurance many governments subsidize farm insurance at high program. Such risk assessments should also take and sustained levels in the pursuit of broader social account of expected changes in climate risks. and political goals, and this complicates some of the guidelines. Our guidelines are as follows: • Articulate what the subsidy aims to achieve. Once the need for insurance has been verified, • Start by assessing risks and establish the the next step is to develop a clearly stated and need for insurance within a broader policy well-documented purpose for the subsidy that framework that also encourages risk reduction. is agreed with the relevant policy makers. This WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 22 should be based on some of the arguments onto their premiums and then provide vouchers presented in section 3 of this paper, and which to farmers to cover delivery costs and let have been empirically analyzed to demonstrate them choose their preferred supplier. Also, a clear ex ante economic rational (for an awareness campaigns amongst farmers and example, see Box 1). their organizations can help them become more savvy clients when buying insurance. • Provide a financing plan for the subsidy. As Consumer protection agencies can also help part of the plan, there should be an explicit strategy protect farmers from bad practices by insurers or financing arrangement for the subsidy. If the and lenders. In countries where there are few if subsidy is intended to help insurers overcome any existing agricultural insurers, the challenge initial establishment problems for the insurance, is to avoid setting up institutional arrangements then there should be a time bound sunset clause. that crowd out the subsequent development of If the subsidy is intended to continue on a longer- private sector competition. term basis in the pursuit of some social or political goal, then there should be an agreed financing • Avoid using subsidies to reduce the cost of plan so that the subsidy does not become an insurance below its pure risk premium. In unexpected burden on the public purse. order to reduce disincentive problems that lead farmers to take on too much risk or of the wrong • The subsidy should be implemented through types, the premium rate farmers pay (net of credible agricultural insurance programs any subsidy) should ideally never be less than or agencies. Agricultural insurance faces its the actuarially fair (or pure risk) premium. This own challenges in designing, delivering and means that subsidies will be less distorting if administering insurance contracts that farmers limited to offsetting an insurer’s administration are willing to purchase, and adding a subsidy and development costs rather than subsidizing to a badly performing insurance program or the premium rates paid by farmers, and these insurer is unlikely to be a recipe for success. For costs can be quite substantial during the early example, subsidizing an index based insurance stages of a new insurance program. Few publicly program that suffers from a serious basis risk subsidized insurance programs adhere to this problem is unlikely to make it more attractive guideline7, and as discussed earlier, governments to farmers. The first priority in this case should provide higher premium subsidy rates for be to overcome the basis risk problem. commercial farmers in pursuit of broader social • Encourage competition amongst insurance and political purposes. Where the pure risk cost providers. Where possible, the subsidy should is to be subsidized, there are ways to reduce be used to encourage competition among the disincentive problem. One way is to restrict insurers. For example, if delivery costs are the amount of subsidized insurance farmers subsidized, insurance companies should be can buy for each insured crop, or not to offer encouraged to deliver at the lowest possible a subsidy at all for high-risk crops, farmers or cost. This could be done by having companies regions where disincentive problems are likely bid their delivery services to the government, to be large. Yet another way is to structure the or by allowing the companies to load expenses subsidy in a way that respects the relative risk Mahul and Stutley (2010) found only 7 countries with subsidized insurance programs during 2003-07 met this requirement. 7 6. PRINCIPLES AND GOOD PRACTICES IN THE DESIGN OF SUBSIDIES FOR AGRICULTURAL INSURANCE 23 levels across insured activities8. For example, the audit costs, awareness campaigns, stop-loss pure risk component of the premium rates could arrangements etc. Tracking impact will depend be subsidized on a proportional basis so that if on the purpose of the subsidy. For instance, the unsubsidized premium rate for one crop is if the subsidy is intended to increase farmers’ initially twice that of another, then its subsidized access to agricultural credit, then the terms of premium rate would also be kept twice as high. loan (interest rate, maturity) and loan recovery rates should all be monitored. Morsink, Clarke • Consider what form the subsidy should take. and Mapfumo (2016) discuss suitable M&E Where a subsidy is to be paid directly to an indicators in more detail. insurer to help cover some initial set up costs, then depending on circumstances, it may be • Conduct a cost-benefit analysis. To better to provide subsidized reinsurance rather demonstrate that the subsidy is money well than a direct administrative subsidy. A good spent, it should be shown that either the subsidy example is when the subsidy is designed to leads to a net social gain through a cost-benefit offset high but temporary risk loadings because analysis (as when correcting market failures of inadequate information about the insured and externalities), or when the subsidy is being risks. The Annex to this paper explores this used to achieve broader social and political guideline in more detail. gains, that it is more cost effective than alternative intervention policies. • Consider a cap on the subsidy level. To avoid adverse distributional outcomes in which larger Guidelines for Subsidizing farms capture a disproportionate share of the Agricultural Insurance for Poor subsidy, a cap could be placed on the level of Farmers subsidy or subsidized insurance available to Even when agricultural insurance for commercial each farm. farmers is well developed, it is often the case that • Establish an M&E framework. To ensure that many poor farmers are left out because they are the subsidy is achieving its intended purpose, perceived to be too risky or too costly to serve, a good long-term monitoring and evaluation or because they are too poor to pay an insurance (M&E) system that tracks the performance of premium. This has led to many attempts to provide the subsidized insurance is required. This has targeted and subsidized insurance that meets the rarely been done in the past. In addition to special needs of poor farmers. It is often hoped basic performance data on coverage (number that providing them with subsidized insurance will farmers, sum insured), premium collected, provide a pathway that enables them to access credit claim payments made, and claims ratios (C and adopt higher earning but more risky farming over P) recorded by insurers, etc., it is also strategies and technologies that will lift them out important to monitor the costs of the insurance of poverty. For some farmers, an initial subsidy to government, and its impacts against the may be sufficient to enable them to transition to intended goals of the