FINANCE & MARKETS GLOBAL PRACTICE | GLOBAL INDEX INSURANCE FACILITY Unlocking Smallholder Credit: Does Credit-Linked Agricultural Insurance Work? Global Index Insurance Facility MANAGED BY Rights and Permissions This work is available under the Creative Commons CC BY-NC-ND 3.0 IGO license. Copyright 2017 International Labour Organization (“ILO”) and International Finance Corporation (“IFC”). All rights reserved. This is a joint publication of ILO and IFC. The material in this work is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. IFC does not guarantee the accuracy, reliability or completeness of the content included in this work, or for the conclusions or judgments described herein, and accepts no responsibility or liability for any omissions or errors (including, without limitation, typographical errors and technical errors) in the content whatsoever or for reliance thereon. 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All names, logos and trademarks in this publication are the property of either the IFC or the World Bank Group, or property of the International Labor Organization. Unless expressly stated otherwise, and you may not use any of such materials for any purpose without express written consent from the trademark owner. Additionally, “International Finance Corporation” and “IFC” are registered trademarks of IFC and are protected under international law. Publications of the International Labour Office enjoy copyright under Protocol 2 of the Universal Copyright Convention. Nevertheless, short excerpts from them may be reproduced without authorization, on condition that the source is indicated. Photo Credits: World Bank Photo Library and Shutterstock WHEN AND HOW SHOULD AGRICULTURAL INSURANCE BE SUBSIDIZED? ISSUES AND GOOD PRACTICES Richard Meyer and Peter Hazell | independent consultants Panos Varangis | Finance & Markets Global Practice | World Bank Group. C UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? Table of Contents Acknowledgements..................................................................................................III Executive Summary................................................................................................. V 1. Introduction and Objectives................................................................................. 1 2. Challenges Created by Farm Level Risks...........................................................5 3. How Might Credit-linked Insurance Resolve Some of the Problems that Farmers, FSPs, and Insurers Now Face?.................................................. 9 4. Alternative Institutional Mechanisms for Providing Credit-linked Insurance.....................................................................................13 5. What Situations May not be Well Suited for Credit-linked Insurance?................................................................................... 23 6. Impacts of Credit-linked Insurance on Credit Markets ................................27 7. Constraints on the Development of Credit-linked Insurance.......................31 8. The Role of Supportive Agents and Government Policies ........................... 33 9. Key Lessons ........................................................................................................ 39 Reference................................................................................................................. 43 TABLE OF CONTENTS I UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? II Acknowledgements The authors acknowledge and appreciate the many useful comments received from Pranav Prashad, Mario Miranda, Carlos Cuevas, Michael Carter, and Xavier Giné. They are relieved from responsibility for the final product. Appreciation is also extended to Pavis Devahasadin and Joost Tijdink for coordinating the production process; and Aichin Lim Jones and Li Wen Quach for design and layout support. Global Index Insurance Facility The Global Index Insurance Facility (GIIF) is a multidonor program that supports the development and growth of local markets for indexed/catastrophic insurance in developing countries, primarily in Sub-Saharan Africa, Latin America and the Caribbean, and Asia Pacific. Funded by the European Union, Japan, Germany, and the Netherlands, the Global Index Insurance Facility is managed by the World Bank Group, as part of the Finance & Markets Global Practice. Impact Insurance Facility Housed at the International Labour Organization, the Impact Insurance Facility enables the insurance industry, governments, and their partners to realize the potential of insurance for social and economic development. The Facility was launched in 2008 with generous support from the Bill & Melinda Gates Foundation, and has received subsequent funding from several donors. ACKNOWLEDGEMENTS III UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? IV Executive Summary 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. EXECUTIVE SUMMARY VV Key lessons Agents within value chains (e.g. agri-businesses) have some advantage over FSPs in lending to There are situations where insurance may unlock farmers and bundling insurance with credit, but credit, but linkage with insurance is far from being they also have additional methods of contract a silver bullet for the credit constraint problem. enforcement, particularly in tight value chains, so Several reasons might encourage FSPs to offer may have less interest in insurance (e.g., since they crop insurance including