Index-based agricultural insurance to address smallholder vulnerabilities to climate change: A look at ‘sustainability through design’

Index-based agricultural insurance (IBAI) is one of many financial derivatives that are being promoted with the intention of mitigating smallholder vulnerability in the context of climate change, market uncertainty and the rollback of state support to agricultural producers.

Unlike traditional indemnity insurance for agriculture, which provides insurance payments based on the direct measurements of livestock and crop loss or damage, IBAI makes use of a predetermined index that correlates with crop or livestock loss, eg rainfall, evapotranspiration, average temperatures or rangeland condition.

IBAI is part of a global trend towards the financialization of the agri-food sector. IBAI has been assigned a central role in various initiatives to ‘climate proof’ agricultural production. IBAI can be traced back to the development of the weather derivatives markets in the mid-1990s.

The Kyoto Protocol of 1997 gave impetus to the support of climate insurance and in 2009 the Global Index Insurance Facility (GIIF) was established to facilitate the expansion of IBAI. Although there is no comprehensive survey of all existing IBAI projects in the Global South, ‘the number is likely to be in the hundreds, spanning dozens of countries’ and covering ‘in the tens of millions’ of smallholders.

The model has received significant policy support from a range of influential actors in the rural development and agrarian reform sector, notably the World Bank’s International Financial Corporation (IFC), United Nations, the G20, CGIAR, OXFAM and the Grameen Foundation.

However, in spite of the excitement around the potential for IBAI to help smallholders navigate the uncertainties of agricultural production and provide a cost-effective way to insure smallholders against risks by mitigating the transaction costs that often prohibit their access to traditional indemnity insurance, many caveats remain.

But is IBAI able to address social equity and to encourage sensible and fair decision-making in the agricultural sector? There is an ethical imperative to ensure that IBAI addresses smallholder vulnerabilities to the shocks and stresses they encounter and at the very least does not contribute to further impoverishment and food insecurity.

Advocates of IBAI

Proponents of IBAI claim that it is ‘pro-poor’ and a progressive form of ‘poverty capital’ because it provides financial services to poorer smallholders who are traditionally excluded, since they are categorised as too risky to be covered by conventional financial services. Smallholders are able to access IBAI products without having to provide evidence of their assets or private property (useful in contexts dominated by customary land rights).

They claim IBAI can overcome poverty traps by encouraging them to move away from low-risk but low-return livelihood strategies and protect farmers from unexpected shocks and asset losses that could trap them in poverty.

Proponents of IBAI conceptualise the vulnerabilities that smallholders face as “insurance and credit market failures”, which are seen as contributing to chronic poverty among smallholders in low-income countries.

IBAI is believed to assist market-oriented smallholders to further ‘commercialise’ their enterprises and to crowd-in credit by improving the outlook of households from the perspective of creditors. A case study from Uganda found that IBAI helps combat the negative effects of risk aversion. Index insurance that has been bundled with access to credit and inputs, could encourage investment, particularly where it is provided to risk-sharing groups rather than individuals.

Critics of IBAI

Critics of IBAI contend that these forms of ‘poverty finance’ fail to address the systemic causes of economic marginalisation. They warn of potential increases in household-level debt and argue that it is finance capital who are benefiting the most from these schemes. IBAI could increase rather than mitigate smallholder vulnerability through adversely incorporating smallholders into agricultural value chains.

The agrobiodiversity of farming systems may be undermined by coupling insurance with various environmentally harmful and unsustainable inputs (seeds, fertilisers and pesticides) and livelihoods may be at risk by encouraging the adoption of riskier but more lucrative cash crops.

Moreover, for IBAI to be effective it is important that the index that is chosen correlates closely with possible losses farmers may incur. If it doesn’t, smallholders could be subject to ‘basis risk’ and may not be compensated even when suffering substantial losses.

Research has also indicated that there is ‘only limited demand’ for IBAI among smallholders who prefer to manage their risks through other strategies.

Critics of IBAI commonly emphasise that the model fails to take adequate consideration of social equity concerns. The poorest smallholders are often excluded in IBAI schemes, which could worsen inequality in rural areas.

In cases where smallholders pay for IBAI products, ethical concerns emerge. Should they have to pay for this service given that the poorest rural producers often carry the heaviest burden of climate risk, while contributing least to its drivers?

Therefore, IBAI could perpetuate existing inequalities or even make them worse by transferring the burden and costs of managing climate change on to the poorest rural producers in the Global South.

Sustainability through Design: Can IBAI address smallholder vulnerabilities?

The review of existing evidence on IBAI indicates that under certain conditions, IBAI may assist smallholder farmers in navigating the negative impacts of climate change and provide the financial means to manage some of the risks associated with agricultural commercialisation and modernisation.

However, there is also a distinct risk that the model may exacerbate existing inequalities and vulnerabilities, particularly for poorer farmers in the Global South. This is because it exposes farmers to new types of economic and social risks. Overall, there is a call for prudence in the design and targeting of index insurance schemes and a more critical evaluation of existing pilot projects.

The building enthusiasm around index insurance risks promoting it as a panacea to address rural poverty. Instead, what is required is a broader programme focused on social protection mechanisms, comprehensive state support for producers, creating jobs and diverse livelihood strategies, and upscaling agro-ecological practices.

IBAI might comprise a small component of this broader strategy under the right conditions. We must also avoid implementing IBAI without an explicit concern for social equity, which risks excluding the poorest smallholders and worsening existing inequities in rural communities.

There is clearly a need for more considered research to understand how IBAI can fit within more comprehensive rural development strategies, under what conditions it is most effectively deployed and how IBAI can respond inclusively to the needs of a diversity of smallholders.