subsidy. The cost data unsubsidized commercial insurance, but for many should include the cost to the government in of the poorest a sustained subsidy may be necessary annual premiums subsidies, investments in data to help keep them afloat. Most of the guidelines collection, contributions to management and provided above for subsidizing insurance for 8 Past experiences in India has shown that subsidies directed at risky crops may encourage farmers to cultivate more of these crops (e.g., groundnut in Andhra Pradesh and Gujarat). Changes in actuarial design introduced by the Government of India in 2010, with support from the WBG, have significantly improved risk signaling and incentives to adapt to climate change. WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 24 commercial farmers still hold, but we make the there are potential negative incentive problems, following exceptions and additions: although these are likely to be less severe for small scale, often subsistence oriented farmers • Since the insurance is targeted to poor farmers than for larger-scale commercial farmers. One each of whom will buy only a small amount of way to reduce the problem for poor farmers is to insurance, then an intermediary organization require them to repay the subsidy in the form of in- that can aggregate up the needs of many small kind labor payments by working on community farms and administer the insurance on behalf projects that contribute to greater resilience of an insurance company is typically needed. against losses, as with the R4 Risk Resilience A variety of institutions might fill this role, initiative in Ethiopia9 (Box 2). Another way including an NGO, a farmers association would be to limit the payments so it can be more or cooperative, a mutual insurance group, of an income support (rather than compensation an agricultural development bank, and a for actual losses) to protect basic needs in the microfinance organization. It is important to event of severe crop or livestock losses. identify and select an appropriate intermediary. It also needs to be recognized that providing • When the subsidy is intended to benefit specific subsidized insurance on its own is unlikely segments of farmers or herders to help them to be a game changer for the poor unless a) escape poverty, the subsidy should be well they can access credit if they purchase the targeted to those segments to minimize the cost subsidized insurance, and b) are able to use of inadvertently subsidizing others. When the the credit to obtain the complementary inputs insurance subsidy is tied to credit at selected like fertilizer, improved seeds, and extension financial institutions, then it is relatively easy for needed to raise their farm productivity. This the financial institution to distinguish between can be a challenge for many poor farmers who targeted and non-targeted borrowers. More are anyway disadvantaged by high transactions generally, insurers or intermediary institutions costs in accessing inputs and markets, and like cooperatives and NGOs will need who are typically the least likely to receive sufficient household specific information and assistance from public extension agents. For an operational capacity to identify and service many poor households, it typically takes poor households, and some compensation for concerted action by governments, donors or an the extra administrative costs. Hill et al (2014) intermediary organization like a cooperative discuss the issues and some of the options or NGO to provide the subsidized insurance for targeting subsidies in some detail. One within a complementary package of other promising approach is to link the insurance requirements for change, and this should also with existing social protection systems, such be considered when selecting an intermediary as safety net and cash transfer programs, as organization to aggregate and distribute the these already have an infrastructure in place subsidized insurance. A good example is the R4 for identifying the poor and vulnerable and Risk Resilience initiative in Ethiopia (Box 2). delivering assistance. The R4 Risk Resilience initiative in northern Ethiopia has used the • Most insurance subsidies for poor smallholders Ethiopian Government’s safety net program to will need to cover a substantial part of the pure identify poor households (Box 2). risk cost if it is to be affordable. This does mean 9 Based on RCTs in Ethiopia, Tadesse et al (2016) found that most smallholders were willing to undertake such work at below normal wage rates. 6. PRINCIPLES AND GOOD PRACTICES IN THE DESIGN OF SUBSIDIES FOR AGRICULTURAL INSURANCE 25 Box 2: The R4 Risk Resilience Initiative in Ethiopia Weather-related shocks are a constant threat to the security and well-being of many poor farmers in Ethiopia. To help them build resilience and face these challenges, Oxfam America, Swiss Re, and their partners developed the Horn of Africa Risk Transfer for Adaptation (HARITA) program in the state of Tigray in Ethiopia in 2008. HARITA is an integrated risk management program aimed at strengthening farmers’ food and income security through a combination of improved resource management, insurance and microcredit. HARITA allows cash-poor farmers the option to work for their insurance cover by engaging in community- identified projects to reduce risk and build climate resilience, such as improving irrigation or managing soil. Though the premium is fully subsidized for some farmers, they still contribute to the cost of the insurance with their work. Farmers who are in a slightly better financial situation, on the other hand, must contribute in cash to the cost of the coverage in order to enjoy the same benefits. The long-term goal of the program is that farmers participating in the “work-for-insurance” modality can eventually graduate and afford to pay in cash, allowing other farmers in need to take their place in the program. In the event of a seasonal drought, insurance payouts are triggered automatically when rainfall drops below the determined threshold, enabling farmers to afford the inputs necessary to plant in the following season and protecting them from having to sell their assets. However, the most innovative feature of HARITA is that farmers benefit even when there is no payout, as the risk management infrastructures built through their work will help reduce risk during next seasons. In order to target the vulnerable low-income rural population living in Tigray to participate in the program, HARITA is integrated with the Government’s “food- and cash-for-work” Productive Safety Net Program (PSNP), a well-established scheme that serves 8 million chronically food-insecure households in Ethiopia. By using an already existent safety net program, HARITA managed not only to better reach its target population, but also to reduce the costs of establishing a distribution network from the start. While the distribution model makes it easier to reach those who have time to spend on community work, it excludes poor households that do not have excess labor capacity, such as female-headed or elderly households. In December 2010, after a partnership with the WFP, HARITA was renamed “R4” and expanded to 76 villages in Tigray, reaching around 20,000 farmers. The program has experienced high demand and the “work-for- insurance” segment reaches capacity within the first couple of days of being introduced in a new area. Though the idea is to extend the program to other areas that face the same constraints, lack of funding limits scale. The reliance