Does Credit-Linked Agricultural Insurance Work?
Governments and donors have introduced many programs and policies designed to increase lending to the agricultural sector generally, and to small farmers specifically. In spite of these efforts, it is widely believed that the sector and smallholders continue to be credit constrained so they miss opportunities to adopt productivity-enhancing projects requiring greater cash outlays but offering the prospect of higher yields and farm incomes.
This problem has sparked renewed interest in using agricultural insurance to reduce the risk for farmers of adopting new technologies and production practices and, thereby, reducing default risks for financial service providers (FSPs) so they will invest in developing sustainable methods to serve agriculture. Past experiences in using publicly supplied crop insurance to underwrite farm loans issued by specialized agricultural development banks were generally unsuccessful and financially expensive, but recent developments with privately provided agricultural insurance and index based insurance products have significantly improved the performance of agricultural insurance. This has opened up new possibilities for credit-linked insurance to serve as a win-win-win solution for farmers, FSPs, and insurers. In particular, it is hoped that private insurers will develop crop insurance products that smallholders will find attractive to purchase and apply any indemnities received to their loan commitments. If so, this should encourage both FSPs and informal lenders to unlock credit, leading to a greater adoption of productivity enhancing projects. This paper reviews possibilities for, and experience with, credit-linked crop insurance, including different types of insurance and credit arrangements, ranging from insurance sold to individual farmers to meso insurance sold to FSPs to cover losses suffered by farmer borrowers. The paper describes the main methods of linkage that are being tested or proposed, identifies the critical features of each method, and discusses the advantages and limitations for the three parties – farmers, FSPs, and insurers. The key to understanding if insurance linkages really make an impact on credit involves comparing what is likely to happen in the credit market with and without insurance linkages, that is do insurance linkages make a difference.
There are situations where insurance may unlock credit, but linkage with insurance is far from being a silver bullet for the credit constraint problem. Several reasons might encourage FSPs to offer crop insurance including the possibility of reducing default risks, reducing the use of more costly and less efficient risk management techniques, reducing interest rates, raising profits, attracting more clients, reaching poorer smallholders, competing better with competitors, and generating fee income. But if the insurance is administered by the FSP as part of its loan process, these benefits have to be balanced against the cost and management challenges faced in training and monitoring loan officers and others who explain the product to smallholders, and the incentives needed for staff members who take on these additional tasks. If index insurance is used, the FSPs need to teach borrowers the complexity of basis risk, how payouts are made, handle their complaints when they experience losses but do not receive payouts, or experience insured losses and receive some payouts, but still owe balances on their loans.
Agents within value chains (e.g. agri-businesses) have some advantage over FSPs in lending to farmers and bundling insurance with credit, but they also have additional methods of contract enforcement, particularly in tight value chains, so may have less interest in insurance (e.g., since they simultaneously operate in other markets, they may be able to exert market power over smallholders dependent on them for access to scare inputs or product markets). Some value chain agents are undercapitalized themselves and prefer to invest in their own businesses rather than make loans to farmers. Another limitation of agents is that they are only interested in fulfilling the financing needs of farmers related to the production of the main crop the agent handles. Therefore, farmers with other financial needs beyond specific production loans are not fully served by value chain finance. When FSPs and other lenders have the ability to enforce formal loan contracts through the use of collateral or collateral substitutes, they will likely be less interested in insurance. But their interest will likely be greater if they face pressures to lend or to forgive or restructure defaulted loans.
Making insurance compulsory has the advantage of simplifying administrative arrangements for the FSPs and reduces their lending risks, while avoiding adverse selection problems for the insurer. The drawback is that compulsory insurance may discourage farmers from seeking loans, thereby forgoing the benefits of investing in new projects to enhance productivity and income.
Insurance is likely to play a greater role in promoting FSP lending to smallholders in credit constrained environments where farmers have weak collateral to offer, and systemic risks are the main cause of loan defaults. Insurance will be less effective if the risks it covers are not a major cause of loan defaults. This will depend in part on the type of borrower. Better and/or well diversified commercial farmers that can post good collateral or have important nonfarm sources if income may need less insurance as a condition for credit. On the other hand, smallholder farmers who depend primarily on agricultural income and have weak collateral may need more insurance. Even where insurance is potentially useful to FSPs, it may not be attractive to borrowers if the insurance premium plus the interest charge on the loan exceeds the potential returns from a borrower’s project investment.
The literature consulted on credit-linked insurance suggests there is relatively little that is really known about its effectiveness in overcoming credit constraints for smallholder farmers. A proper evaluation would need to show how insurance impacted FSP lending practices, and how this in turn impacted farmers’ access to and use of credit and their on-farm investments, productivity and income. For sustainability, it would also be important to evaluate the impact on the insurer, and whether the insurance is profitable enough for them to continue to offer it to FSPs and/or farmers. Most studies provide limited information about the benefits to farmers and FSPs, and virtually none provide evidence about the value to insurers. There is a real need for more evaluations and impact assessments of credit-linked insurance, especially when public funds are invested in providing relevant public services and subsidies. Future evaluations will require implementation of more formal Monitoring and Evaluation (M&E) systems built into the design of credit-linked insurance programs and projects.
Want to read the complete paper? You can find it here.
This article has been previously published on the Impact Insurance website. You can find it here.