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Agriculture is an integral part of the economy of many countries. At the same time, this sector faces many challenges related to climate change, which negatively affect its productivity. Farmers have to search for different methods to prevent plant frost damage and save the crops from drought. In addition, climate change and the challenges of adapting to it threaten global food security, disrupt marketing and production chains and undermine macroeconomic stability. Climate shocks also cause corruption and fiscal volatility.
Insurance enables farmers to secure and develop their businesses, minimizing risks connected to crop damage and low yields. Moreover, it helps to repay loans, which is crucial for agri-banks, reduces the volatility of budget spending, transferring climate-related risks to the private sector. Thus, even in years of instability related to the global economy and weather events, including cases of failed preventing blossom frost damage cases, the agricultural industry continues to grow and create new jobs. Together, these factors can lead to a reduction in corruption and financial leakage. In any case, insurance makes doing business more stable and secure.
Index insurance is a relatively new practice that involves payouts based on a predetermined index. Payments are made in case investments, or working capital assets are lost due to natural disasters and extreme weather conditions, for example, if farmers fail to prevent plants from frost damage. The claims handling process in index insurance is faster and more objective, as claims adjusters are not always involved.
Another feature of index insurance is developing a statistical indicator before the beginning of the insurance period. The index reflects deviations of various parameters from the average level. It’s about temperature, livestock mortality, rainfall, and earthquake magnitude indicators.
Data on average yields and precipitation are the main indicators for index insurance payment. In developing countries, this type of insurance is a reliable risk management tool, which is also more profitable than traditional insurance. Index insurance solves several other problems in agriculture that involve moral risks and adverse selection.
Adverse selection would be a case when only farmers who face a high probability of incurring losses, buy insurance. As for moral hazard, when purchasing insurance, some growers may reduce their efforts to increase crop yields or to improve frost damage prevention of crops. Index insurance, on the other hand, is based on factors that farmers and no one else can influence, so these risks are no longer dangerous.
Each index, including the NDVI, gives a statistical projection of cattle and plants losses for each farm and various inputs. In addition, technology makes it possible to measure most of these indices remotely and improve the accuracy of forecasts at no additional cost.
Index insurance is a relatively new risk management tool. The main difference between traditional and index insurance is that payments are made based on forecasts of rainfall and other indicators that will affect crops and not on the effects of weather events and damage. This type of insurance can solve several fundamental problems of farming insurance, including the absence of the need for representatives of the insurance company to visit the fields and assess the damage.
All calculations and measurements are made remotely. In addition, if the rainfall is less than expected, the insurance will still be paid. Thus, farmers do not lose the incentive to develop farmland, increase productivity, protect crops and improve methods growers use to prevent frost damage. All of the above helps reduce transaction costs and increase the availability of insurance for small farmers.
Uninsured risks for growers harms the economic development of countries dependent on agriculture. In turn, index insurance, as an effective risk management tool, contributes to the stabilization of the financial situation of small farmers and economic growth. Satellite imagery and remote sensing enable index-based insurance to evolve and become more efficient and affordable.
The more accurate the indices become, the faster various farming market risks can be reduced. Furthermore, due to the lower cost of index insurance compared to traditional insurance, the purchase of insurance becomes more affordable for more farmers. This insurance method is also the most sustainable and contributes to better social protection, which helps fight poverty.