on subsidies limits the scale at which the insurance can be offered, as funding is needed to pay for the public works and to pay for the premium. The R4 illustrates several good practices: a) it uses a safety net program to identify the poor, b) it encourages farmers to undertake ex ante risk reduction measures, c) it packages the insurance with access to credit, inputs and extension advice to help promote increases in farm productivity, and d) requires farmers to contribute to the cost of the insurance either in cash or by providing labor to community development projects. However, despite its promise, the program has yet to demonstrate its full impact and net social value through a cost- benefit analysis. Also, while the initiative demonstrates several good practices, and is generally a well designed and administered program, it has not reached scale, even after 8 years, there is no obvious strategy for phasing out the annual subsidy that is provided by donors. Source: Hill et al (2014) and authors. WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 26 Guidelines for Subsidizing Insurance To obtain quicker and more assured access to funds to Improve or Replace Disaster in times of need, some DAPs have been able to Assistance purchase international reinsurance to cover part of their expected assistance payments. Not only does Spending on disaster assistance programs (DAPs) this lead to more assured and timely payments from has increased significantly in recent years, and a reinsurer when a disaster occurs, but reinsurance seems destined to increase further in many countries can also help smooth out the annual cost of a with climate change. Such spending is driven DAP to government and/or donors in the form of more by humanitarian concerns than development a predictable and regular annual premium. Even agendas and often its primary value is in saving if only part of the disaster risk is insured, this can lives. Some DAPs also aim to rebuild assets and enable governments to better plan for disasters, and livelihoods as part of recovery efforts. DAPs are help fill the short-term post-disaster funding gap particularly helpful to the poor, who are generally while additional assistance is being sourced (Clarke more exposed to catastrophic risks because they and Dercon, 2016). This kind of reinsurance have the least options for coping with losses when works because most catastrophic losses caused by they occur, and because they often live in more natural disasters are relatively easy and transparent remote and high-risk areas. to observe, and can be indexed on the basis of While most DAPs achieve their primary objective of existing data series to create an attractive index saving lives, they vary widely in terms of their cost, based insurance (IBI) product for the reinsurance efficiency, and protection of assets and livelihoods. market. A good example is the Agricultural Fund Two of the biggest practical challenges facing DAPs for Natural Disasters (CADENA) in Mexico, are a) the difficulty of targeting assistance to the which internationally reinsures part of the costs truly needy under emergency conditions while at the of Mexico’s state-managed relief programs (Hess, same time not wasting assistance on the non-needy; Hazell and Kuhn, 2016). and b) by the time an emergency has been declared To solve the targeting problem, one promising and an assistance effort funded and launched, the development is the linking of DAPs with existing assistance may arrive too late to relieve the worst social protection systems, such as safety net and suffering and losses. Another problem discussed in cash transfer programs, as these already have an Section 4 is that since DAPs are fully funded by infrastructure in place for identifying the poor and donors, UN agencies and governments, and, unlike vulnerable and delivering assistance (Grosh et al., insurance, do not try to recoup their costs from 2008; Alderman and Haque, 2008). The objective is the beneficiaries, they may lead to disincentive to give these social protection schemes the capacity problems, particularly once people begin to take to scale up rapidly after a disaster and increase the them for granted. Finally, because DAPs focus on size of the cash payments they make to beneficiaries ex post compensation and recovery, they may do and the number of beneficiaries they can support. little to encourage recipients to take preventative ex In Ethiopia, for example, the government, World ante actions that reduce risk exposure and increase Food Program and the World Bank established resilience, including discouraging recipients from the Livelihoods, Early Assessment and Protection purchasing their own insurance. Recognizing (LEAP) mechanism in 2008 (Hess and Hazell, these limitations, there have been some recent and 2016). LEAP is an integrated food security and useful innovations in developing better approaches early response system that combines early warning, to DAPs, and which involve the application of capacity building, contingency planning and subsidized insurance. contingent finance. While LEAP is based on donor- 6. PRINCIPLES AND GOOD PRACTICES IN THE DESIGN OF SUBSIDIES FOR AGRICULTURAL INSURANCE 27 provided contingent financing rather than commercial the vouchers for free, recipient households can be insurance, it uses an index-based approach. asked to contribute labor towards enacting certain risk reduction measures, such as participation To help encourage greater ex ante risk prevention in training for good agricultural practices or and management practices among recipients, disaster proofing homes, or by participating in another innovative approach is to replace part or all community organized activities to improve disaster of disaster relief with new types of subsidized IBI. preparedness and mitigation. This can help increase The primary object here is to provide subsidized resilience, and, as with the R4 Risk Resilience insurance contracts to vulnerable households initiative in Ethiopia, reduce some of the perverse each year so that when an insured catastrophe incentive problems associated with subsidizing occurs, they receive automatic cash payouts from the true risk cost of the insurance. The availability the insurance without having to wait for a relief of ERVOs that remove important covariate risks effort. One example is the use of Early Recovery may also encourage the uptake of complementary VOuchers (ERVOs) as proposed by the World Food forms of agricultural insurance for managing other Program (WFP) and GIZ (Hess et al., 2010. ERVOs agricultural production risks. The index chosen are index based insurance contracts targeted to poor for the insurance should correlate highly (on the households who are identified ex ante based on downside) with major losses in the income or assets national poverty lines or by a relevant safety net or of poor households due to catastrophic events, and cash transfer program (see Box 3). When a disaster need not be limited to farming households. ERVO occurs, insured households receive a guaranteed and like schemes are being piloted in China and Peru immediate cash payment, preferably though mobile (Box 4), and have been proposed in Paraguay, and bank accounts. Moreover, instead of distributing their experience bears watching. Box 3: Early Recovery Vouchers (ERVOs) ERVOs seek to make relief more assured and effective for the poor (Hess, Balzer and Calmanti, 2009). ERVOs are motivated by two concerns. First, it is not enough to respond to shocks and rebuild livelihoods; there