Shocks, insurance and welfare : Evidence from field experiments in Ethiopia

Smallholders in Sub-Sahara African region are the most vulnerable groups in the world. Their capacity to manage risks is especially low due to multiple stressors like drought coupled with their poor asset base. Particularly in Ethiopia, rampant crop losses due to climate change induced drought as well as weather and seasonality-based variations typically characterize the economic loss of farm households. The trend of global climate change has remained devastating and future climatic scenarios are also predicted to be pessimistic as changes in climate and weather patterns are inevitable. In spite of rapid advances in using remote sensing and simulation models, there is no clear picture of how climate variables will change. Hence, in the face of changing climate, the enhanced role of agricultural risk management should be to contribute to mitigation without compromising the role of agriculture for adaptation and food security. As adaptation to climate change is a priority for smallholders and a top agenda for development, demand-driven innovations in agricultural technologies and services are deemed for interventions. Consequently, the last several years have seen the development of innovative instruments for managing weather-related agricultural risks in which global efforts to reduce the impact of climate change on the welfare of households has significantly increased. One of the recent innovations is the index-based insurance (IBI) which was piloted in different areas in developing countries for managing agricultural risks. The preference for IBI innovations were fueled due to the fact that IBI contracts avoid the twin asymmetric information problems of adverse selection (hidden information) and moral hazard (hidden behavior). Since the indices in IBI innovations were not individual specific, but rely on external parametric measures, neither the insurer nor the insured can manipulate the functioning of IBIs in order to derive unfair financial advantage. These innovations thus explicitly target and transfer covariate risks to insurers within the contract place and period. Due to these essential characteristics and their potential for adaptation, IBIs have recently attracted the attentions of various scholars and practitioners in the insurance industry. However, almost all pilot experiments undertaken in diversified agro-ecological regions in Africa, Asia and Latin America have met unexpectedly low uptake. While the inherent problem is the prevalence of basis risk in the design of IBI products, various additional caveats were observed in terms of trust in the insurer, financial literacy and farmers’ ability to understand insurance actuaries as well as the problems of liquidity among smallholders to effect upfront premium payment. Beyond examining behavioural impediments of IBI adoption like risk and ambiguity aversion which were given less emphasis in previous studies, this thesis was mainly devoted on analysis of the uptake and impact of innovative IBI products that can overcome the longstanding problems like liquidity due to time inconsistency, trust and financial literacy. In Chapter 2, we investigated the role of risk and ambiguity aversion behaviour of smallholders in Ethiopian Rift Valley zone using lab-in-the-field experiments finding that risk aversion behaviour enhances the adoption of IBIs while ambiguity aversion deters the adoption of IBIs among smallholder farmers. In Chapter 3, we designed an innovative IBI product that postpones the premium payment, and we conducted a randomized control trial in which we exogenously vary between the standard and the innovative IBI as well as between delivery through the conventional statutory cooperative channel and the Iddir-based customary channel. In essence, these innovations help to overcome liquidity constraints and trust problems among the smallholders in deciding to purchase IBI. In addition, since premium postponement potentially invites strategic default, our experiment involves some farmers to sign legal contracts. This experiment first helped us to learn that innovative insurance products that closely address the liquidity constraints of smallholders have significant incremental uptake when channeled through Iddirs which constitute customary social institutions that bear altruistic trust. Second, we learnt that market-based index insurances and predominant indigenous social insurances can function as complementary rural risk management options. IBIs can get an avenue and trustworthiness to reach the community through informal insurances. Informal insurances also benefit from IBIs that manage covariate risks that otherwise erode informal insurances. Integrating the two reinforces (crowds-in) risk-sharing among households. In Chapter 4 and 5, we systematically measured the impact of IBIs on various categories of household welfare. First, we learned that the adoption of IBIs can help to overcome credit rationing with the implication that credit and IBIs are complementary in the functioning of rural financial markets. Second, the impact evaluation study we reported in Chapter 5 reveals that the adoption of IBI have positive effect on household farm investment. Households who adopted IBI have increased investment in high-risk high-return agricultural inputs including chemical fertilizer, improved seed variety as well as pesticide and herbicide. These findings corroborate the theory that adoption of IBIs can have ex-ante (before payout) benefits. In indemnity-based insurance, ex-ante benefits can be negative as insured agents may deliberately produce sub-optimal due to moral hazard. But since IBIs are not prone to moral hazard, IBI policy holders can realize such ex-ante benefits from their prudential investment on their insured farms. The implication is that IBI-insured households optimally exert productivity enhancing efforts. Hence, categorizing ex-ante impacts into two as positive (where insured households optimally exert output enhancing efforts) and negative (where insured households may shrink efforts to lower yields and claim payouts), we understood that IBI provides higher ex-ante benefits than indemnity insurance. Thirdly, our welfare impact assessments have shown that the adoption of IBIs increases household consumption. This consumption smoothing role of IBI is the ex-post benefits that insured households enjoy to achieve improved level of welfare compared to their non-insured counter parts. In general, the results in this dissertation evidence that IBIs are market-based innovative instruments that help to mitigate the adverse effects of climate change and local weather variations on the welfare of households. Though the uptake of the product faces significant challenge due to a host of factors including basis risk, trust, liquidity and understandabaility, uptake can be improved through innovations in product design and/or through innovations in delivery channel. Overcoming the uptake challenges and offering IBIs in a larger scale helps rural households to derive a range of benefits including enhanced access to financial markets, ex-ante prudential investment in productivity enhancing high-risk high-return inputs as well as ex-post consumption smoothing and shock copying.