Life at the bottom of the world’s income distribution is massively risky. Poor households lack basic buffers—savings accounts, health insurance, water tanks, diversified income sources, and so on—against drought, pests, disease and other hazards. Even modest shocks, such as a temporary dry spell or a routine infection, can be devastating.
These risks have knock-on effects. To take one prime example, the expected economic return on the use of fertilizer is very high in Africa, yet impoverished farmers cannot obtain it on credit because of the potential for a catastrophic loss in the event of a crop failure. Their households cannot bear the risk of a loan, and so they remain destitute. Managing risk is therefore important not only for smoothing out the well-being of these farmers over the years but also for enabling their escape from extreme poverty.
Traditional crop insurance is almost nonexistent in Africa.
For these reasons and others, financial risk management is likely to come to the forefront of strategies for poverty reduction. Microfinance has already introduced markets for the poor. Microinsurance and other kinds of risk management will likewise yield important tools.
Traditional crop insurance is almost nonexistent in Africa for several reasons. Suppose a company tried to sell a crop insurance policy to a peasant farmer with a one-acre farm. A standard policy would specify payments in the event of measured crop losses from specified hazards (such as drought, pests and temperature extremes), and would require an actuarial model of applicable risks and the completion of a contract. Payments would occur only after the verification of losses and (usually) of the underlying adverse events.
Multiple problems would be fatal to such a policy: the absence of an actuarial risk model; adverse selection (farmers with especially risky conditions would seek the contracts); moral hazard (farmers covered by insurance might fail to take other protective measures); and the enormously high relative costs of marketing, signing and assessing losses.
Two huge innovations are correcting these weaknesses. First, instead of insuring a farmer’s actual crop losses, a policy can diversify much of a farmer’s risk by creating a financial derivative, such as a weather-linked bond that pays in the event of a seasonal drought, dry spell or other adverse shock. A weather station or satellite can observe a drought objectively, eliminating the need to examine outcomes on individual farms. Moral hazard and adverse selection are irrelevant, because the price of the “drought bond” depends on the objective probabilities of measurable weather shocks, not on the behaviors of an individual farmer.
The second key strategy is to combine the weather-linked bonds with other financial services to the farmer. For example, a bank could make a seasonal loan to a cooperative of hundreds or thousands of farmers for the mass purchase of fertilizers and high-yield seeds, with the loan repayment due to be reduced or waived in the event of a drought and the repayment schedule calibrated to the drought’s extent. The bank, in turn, would buy a weather-linked bond to insure itself against such a dry spell.
Earlier this year the Earth Institute at Columbia University and the reinsurer Swiss Re designed and implemented a rainfall-index contract for the Sauri Millennium Village in western Kenya. The experience was heartening. Climatologists demonstrated, for example, that satellite data could be used to design a relevant financial instrument to defray the high climate risks facing the village. Other institutions, such as the World Bank, the World Food Program, the government of Ethiopia and various insurance companies, are striving to mitigate climate risks in other impoverished regions.