the possibility of reducing simultaneously operate in other markets, they may default risks, reducing the use of more costly and be able to exert market power over smallholders less efficient risk management techniques, reducing dependent on them for access to scare inputs or interest rates, raising profits, attracting more clients, product markets). Some value chain agents are reaching poorer smallholders, competing better undercapitalized themselves and prefer to invest with competitors, and generating fee income. But if in their own businesses rather than make loans to the insurance is administered by the FSP as part of farmers. Another limitation of agents is that they its loan process, these benefits have to be balanced are only interested in fulfilling the financing needs against the cost and management challenges faced of farmers related to the production of the main in training and monitoring loan officers and others crop the agent handles. Therefore, farmers with who explain the product to smallholders, and the other financial needs beyond specific production incentives needed for staff members who take on loans are not fully served by value chain finance. these additional tasks. If index insurance is used, the FSPs need to teach borrowers the complexity When FSPs and other lenders have the ability to of basis risk, how payouts are made, handle their enforce formal loan contracts through the use of complaints when they experience losses but do not collateral or collateral substitutes, they will likely receive payouts, or experience insured losses and be less interested in insurance. But their interest receive some payouts, but still owe balances on will likely be greater if they face pressures to their loans. lend or to forgive or restructure defaulted loans. UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? VI Making insurance compulsory has the advantage on the loan exceeds the potential returns from a of simplifying administrative arrangements for borrower’s project investment. the FSPs and reduces their lending risks, while The literature consulted on credit-linked insurance avoiding adverse selection problems for the insurer. suggests there is relatively little that is really The drawback is that compulsory insurance may known about its effectiveness in overcoming credit discourage farmers from seeking loans, thereby constraints for smallholder farmers. A proper forgoing the benefits of investing in new projects to evaluation would need to show how insurance enhance productivity and income. impacted FSP lending practices, and how this Insurance is likely to play a greater role in promoting in turn impacted farmers’ access to and use of FSP lending to smallholders in credit constrained credit and their on-farm investments, productivity environments where farmers have weak collateral to and income. For sustainability, it would also be offer, and systemic risks are the main cause of loan important to evaluate the impact on the insurer, defaults. Insurance will be less effective if the risks and whether the insurance is profitable enough for it covers are not a major cause of loan defaults. This them to continue to offer it to FSPs and/or farmers. will depend in part on the type of borrower. Better Most studies provide limited information about the and/or well diversified commercial farmers that benefits to farmers and FSPs, and virtually none can post good collateral or have important nonfarm provide evidence about the value to insurers. There sources if income may need less insurance as a is a real need for more evaluations and impact condition for credit. On the other hand, smallholder assessments of credit-linked insurance, especially farmers who depend primarily on agricultural when public funds are invested in providing income and have weak collateral may need more relevant public services and subsidies. Future insurance. Even where insurance is potentially evaluations will require implementation of more useful to FSPs, it may not be attractive to borrowers formal Monitoring and Evaluation (M&E) systems if the insurance premium plus the interest charge built into the design of credit-linked insurance programs and projects. EXECUTIVE SUMMARY VII UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? VIII 1. Introduction and Objectives The lack of access to credit has long been identified as an important, if not the main, constraint for farmers in developing countries, especially smallholders. As a result, governments and donors have, over several decades, tried a variety of 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 often continue to be credit constrained. Financing from formal financial service providers (FSPs)1 can be important for several reasons. Households may find formal finance provides important additional tools to aid in smoothing consumption over time. Surveys of recipients of microcredit often conclude that this is a major reason for borrowing small loans. More frequently, however, is the concern for additional financing for productive and investment purposes. For farmers, this may be important for the relatively simple process of adopting improved seed varieties more responsive to chemical fertilizers. Financing may also be needed for more complex changes such as becoming a contract farmer for new high quality commodities supplied to upscale international markets. There may also be a need for financing investments to make farming more resilient and adaptive to climate change. For