Index Based Livestock Insurance FAQs
What is Index-based Insurance?
Like any insurance product, the purpose of index-based insurance (IBI) is to compensate clients in the event of a loss. IBI is used to protect against shared rather than individual risk such as the risks associated with weather fluctuations, disease out breaks or price loss. Unlike traditional insurance which assesses loses on a case by case basis and makes payouts based on individual client’s loss realizations, IBI offers policy holders a payout based on the external indicator which triggers a payment to all insured clients within a geographically defined space.
How does index-based insurance work?
For index insurance to work there must be a suitable indicator variable (the index) that is highly associated with the event being insured but is not prone to manipulation by either the insured or insurer. For example, if one is insuring against livestock mortality, then an indicator such as rainfall or forage availability may be suitable. The idea would be that rain failure during the rainy season, shortage of available forage, or a combination of the two would result in some level of livestock mortality. Having sufficiently modelled this relationship, one could then write an insurance contract based on a rainfall or forage indicator to protect against various degrees of aggregate livestock losses. Users pay a regular insurance premium and receive payouts when an index (linked to poor agricultural production outcomes e.g. rainfall failure; or one linked to livestock mortality e.g. forage availability) crosses an agreed trigger point.
What is the advantage of index-based insurance product?
IBI makes a payment when a geographic area based indicator that is highly associated with the risk outcome being insured against (e.g. livestock mortality) is triggered. This differs from traditional insurance which requires that the insurer monitor the activities of their clients and verify the truth of their claims on a case by case basis. For relatively small clients in infrastructure deficient environments the costs of such monitoring are often overly prohibitive. With index-based insurance products, all one has to do is monitor the index. Traditional insurance also suffers from a problem commonly described as “moral hazard” – this described the tendency for an insured person to be more neglectful of protecting their insurance against loss, since the insurance guarantees that he is paid in the event of loss. Traditional insurance also suffers from “adverse selection” problem where more risk-prone individuals will self-select into the contract. These two problems can make traditional insurance commercially unsustainable. On the other hand, IBI does not suffer from these two problem since the index is based on aggregated regional variables instead of individual risk-proneness and behaviors.
What are the possible limitations of indexed based insurance product?
A possible limitation of IBI is “basis risk” – this refers to the imperfect correlation between an insuree’s potential loss experience and the behaviour of the underlying index on which the insurance product payout is based. It is possible that individuals suffer losses specific to them but fail to receive a payout because the index does not trigger. On the other hand, lucky individuals may receive indemnity payments that surpass the value of their losses. While this problem cannot be completely eliminated, one can carefully design the IBI contract to minimize basis risk and therefore to maximize its value to the insured population.