Drought and informal insurance groups: A randomised intervention of index-based rainfall insurance in rural Ethiopia

The Ethiopian economy is still predominantly dependent on rain-fed agriculture. Drought is a common occurrence, and financial markets, especially those offering insurance, are underdeveloped. The costs of such uninsured risk are high, from immediate welfare losses for farmers to the discouragement of innovation and investment in modern technologies. Crop insurance is one interventional tool, but standard schemes tend to be costly and inefficient and prone to problems of moral hazard and adverse selection. In recent years, alternatives have been developed in the form of innovative index-based weather insurance products. Rather than requiring any loss assessment, these schemes offer farmers a product that, against the payment of a premium, offers a payout if rain at a local rainfall station falls below a particular level, and no payment otherwise. By solving issues of moral hazard and adverse selection but remaining relatively inexpensive, such methods offer rural households an affordable formal insurance against uninsured covariate shocks, in turn boosting agricultural productivity and rural growth. Yet early field experiments have found that demand for such formal micro-insurance contracts in rural settings is very low. Studies from India and Malawi suggest credit constraints, low levels of trust and existing informal insurance as potential explanations. At the same time, there is lingering doubt that basis risk - the difference between risk insured and the actual risk experienced - is high, as farm-level rainfall experience and its consequences for crops may be rather different from the rainfall as measured at the station. Furthermore, the net impact of insurance may be low if informal insurance mechanisms are crowded out by the new product.

This study aims to introduce an index-based drought insurance product in 15 areas in rural Ethiopia, a country whose economy is heavily dependent on rain-fed agriculture. We are looking for ways to improve project uptake, and at the same time ensure basis risk is reduced and informal insurance mechanisms are not undermined but used to increase coverage. We will be offering products to farmers via their informal insurance groups, the local funeral societies. In Ethiopia, these groups are widespread, highly inclusive and well structured. They charge premiums against risks and increasingly offer other products beyond funeral insurance. We will offer a weather index product, calibrated for local circumstances and sold via a private insurance company, Nyala Insurance. We are conducting our study using a randomized controlled trial, in which some groups will be offered a group policy, others asked to provide individual farmers with a policy and finally a control group of funeral groups not offered any products. We will study the uptake among groups and farmers, and the way it affects their functioning and the behavioural impact on agricultural technology choices and productivity. We will also study how the introduction of these products will affect existing informal insurance arrangements.