simplicity, these productive purposes will be referred to as farm “projects” that have the common characteristic of requiring greater cash outlays than required for traditional smallholder livelihood strategies. Greater cash outlays may mean that smallholders cannot adopt them by using their own savings or traditional sources of informal finance. Therefore, they will forego opportunities to adopt productivity enhancing projects that require greater cash outlays but offer the promise of higher yields and farm incomes.2 1 FSPs are defined here to include any kind of formal financial service provider that makes loans and may take savings and deposits. In rural areas, they include banks, microfinance institutions, financial NGOs, and various kinds of credit and savings groups including savings and credit cooperatives (SACCOs) that are weakly regulated. They do not include informal sources of loans and savings services such as small savings groups, traders, aggregators and other mechanisms that operate in value chains and provide finance linked to specific commodities. These informal sources can be important sources of finance and are discussed below. 2 See Asfaw (2012) for one of many publications that report on the potential impact of improved technologies on rural household welfare and higher consumption expenditures that translate into lower poverty, higher food security and greater ability to withstand risk in Africa 1. INTRODUCTION AND OBJECTIVES 1 Several reasons have been identified to explain Recent years have seen a renewed interest in the reluctance of FSPs to better serve agriculture. using agricultural insurance to reduce the risk Clarke and Dercon (2009) efficiently clustered for farmers of adopting new technologies and them into the four categories of: (i) information production practices and, thereby, reduce default asymmetries (access to different information); (ii) risks for FSPs so they become more willing transaction costs; (iii) enforcement constraints; and to invest in learning how to sustainably serve (iv) ambiguity aversion. Information asymmetries agriculture. Past experiences in using publicly lead to moral hazard and adverse selection. provided crop insurance to underwrite farm loans Transaction costs are high as lenders must reach out issued by specialized agricultural development to a large number of smallholders, each of whom banks were generally unsuccessful and financially borrows relatively small amounts, and because expensive3 (Hazell, Pomareda and Valdes, 1986; they must evaluate each borrower’s reliability, Seibel, 2000), but more recent developments with capacity to repay and intentions to use borrowed privately provided agricultural insurance and index funds wisely. Enforcement problems are created if based insurance products have led to significant borrowers attempt to engage in strategic default, improvements in the performance of agricultural and it is difficult and costly for lenders to distinguish insurance (Hess, Hazell and Kuhn 2016). As such, between lack of willingness and lack of capacity to it is hoped that these improvements can also lead repay. The use of collateral to induce repayment is to new forms of credit-linked insurance that will frequently restricted because poor borrowers have be win-win-win for farmers, FSPs, and insurers. little collateral to offer, and the process of seizing In particular, it is hoped that private insurers will and disposing of seized assets is often costly develop crop insurance products that smallholders and inefficient. Ambiguity aversion refers to the will find attractive to purchase and apply any preference of FSPs for serving familiar clients with indemnities received from insured losses to their loan known risks rather than learning the complexities commitments. It is hoped that this will encourage and risks of serving agriculture due to its special both FSPs and informal lenders to unlock credit spatial and risk characteristics (Binswanger and for insured producers, leading to more widespread Rosenzweig, 1986). An additional reason for adoption of productivity enhancing projects. reluctance to lend is the existence of significant The general terminology “credit-linked insurance” systemic risks, such as price and production risks, is used in this paper to include several different that can affect large numbers of farmer borrowers insurance and credit arrangements.4 It includes a at the same time, and require the restructuring of variety of arrangements in which insurance is sold many loans to avoid default. In the absence of ways directly to farmers, which they may voluntarily buy to ameliorate such risks, FSPs will likely ration or be compelled to purchase to obtain a loan, as well agricultural lending to limit their risk exposure. as more formal linkage arrangements where the 3 A particularly ruinous example was the use of the public agricultural insurer (ANAGSA) to insure the loans of the agricultural development bank (BANRURAL) in Mexico in the 1970s. Both institutions were heavily subsidized, but in ways that enabled BANRURAL to collect repayment of a large share of its loans each year from ANAGSA, even in the absence of any widespread losses from insured events (Hazell, 1992). 