is a need to invest in disaster preparedness and mitigation measures. Communities that become more resilient and prepared to respond to disasters, when combined with government disaster preparedness efforts, significantly reduce disaster-related losses of life and livelihoods. In fact, studies show that every dollar invested in disaster risk reduction saves four or more dollars in future costs of recovery and rehabilitation.10 A second motivation is that the poor, who rely disproportionally on disaster relief when catastrophic events occur, are probably the least well served. The relief they receive is often inadequate because of the type of aid they receive (e.g., food aid rather than cash), the amount they receive (especially when there are high leakages to the non-poor), and the timing is often too late to be truly effective. ERVOs attempt to address both these problems by providing direct ex ante disaster protection for the poor In a report to the United States Congress, the Federal Emergency Management Agency (FEMA) and the Multihazard Mitigation Council 10 stated that “On average, a dollar spent by FEMA on hazard mitigation (actions to reduce disaster losses) provides the nation about $4 in future benefits.” WFP estimates that US$1 spent on early livelihood protection in Ethiopia generates about US$4 in future cost savings and benefits. WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 28 by covering eligible households with an insurance policy that guarantees immediate disaster payments in cash following natural disasters. Moreover, instead of distributing the vouchers for free, recipient households might be asked to enact certain risk reduction measures, such as participation in training for good agricultural practices or disaster proofing homes, or by participating in community organized activities to improve disaster preparedness and mitigation. ERVOs payments would be triggered by an index using weather station or satellite data about catastrophic events, and which would meet the objectivity and transparency requirements for international reinsurance. The insurance cover is aimed at poor households identified ex ante based on national poverty lines or by a relevant safety net or cash transfer program. With the development of mobile banking systems like M-PESA in Kenya, households could be uniquely identified and registered by mobile phone and payments, when due, made directly into their accounts where they could be accessed by mobile phone. For example, the identified and registered households might receive a natural disaster insurance that paid out up to $500 on their private account in the event of an extreme drought, flood or storm. Governments and donors pay the premiums and the insured household covers a small processing fee in order for the households to realize that they are insured. Where mobile banking is not available, ERVOs might be distributed by existing organizations that have a grass roots presence, such as safety net and cash transfer programs, microfinance institutions, NGOs, farmer cooperatives, etc. Payments could be announced on public radio, and made available at local banks or post offices. Technological advances in delivery technology (mobile wallets) as well as index technology (satellite-based) and geo-referencing of household locations (GPS) allow for the large-scale roll out of such ERVO schemes. ERVOs have several attractive features: • They offer benefits to the poor in terms of direct and timely assistance when a catastrophic loss occurs. Moreover, since the amount of assistance is assured, poor households would be able to take on greater risk in their livelihood strategies, hopefully increasing their average incomes. • Through their conditionality, they could contribute to building more resilient community infrastructure, livelihoods and farming systems. • They are an indexed form of insurance that can be reinsured through an index product for the managing agency. • They can also be interfaced with existing safety net and cash transfer programs, which offer a reliable way for the ex ante identification of the poor and vulnerable. • To avoid the negative incentives that arise from assured but free disaster assistance, households might be asked to make a small financial contribution (e.g. pay a processing fee), or pay a graduated premium – a basic amount of coverage could be free but there would be an option to buy more coverage at an escalating price. For the poor, there might be an option to pay the premium through an insurance-for-work scheme working on community projects that help build resilience. A graduated premium would solve the problem of what to do with households who choose not to buy the insurance – disaster relief would be provided to all the needy during an emergency, but those who had not bought vouchers would only be given the basic amount of assistance that is free. 6. PRINCIPLES AND GOOD PRACTICES IN THE DESIGN OF SUBSIDIES FOR AGRICULTURAL INSURANCE 29 • Another nice feature of ERVOs is that by removing some of the worst catastrophic risks facing farmers, this could open up more possibilities for insuring the more normal and less covariate risks that arise in agriculture. This might be especially relevant for many small to medium sized farms that want to pursue commercial farming opportunities. A challenge for ERVOs is finding an index with a low basis risk for the households who receive the vouchers. This is a less daunting task than finding indices for crop insurance because a) the insurance is limited to the kinds of low frequency, high impact, highly covariate weather risks that affect most people in a region at the same time; and b) an index that correlates highly (on the downside) with losses in household incomes or assets may be more robust than indices that correlate with yield losses for specific crops. The type of index required for an ERVO scheme could also be meaningful to poor households in a region who are not engaged in farming, and who would benefit from receiving ERVOs. ERVOs would have to be substantially funded by governments and donors, but if they could replace part of existing disaster assistance programs, and possibly some forms of publicly funded agricultural insurance that insure some of the same catastrophic risks, then there might be sufficient savings from existing funding commitments to enable ERVOs to be implemented at some scale. Source: Hess, Hazell and Kuhn (2016). Box 4: Seguro Agricola Catastrófico (SAC) in Peru The catastrophic agricultural insurance (or SAC by its Spanish acronym) in Peru, is a government program that has the objective to support the small producers in the poorer and most climatic vulnerable regions of the country. It aims to protect a portfolio of basic crops against various climatic risks. The program started in 2009 and is being implemented in 8 departments, covering approximately 425,000 ha on average per crop year. SAC is not only a financial resource to enable the provision of this insurance, but the first element of an agricultural policy that aims to strengthen the strategies for prevention and protection of agricultural families within the policy framework for social inclusion. The main characteristics of SAC are as follows. • Same insurance policy protects homogeneous groups of crops (basic crops, fruits, vegetables), in extensive areas of small and medium producers. • Insured value per hectare is the same for all the insured/protected crops corresponding to an average area yield that has been established statistically. This