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Sunday, May 23, 2010

The WRMF on Index Insurance

The Weather Risk Management Facility recently produced an overview of the issue of weather index insurance. Index insurance, as defined in the report, "is a financial product linked to an index highly correlated to local yields." In contrast to traditional crop insurance, index insurance covers the risk of adverse environmental conditions (e.g., rainfall deficit) as opposed to suboptimal yields or production. As such, there's no threat of moral hazard as those who realize poor yields under favourable conditions can't benefit from an insurance payout. Furthermore, as index insurance is based upon a verifiable indicator, it is eligible for reinsurance, which further spreads the risk.

The report highlights the potential benefits of index insurance for agricultural risk management at range of scales (e.g., individual farmers to government agencies or relief organizations), but also notes some of the challenges. These include the complexity of establishing an index insurance market, which is dependent upon access to reliable environmental monitoring data and the ability to cultivate and maintain consistent market demand. Nevertheless, the report showcases a number of case studies where index insurance markets have been developed, often with success.

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