4 See Prashad (2016) and Mukherjee et.al. (2017) for a discussion of the concept of bundling credit with other services, and a description of several examples of bundling insurance with credit. UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 2 insurance is bundled with credit and sold through is often now offered in the form of yield or weather an FSP. It also includes meso insurance products indices that are assessed at community or regional sold to an FSP to cover losses suffered by farmer levels5. By crop insurance, we include indemnity borrowers. While financial institutions are the most based insurance, such as named peril or MPCI common target for credit-linked insurance, other insurance, as well as area yield and weather index firms along value chains (e.g. input suppliers) may insurance in this paper. also find it useful as a way to reduce their risk The paper is organized as follows. The next section exposure when lending to smallholder farmers. reviews the problems that agricultural risks create The purpose of this paper is to describe various for farmers, FSPs and insurers, and which impact methods of linking insurance with credit that are the provision of financial services for smallholder being tested or proposed, identify the critical farmers. Section 3 then reviews the potential of features of each method, and show the advantages credit-linked insurance to overcome some of these and limitations for the three parties in these risk problems in order to unlock more credit for arrangements – farmers, FSPs, and insurers. smallholder farmers in ways that are mutually Studies and cases are reviewed to identify how beneficial to farmers, FSPs and insurers. Section 4 the fundamental problem is resolved of finding the considers the alternative institutional mechanisms intersection of interests between lenders, insurers, available for providing credit-linked insurance, and smallholders who must choose and pay for while section 5 focuses on situations where credit- the credit and insurance. The key to understanding linked insurance would not be suitable. Section if insurance linkages have an impact on credit 6 reviews the potential impacts of credit-linked conceptually involves determining what happens insurance on the provision of credit to smallholder in the credit market with and without insurance farmers, and reviews available empirical studies. linkages, that is do insurance linkages make a Section 7 identifies constraints that prevent difference and, if so, how? As will be discussed, the spontaneous development of credit-linked the issue can be more complex than just evaluating insurance in market economies, leading in Section the amounts of credit lent and at what interest 8 to a discussion of the roles of supportive agents rates. To simplify, the analysis in this paper will and public policies and investments, including the be limited to crop insurance. Crop insurance was potential role of subsidies, in helping to kick-start traditionally provided in the form of multi-peril credit-linked insurance. Finally, section 9 contains crop insurance (MPCI), but due to its high costs and our key lessons. poor performance, crop insurance for small farms 5 Index insurance contracts are written against events defined and recorded at regional levels rather than at individual farm levels (e.g., a drought recorded at a local weather station, or a low official crop yield estimate for a district or county). To serve as agricultural insurance, the index should be defined against events that are highly correlated on the downside with regional agricultural production or income. All buyers in the same region are offered the same contract terms per unit of insurance coverage. That is, they pay the same premium rate and, once an event has triggered a payment, receive the same rate of payment, and their total payments and indemnities would be that rate multiplied by the value of the insurance coverage purchased. 1. INTRODUCTION AND OBJECTIVES 3 UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 4 2. Challenges Created by Farm Level Risks For Farmers Farmers in developing economies face many production, price and marketing risks that result in wide swings in farm household income and consumption. Given that smallholder farmers are typically risk averse in their behavior, in the absence of ready access to savings, insurance and credit markets, they rely on traditional methods of risk management. These include choosing diversified crop and livestock enterprises, avoiding high risk-high return agricultural activities, reducing investments in projects such as using improved seeds and fertilizers, and holding precautionary savings or physical assets that can be liquidated in emergencies. They may also participate in local informal saving groups and other informal financial methods that provide opportunities to save and borrow small amounts for investments or emergencies, and invest in informal village insurance arrangements. However, these informal methods of risk management have been shown to be incomplete and cannot effectively reduce the negative impact of large systemic shocks. Moreover, smallholders may practice internal credit rationing, and not demand formal credit from FSPs that require collateral and/or that engage in strong contract enforcement measures, including obligating borrowers to liquidate assets to repay loans in the event of systemic or idiosyncratic shocks.6 Likewise, there is often little demand for formal credit by the poorest, while the richest may rely on savings or borrow from cheaper sources rather than from local FSPs that specialize in micro or small loans made at interest rates high enough to sustain their operations. This situation, therefore, locks smallholders into traditional low return-low risk farming technologies and diversified farm enterprises that have proven over time to sustain them except in major catastrophes, while richer farmers choose more specialized enterprises and more advanced technologies. 