average area yield is the trigger that determines the occurrence of the catastrophic event. • SAC does not cover all the production costs nor the total losses of farmers when the catastrophic event occurs. SAC aims to provide for a basic compensation that increases the capacity of farmers to endure the negative impacts of the catastrophic event, and more specifically, to enable them to recover their own labor cost and be able to re-plant. The sum insured for 2015/16 was approximately $160/ha. • Premium is 100% subsidized and paid by the government. • In 2007 the government passed Law 29148 that establishes SAC. • Insurance offered by a pool of two private companies: La Positiva and Mapfre Peru. Insurance companies are competitively selected. WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 30 Year Premium (Soles) Insured Area (Ha) Sum Insured (Soles) Loss Ratio % 2009-10 S/.39,447,693.84 490,069 S/.220,995,300.00 29.14 2010-11 S/.39,970,678.29 442,210 S/.238,387,122.00 71.4 2011-12 S/.39,982,850.01 450,108 S/.241,922,716.20 28.85 2012-13 S/.39,589,760.05 414,149 S/.239,543,306.00 35.52 2013-14 S/.30,000,000.00 329,943 S/.181,468,697.62 47.99 2014-15 S/.24,117,855.22 343,441 S/.188,892,324.50 46.35 2015-16 S/.39,000,001.22 550,296 S/.302,662,800.00 NA Source: Seguro Agricola Catastrófico, MINAGRI, GIZ (2016). Farmers receive indemnification when a certain threshold of yield loss (average area yield loss) is exceeded. Payment of indemnification is done directly from the insurance company to the beneficiaries, the small holder farmers, who have an account at a financial institution to receive directly into their account the payment from the insurance company. Farmers who are the beneficiaries of SAC are pre-identified and registered. The 8 departments selected for SAC are those with the higher concentration of poorer small holder farmers exposed to climatic risks. Between 2009/10 and 2013/14 crop years a total of 310,587 small holder producers received compensation reaching the sum of S/. 67.5 million (approx. US$22 million; or US$70 average per beneficiary). According to a report by MINAGRI (2016), a key factor for the success of SAC has been the strong support by the government, not only in terms of financial support, but also investments in technical capacity related to understanding small holder agriculture, agroclimatic risk analysis, and insurance, and making insurance an important instrument for the public policies for agriculture. For the insurance sector, SAC has brought new opportunities for the private insurance companies and increased their interest to develop additional insurance products for agriculture beyond catastrophic insurance. An important impact of SAC, has been its impact on financial inclusion, by requiring beneficiary small holder farmers to open an account at a financial institution to receive payments. Many of these farmers prior to SAC had no relation with formal financial institutions. Furthermore, relations with financial institutions now open the possibility that the small holder farmer could potentially access credit. SAC also offers opportunities for these small holder farmers to take new decisions about crop choices to grow and cultivation practices. The protection offered by SAC could enable farmers to take some additional risks in choosing to grow other crops/products or putting more investments in existing crops they grow with potential positive effects on productivity and income growth. ACKNOWLEDGEMENTS 31 Best practice guidelines for using subsidized not correlate highly with individual losses, this catastrophe insurance to complement or replace discretion helps reduce basis risk problems for DAPs are as follows: farmers,. In Peru, the farmers are pre-identified individually and know that they are insured. • First, assess whether insurable catastrophe When an insured event occurs, they receive risks are the main problem, otherwise continue compensation directly into their bank accounts with a DAP which can be more flexible and ad from the insurance company (Box 4). hoc in choosing when to provide assistance. Also, consider whether it might be better to • If opting for direct farmer insurance such as invest in infrastructure and technologies that ERVOs, then there needs to be an efficient way can improve resilience and reduce exposure to of identifying the target households who should catastrophic losses. receive the ERVOs on a fully subsidized basis. One promising development is the linking of • Develop a clearly stated and well documented DAPs with existing social protection systems, plan that is agreed with policy makers, and such as safety net and cash transfer programs, which is clear about the risks that are to be as these already have an infrastructure in place insured and which risks may still need to be for identifying the poor and vulnerable and covered by a DAP. delivering assistance. • Develop a long term financing plan for the • By removing important covariate risk, ERVOs subsidy. could open the way for supplementary forms • Determine whether the subsidized insurance of agricultural insurance for some types of is to be distributed directly to intended farmers. This should be encouraged. beneficiaries like farmers who would also • Since DAPs are heavily subsidized, then receive the claim payments (e.g., ERVOs), insurance substitutes are likely to be so too. or used to insure a DAP agency that retains However, given the ex ante nature of insurance, responsibility for making payments to there is greater opportunity with ERVOs to ask beneficiaries. The Agricultural Fund for some beneficiaries to pay part of the premium, Natural Disasters (CADENA) in Mexico is a perhaps on a compulsory basis, and this good example of the latter approach (Box 5). could reduce potential disincentive problems. In this case, the budget of local governments As with insurance for poor farmers, it may for disaster assistance in protected, but farmers also be plausible to ask poor beneficiaries to may or may not know that they are insured. participate in community projects to build The scheme only specifies what type of greater resilience. farmers are eligible to receive assistance but leaves discretion to the local government to • As with agricultural insurance for farmers, decide ex post which individual farmers will there should be an M&E system in place be compensated. Since the insurance payouts and occasional evaluations to check that the are tied to a regional weather index that may program is achieving its purposes and giving value. WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 32 Box 5: The CADENA Program in Mexico The Mexican Agricultural Fund for Natural Disasters (CADENA) aims to internationally reinsure part of the costs of its state managed relief programs. CADENA was launched in 2003 by the Ministry of Agriculture and contains two main components: a) the Catastrophe Agricultural Insurance (SAC) program for farmers, livestock producers, aquaculture farmers and fishermen; and b) in States where SAC is not provided, direct compensation payments to farmers in the event of natural disasters. Under the program, State Governments purchase insurance to protect their budgetary allocations against natural disaster compensation for the most vulnerable farmers. The states are the insured, and the premiums are financed by the federal and state governments. Payments are made against a number of indices. Small-scale, low-income farmers without access to commercial crop, livestock, or aquaculture insurance are the intended