The El Niño Southern Oscillation (ENSO) is a climate event associated with warming sea surface temperatures in the Pacific Ocean. In years of extreme El Niño events, areas in northern Peru experience catastrophic flooding. As of 2010, it is possible for stakeholders in northern Peru to purchase a new form of insurance that pays out just as flooding begins and stakeholders begin incurring extra costs and consequential losses. Given the high basis risk associated with selling index insurance to households, this insurance is designed for firms and institutions that serve households that are highly exposed to El Niño. ENSO insurance is sold by a Peruvian insurance company, and a major global reinsurer carries most of the risk. This new insurance product is the first insurance to use sea surface temperature as the proxy for catastrophic losses and also the first regulated “forecast index insurance” product in the world. This innovation could enhance progress in developing index-based insurance products for extreme weather events.
Recent years have seen a growing number of pilot tests of index insurance for weather risk, motivated by an increased understanding of how natural disasters affect developing countries. Beyond immediate suffering (including deaths, destroyed assets, and lost income), disasters have troublesome indirect effects: economic growth can be disrupted, the poor are thrust into permanent poverty traps, and the mere presence of these risks constrains access to financial services and causes many decisionmakers to pursue low-return, low-risk strategies that impede economic progress.
Much of the development of index insurance focuses on agriculture, because activities associated with agriculture remain the primary livelihood strategies for the rural poor in developing countries. Thus far, most index insurance pilots have involved products targeted at households—that is, micro-level products. Index insurance uses an objective measure (an index) of a natural event known to cause losses (such as excess rain, high river levels, or extreme sea surface temperatures). Using an index as the proxy for loss dispenses with expensive loss assessments. Furthermore, use of an index diminishes moral hazard and adverse selection, problems that plague traditional forms of insurance. Given these advantages, index insurance may be well suited to developing countries where data are sparse and delivery of financial services to smallholder households increases the per-unit cost of traditional insurance.
Despite the promise of index insurance, uptake by smallholder households is slow. Presently, index insurance may be better suited for risk aggregators—that is, groups or institutions that aggregate the risk of households either through the services they provide or through informal risk-sharing arrangements (for example, agricultural lenders, firms in the value chain, and farmer associations). Focusing first on risk aggregators should also help build linkages and sustainable products that will directly serve smallholder households.
This brief is one of series on innovations in rural and agriculture finance.