6 Boucher et al. (2008) show how risk rationing can occur “when insurance markets are absent, and lenders, constrained by asymmetric information, shift so much contractual risk to the borrower that the borrower voluntarily withdraws from the credit market even when she has the collateral wealth needed to qualify for a loan contract ” (p. 409). 2. CHALLENGES CREATED BY FARM LEVEL RISKS 5 For FSPs or lenders, who provide them recourse to emergency funds so they can more easily roll over overdue Even in the absence of farm level risks, FSPs have loans, stretch out repayment schedules, and make many reasons to be reluctant to lend to small farms. additional loans to delinquent borrowers so they can These include government actions that discourage plant next season’s crops. They may also need funds rather than encourage FSPs to engage in market to cover provisions that regulators often require for oriented finance in rural areas, such as caps on problem loans. Larger commercial or development interest rate or margins, or government pressure to banks tend to have dispersed branches and a greater forgive loans or postpone repayment in the event capacity to withstand localized systemic shocks, of adverse weather events or collapses in markets but their high operating costs make it difficult and prices. FSPs also may face limited demand for for them to profitably make small loans. They formal credit from smallholders, and those who can reduce costs by utilizing agent networks but do borrow are expensive to serve because they managing such networks is difficult. They may be typically prefer to borrow only small amounts. able to reduce costs through mobile banking but Most have few if any assets to offer as collateral, their customers may lack access or know how to and their assets may be difficult and expensive to use this technology. liquidate. To limit the perceived riskiness in agricultural Farm level risks add to these problems because lending, FSPs engage in many practices to limit FSPs have to devote more resources to assessing default risks. For example, they may impose high and managing the risk of default amongst collateral requirements (high collateral/loan ratios). individual borrowers. Also, FSPs face the systemic They may require collateral substitutes such as or covariate nature of many farm level risks, which co-signors, joint liability group lending, or large can lead to many borrowers defaulting at the savings in blocked savings accounts. In strong same time. In principle, an FSP can diversify its village societies they may require the signature lending portfolio across geographies to reduce its of village chiefs. They may only lend to highly exposure to systemic risk, but this is difficult for diversified smallholders with large amounts of non- many small FSPs, such as microfinance institutions farm income, or participate in government or donor- (MFIs), credit unions, and unit rural banks, that sponsored partial loan guarantee programs (but see have few, if any, branches so their loan portfolios section 8). They may ration credit by limiting the are geographically specialized. If FSPs mobilize size of their total agricultural loan portfolio, or savings as part of their financial services, they may limit total lending per crop and geographic region. also suffer liquidly management problems when A survey of practices of several types of successful many savers desire to withdraw savings at the same FSPs in Latin America that lend to agriculture time that borrowers do not repay, as may happen, included using: i) expert-based, information- for example, in the event of a systemic shock like a intensive credit technologies; ii) diversification regional drought. Systemic risks may force FSPs to strategies (geographic, sectoral, commodity); iii) ration credit and limit their exposure so defaults are limiting agricultural credit portfolio exposure to not a large part of their loan portfolios. Exceptions reduce risk; and iv) excessive loan provisioning to may arise if they are funded by benevolent donors absorb and internalize risks (Wenner, et.al. 2007)7. 7 A more recent publication specifically focuses on MFIs providing financial services in rural areas (IFC, 2014). It highlighted several of the same practices plus some additional ones. UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 6 These were mostly internal methods of managing because they have alternative and less costly ways credit risk, and few FSPs at that time used of managing risk (Binswanger-Mkhize, 2012). external methods such as insurance or guarantees. Private insurers generally prefer to work with Moreover, insurance tends to be expensive relative larger scale commercial farms and to insure to the returns farmers earn from their crops so FSPs higher value crops against named (rather than may conclude that it is cheaper to limit their risk multiple) perils for which good data are available exposure through diversification than by offering so risks and damage can be easily assessed. If insurance. they reach out to smallholders, it is often through contract farming arrangements where a processor For Insurers or other aggregator includes the insurance within Agricultural insurers face