beneficiaries of the insurance coverage, and the program is designed to provide a minimum level of compensation to smallholder farmers to put them back into production following a major catastrophic event. In 2011, the CADENA program insured about 8 million hectares of crops and slightly over 4.2 million head of livestock. There were around 2.5 million beneficiaries and the total sum insured was approximately US$ 1 billion. CADENA is part of a larger national program – the Fund for Natural Disasters (FONDEN), which transfers part of its risk to the international market through reinsurance and the issuing of catastrophe bonds. Some key characteristics of CADENA: • Designed as a safety net for small scale farmers (less than 20 ha and 60 Tropical Livestock Units or TLUs) which covers a small sum insured (about 200 USD per ha). • State governments are strongly incentivized to opt in the insurance program: they receive a 80-90% federal premium subsidy when they opt in. Alternatively, if they opt-out, the federal Government supports 60% of ex-post disaster relief expenses (“Direct support”). As a result 30 out of 32 states have opted in to the insurance program. • States can choose type of insurance coverage (weather index, area yield, traditional) and have full autonomy on the use of insurance payouts (can be used to pay next year’s premiums). Most of CADENA is under area yield index insurance (AYII). • Municipalities distribute payouts to farmers by check, and farmers need to show proof of identification and property title. 6. PRINCIPLES AND GOOD PRACTICES IN THE DESIGN OF SUBSIDIES FOR AGRICULTURAL INSURANCE 33 WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 34 7. Conclusions Many governments use subsidized agricultural insurance as an instrument of choice for helping farmers and rural communities cope with risk; so widely in fact that globally they spend well over $20 billion annually on such subsidies. There are many reasons behind these subsidies, some having to do with market failures and externalities that constrain the development of privately provided and unsubsidized insurance, and some having more overt political and social objectives such as helping specific segments of poorer farmers access insurance, encouraging increased production of important food or export crops, protecting agricultural lending institutions, reducing the need for disaster assistance payments, or simply as a politically acceptable means of supporting farm incomes. In reviewing the available literature and evidence on insurance subsidies, we are struck by how little is really known about the effectiveness of insurance subsidies in achieving their intended purposes, or whether the impacts they generate justify their costs. In many cases, it is hard to obtain even basic performance data about subsidized insurance programs and pilot projects, let alone evidence about how they affect the behavior of financial institutions and private insurers, or how they impact on the farmers themselves. This leads us to one general recommendation: there is a fundamental need for more evaluations and impact assessments of subsidized agricultural insurance programs. This should involve a) more widespread use of ex ante impact assessments at the design stage of subsidized insurance programs, b) collection, release and analysis of basic data about the operations and performance of subsidized insurance programs, and c) implementation of more formal M&E systems that can provide credible data for assessing the impacts of insurance subsidies. While there would appear to be many contexts in which subsidized agricultural insurance has the potential to offer attractive benefits, experience shows that once introduced, well known challenges with the design and operation of agricultural insurance programs, poor design of subsidies, plus political dynamics can all contribute to disappointing results, an expensive draw on government budgets, and the creation of disincentive problems that lead to significant economic costs and inefficiencies, and in some circumstances, to environmental degradation. To 7. CONCLUSIONS 35 avoid these problems, any insurance subsidy needs • Any insurance subsidy that lowers the cost of to be carefully designed to be “smart”, in the sense insurance to farmers below the actuarially fair that it is cost effective in achieving its underlying (pure risk) premium rate has the potential to purpose, minimizes disincentive problems, and create disincentive problems that distort resource does not become a growing financial burden on allocation decisions. If the insurance is targeted the government. To this end we have proposed at commercial farmers, then it is best if the some best practice guidelines for the design subsidy is limited to the insurer’s administration and implementation of subsidized agricultural and development costs, including any high- insurance. Some of these guidelines are quite risk loadings due to inadequate data about the general, while others are more specific to the exact risks involved. As such, the subsidy could be purpose of the insurance. The general guidelines paid directly to the insurer rather than used to can be summarized as follows: subsidize premium rates. If the insurance is targeted at a specific segment of poor farmers, • First establish that the insurance is the or is intended to replace part of disaster appropriate intervention for the risk problems assistance, then the subsidy will likely have to that farmers face, and that there are no better cover part, if not all, of the pure risk premium. alternatives. Wherever the subsidy does include part of the • Then develop a clearly stated and well- pure risk cost, then practices should be adopted documented purpose for the subsidy that is to reduce disincentive problems. These include agreed with the relevant policy makers. restricting the amount of subsidized insurance farmers can buy for each insured crop, and • As part of the plan there should be an structuring the subsidy in ways that respect the explicit exit strategy or long-term financing relative risk levels across insured activities. arrangement for the subsidy so that it does not When the insurance is targeted at poor farmers, become a growing and uncontrolled financial they could be asked to pay an in-kind premium burden on the government. by working on community projects that build • Select capable partner institutions for resilience. implementing the subsidized insurance. Adding • Wherever possible, and especially for a subsidy to an already badly performing subsidized insurance intended for commercial insurance, credit program, or NGO program or farmers, the subsidy should be used in ways project may make things worse, not better. that crowd in private insurers and encourage • To avoid adverse distributional outcomes, cap competition among them. the amount of subsidized insurance available to • Where the subsidized insurance is intended to each farmer. give a segment of poor farmers access credit • To ensure the subsidy is achieving its intended and thence game changing technologies and purpose, establish a good monitoring and modern inputs, then the insurance should be evaluation (M&E) system, and undertake channeled through credible institutions that periodic evaluations. can a) link the insurance to credit, b) ensure that access to credit also means access to Some additional guidelines apply but vary according complementary inputs, and c) can identify and to the purpose of the subsidy: efficiently reach the intended target group of farmers. WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 36 • In the case of subsidized insurance intended • In regions where both agricultural insurance to compliment or replace disaster assistance and DAPs or catastrophe insurance coexist, payments, it is important to identify which then efforts should be made to make them catastrophe risks the insurance will be able to complementary and not to undermine each cover, and which will still need to be covered other. Since DAPs or catastrophe insurance be a disaster assistance program. like ERVOs remove important covariate risks, they should in principle be complementary to agricultural insurance that covers some of the remaining production risks. 7. CONCLUSIONS 37 WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 38 REFERENCES Alderman, Harold, and Trina Haque. 2010. 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ISSUES AND GOOD PRACTICES 42 Annex: The Choice Between Subsidizing An Insurer’s Costs Verses Providing Subsidized Reinsurance A common problem in setting up a new insurance program in data-sparse environments is that the insurer has inadequate data to properly assess the actuarial risks, and so adds a high-risk loading component to the premium rate it charges farmers. Although initially high, this risk loading component can be expected to fall once the insurer has acquired additional data over time. Climate change can lead to a similar problem even with established lines of insurance, since the insurer is confronted by growing uncertainties about the risks they are insuring. An insurance subsidy introduced as an interim measure to offset part of the risk loading component of the premium rate charged can help overcome this problem. An alternative, and possibly more cost effective solution is for governments to reinsure at subsidized rates some of the extreme layers of risk faced by the insurer, (Carter, 2013). Box 6 reviews the pros and cons of providing reinsurance arrangements for insurers, and the circumstances under which this is better than a direct premium subsidy. Where reinsurance is warranted, it can be implemented through the establishment of a public reinsurance company, which provides reinsurance support to commercial insurers (for example, Agroasemex in Mexico). Alternatively, a stop loss is an agreement for governments to pay claims directly to insurance companies above a pre-agreed loss limit (expressed as a percentage of claims) in the event of a major shock. In order for the government to control its risk exposure in a stop-loss arrangement, there is generally an agreement on the minimum premium rate to be charged by insurers. Stop loss agreements can be funded from government reserves, through contingent debt financing (e.g. from the World Bank in the case of Mongolia), or by partnering with a reinsurance company (paying them a regular premium in return for the reinsurer paying claims). However, governments do face operational challenges when offering reinsurance, such as those arising from the cost of managing budget volatility, timeliness of claim settlement, and challenges with risk-based pricing. Holding large budget lines or capitalizing large contingency funds that will only be drawn down according to the rules of the reinsurance that government is providing can be economically costly, and can undermine sound public financial management principles. For example, it can be challenging for governments ANNEX: THE CHOICE BETWEEN SUBSIDIZING AN INSURER’S COSTS VERSES PROVIDING SUBSIDIZED REINSURANCE 43 to justify not fully exhausting contingency funds agricultural insurance programs do so by partnering when moderately sized disasters occur, even with a regulated reinsurance company or companies, though additional payments are not due under the paying them a regular premium in return for the reinsurance contract. Moreover, if the reinsurance reinsurer(s) paying any claims that government subsidy extends into a more permanent arrangement, has taken responsibility for as they fall due. Box it may provide incentives for farmers or insurers to 7 provides some contrasting examples illustrating ‘game the system’ by acting in inefficient ways that circumstances when subsidized reinsurance is and increase the cost to government but reduce the cost is not preferable to subsidized premium payments to the farmer or insurer. (as in the US) For these for covering risk-loading costs. reasons, some governments that offer reinsurance to Box 6: Pros and Cons of Premiums Subsidies and Public Reinsurance of Extreme Risk Layers Year Premiums Subsidies Public Reinsurance for Extreme Risk Layer Requirement Low: Government only pays for a High: Government might be exposed to for financial share of commercial premiums ( ex- severe losses which require setting aside capacity ante payment) large amounts of capital from the beginning of the project (e.g. Mongolia, Mexico) Cost- Uncertainty loads Uncertainty loads effectiveness • In data-sparse environments, insurers • the uncertainty-neutral public sector charge high uncertainty loads on reinsures extreme layers of risks at a extreme layers of risks(cf Carter, 2013) lower cost to insurers, which benefits • For products where long data series farmers are available (e.g. Satellite products), Profit margins or where insurance companies see • if no claims are paid during the project strong market potential, commercial period that money can be rolled over premiums might not include high to future risk periods uncertainty loads (e.g. Kenya). Financing costs Profit margins • Setting-aside large amounts of capital • Premiums subsidies are partially might be very costly for Governments subsidizing insurance companies’ (depends on borrowing rate/ profit margins (not only claims paid to investment returns) farmers), which Governments/Donors might be reluctant to do. Sustainability Premiums subsidies might constitute If the Government does not set a threshold a large fiscal burden for Governments for commercial premiums, or set the over time, and are often hard to phase- stop-loss too low, this might not provide out (Mahul and Stutley, 2010) incentives for insurance companies to manage risks (e.g. India NAIS). Setting a threshold for commercial premiums might be complex where demand cannot be estimated easily. WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 44 Outreach Premiums subsidies have a direct Stop-loss have can help decrease (number of positive impact on sales (Cai, 2011) commercial insurance premiums farmers) rate, but not as much as premiums subsidies (given a fixed amount of public support). Stop loss might have reduced farmer’s outreach (e.g. Mozambique). Level of Insurers might not offer risky Public Reinsurance of extreme layers coverage per products without stop loss (e.g. may incentivize insurers to offer product I4 projects insurers would not offer innovative or risky products (e.g. products in half of villages - Hill, Mongolia) 2014) However Government might choose to only subsidize certain types of products to ensure products protect farmers when bad shocks happen (e.g. Kenya) Political High visibility of Government support Low visibility of Government support, visibility to farmers which can also make exit strategy easier. Source: Rachel Sbero. Box 7: Some Examples of Public Reinsurance Arrangements Verses Direct Subsidies for Risk Loading Costs Mexico - Setting up a Public Reinsurance Company Fondos are self-insurance funds that have been operating in Mexico since 1988. In 2004, more than 240 Fondos provided insurance against agricultural production risks (including hail, drought, frost, floods, diseases, pests) to their members, accounting for 50 percent of the total insured agricultural area in Mexico. The total liability of the Fondos on an annual basis was approximately US$$400 million dollars in 2004. The Fondos are not allowed to sell insurance to their members unless they have a proper reinsurance treaty negotiated before the beginning of any specific agricultural cycle of production. Since these organizations do not have capital to guarantee the solvency of the Fondos, they must buy enough reinsurance to guarantee that the members of the Fondo will receive the full amount of indemnity in the case of a peril. The regulation requires that any reinsurance contract negotiated by the Fondos should be defined to absorb any exceeding indemnities after the financial reserves of the Fondos have been exhausted. Therefore, an unlimited stop loss reinsurance treaty is implicitly requested. Historically, the state-owned reinsurance company Agroasemex has offered to the Fondos this unlimited stop loss program. Agroasemex provides stop-loss insurance of up to 100 per cent of the total sum insured to mutuals of smallholder farmers whereas traditional stop-loss reinsurance agreements would usually cap the percentage of the total sum insured that they cover. ANNEX: THE CHOICE BETWEEN SUBSIDIZING AN INSURER’S COSTS VERSES PROVIDING SUBSIDIZED REINSURANCE 45 Index-Based Livestock Insurance Program: In a Data-Sparse Environment, Public Reinsurance of Extreme Risk Layers Can Create Confidence and Crowd-In Private Insurance and Reinsurance Started in 2005, this program involved a combination of self-insurance by herders, market-based insurance, and social insurance. Herders retain small losses, larger losses are transferred to the private insurance industry, and extreme or catastrophic losses are transferred to the government using a public safety net program. A syndicate pooling arrangement protects participating insurance companies against excessive insured losses, with excess of loss reinsurance provided by the government. The fiscal exposure of Government of Mongolia toward the most extreme losses is protected with a contingent credit facility. The Government of Mongolia was double exposed to livestock mortality risk under this livestock insurance program (see figure 3 below). First, it covers losses exceeding a specific threshold (e.g., 25-30% of livestock mortality rate) through the Disaster Response Program (DRP). Second, it acts as a reinsurer of last resort for the insurance companies selling the Base Insurance Product (BIP) through stop loss provision at 105% of the base premiums sold to the LIIP (Livestock Insurance Indemnity Pool (LIIP). This double exposure required adequate financing in order to avoid an increase in the fiscal burden of the government. This was financed through: reinsurance premiums received from insurance companies, Government Budget and World Bank Contingent Loan. Figure 3: Government of Mongolia Is “Double Exposed” to Extreme Risks Shock Lifestock Frequency Mortality Rate Disaster Response 1 Program (DRP) 1 in 25 Years 30% Stop loss reinsurance at 2 105% of pre,iu,ms volume Base Insurance Product 1 in 5 Years 7% Self-Insurance This reinsurance agreement between the insurance pool and the government was designed to give the insurance industry time to find external capital on the reinsurance market. Indeed, after seven years, US$ 10 billion was transferred to international reinsurers as part of the Mongolian scheme. The Mongolian IBLI has gone from government reinsurance to international reinsurance funded by donor funds (with some government reinsurance for losses in excess of 2 billion Mongolian Tughriks). WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 46 Mozambique: Not Enough Capital for Stop Loss to Boost Demand In Mozambique, GIIF is supporting the development of index insurance and has conducted a comparative analysis of two options: (1) premiums subsidies, (2) stop loss. Comparing the two options with the same amount of public support over five years (amounting to 1 million USD), it was estimated that this volume of financial support would not be sufficient enough for the stop loss to cover extreme layers of risk (e.g. when claims are above 600% of premiums received). Therefore, preliminary discussions with insurers highlighted that the effect of the stop loss would be minimal on premiums rate (e.g. 10% discount on commercial premiums). It was estimated that a stop loss would only reach 60% of the insurance uptake achieved through premiums subsidy. It was therefore recommended to support agriculture insurance through premiums subsidies. Kenya: Limited Uncertainty Loads, Due to Strong Growth Potential and Investments in Data The WBG has supported the Government of Kenya in setting up a Public Private Partnership for the development of livestock and crop insurance (see Figure 4 below). In this case, the Government has opted for premiums subsidies (50% or 100% depending on product), rather than a stop loss. Figure 4: Agricultural Insurance Program in Kenya Livestock Insurance Crop Insurance Pasture Degradation Asset Protection Index Area Yield Index Insurance Insurance • Initially for maize and wheat farmers, further • Component 1 crops considered going forward • Fully subsidized insurance-linked social protection for the most vulnerable • Linkage to agricultural credit and inputs pastoralists • 50% premium subsidy • Component 2 • Government target of reaching over 170,000 • 50% premium subsidy support farmers across all 33 crops growing counties by • Government target of reaching 70,000 2019 vulnerable pastoralists across all 14 ASAL counties by 2017 As opposed to the livestock insurance product (based on satellite imagery), the crop insurance product was based on area-yield data, for which long data series were not available. It was expected that insurers would charge high uncertainty loads on the crop insurance product. However, given the strong commitment of the Government to support a large-scale program over time and invest in data collection, insurers did not charge high uncertainty loads. On average, commercial premiums for products that would cover 1-in-7 year events reached 7%, which would be brought down to 3.5% for farmers with a 50% subsidy. The Government has therefore opted for a premium subsidy. ANNEX: THE CHOICE BETWEEN SUBSIDIZING AN INSURER’S COSTS VERSES PROVIDING SUBSIDIZED REINSURANCE 47 South Africa: Premiums Subsidies Could Be More Cost-Effective Due to Good Data Availability and High Opportunity Cost of Capital The WBG has supported the Government of South Africa in comparing various options for Public Private Partnership for the development of multi-peril crop insurance. The analysis showed that good data on commercial farming already existed and data uncertainty loadings in pricing were low, therefore limiting challenges associated with premium subsidies. Given South Africa’s cost of sovereign borrowing, and the annual effective interest rate that would be obtained on undisbursed reserve funds, the opportunity cost of pre-financing a reserve fund invested in liquid assets for a stop loss would be high (Clarke et al, 2016). WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES 48 FINANCE & MARKETS GLOBAL PRACTICE | GLOBAL INDEX INSURANCE FACILITY www.indexinsuranceforum.org www.ilo.org/impactinsurance LinkedIn Group: Global Index Insurance Forum impactinsurance@ilo.org Global Index Insurance Facility MANAGED BY