many of the same a package of inputs and access to an assured problems as FSPs when they attempt to insure market outlet. Insurers also use aggregators to smallholders against crop production risks: administer subsidized insurance when reaching small amounts of coverage sold per farmer, high out to broader populations of smallholders, as this transactions costs, asymmetric information about can help reduce costs, improve access, and lead to the likely ‘moral hazard’ behavior of smallholders sufficient scale to make the insurance worthwhile. once insured, poor data leading to uncertainties A bank might serve as an aggregator by selling about the risks to be insured, and a limited rural insurance with its loans. Other types of aggregators network of branches through which they can offer include borrowing groups, farmer associations/ insurance services. Like FSPs, they also face a cooperatives, input suppliers, and agro-processors. systemic risk problem if their insurance portfolio is To serve large numbers of smallholders, insurers not sufficiently diversified across regions. Insurers also prefer index-based products that do not require also face limited demand for agricultural insurance monitoring or assessing damage at individual farm products; the poorest smallholders who most levels. To handle the systemic risk associated need it often cannot afford to buy it, face liquidity with a smallholder portfolio, most insurers need constraints, or have limited understanding of the reinsurance arrangements for at least part of their value of insurance, whereas larger smallholders total risk exposure, or access to financial reserves who can afford to buy insurance often do not need it through a donor or government agency. 2. CHALLENGES CREATED BY FARM LEVEL RISKS 7 UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 8 3. How Might Credit-linked Insurance Resolve Some Problems that Farmers, FSPs, and Insurers Now Face? For Farmers Farmers will be encouraged to buy insurance and borrow to finance new projects if they believe their on-farm investment projects will meet their income and risk requirements, and if the terms and conditions for the credit and insurance seem fair and affordable. If the project produces the expected positive outcome, farmer borrowers will earn additional farm income to pay for insurance and repay the loan. On the other hand, if the project fails because of an insured loss, the farmer can choose to either pay the loan out of the indemnity funds received, or default and use the funds for consumption or other purposes. If the loan principle and interest are not fully paid, the farmer will normally be denied a new loan, and the FSP may engage in enforcement procedures and threaten to seize collateral in order to increase the borrower’s willingness to pay. If the FSP is named as first claimant on the insurance indemnities, it will receive payment directly and any residual will be paid to the borrower. One attractive feature for the farmer of insurance embedded with credit is that the FSP may include the premium in the total loan, thereby avoiding the farmer’s cash flow problem identified in some studies as an impediment to farmer demand for insurance (Hess, Hazell and Kuhn, 2016). A potential downside with credit insurance is that it may not pay off a farmer’s loan if a loss occurs which is not covered by the insurance, or because of basis risk8. In this event the farmer may be worse off than if the loan were not insured because she will have to pay the insurance premium as well as repay the loan (Clark, 2011) 8 Basis risk is the problem that arises with index insurance when an individual farmer suffers a loss but is not paid because the major event triggering a payment for the region has not occurred. For example, an individual farmer with rainfall insurance could lose her crop to drought, but not receive an indemnity if the drought is not widespread and recorded at the local weather station. 3. HOW MIGHT CREDIT-LINKED INSURANCE RESOLVE SOME PROBLEMS THAT FARMERS, FSPS, AND INSURERS NOW FACE? 9 For the FSP market it properly? 9 Should insurance be embedded in all agricultural credit contracts or should it be If the FSP believes that insurance will significantly required only for those borrowers it considers improve the borrower’s capacity to pay and the most risky and cannot offer sufficient collateral or reduction in default risk will lead to higher profits, collateral substitutes? Would a problem of adverse it may grant a loan, in the same or greater amount selection be created if only riskier farmers without with the same or better terms and conditions much collateral were required to buy insurance? If compared to what it would have granted the farmer the insurance indemnities do not cover the insured without the insurance. If the FSP sells the insurance borrower’s full indebtedness, such as can happen product along with credit, it may realize economies with basis risk, should the FSP try to energetically of scope so it will be able to do so cheaper than if recover the balance due or accept the loss and not the insurer sold the insurance directly. If the FSP make a new loan to the farmer? Will insurance has already established a trusting relationship with paid write-offs contribute to an expectation among the farmer or has a good reputation in the local borrowers that there are few serious penalties market, it may be able to overcome some of the for default and thereby affect future demand for trust problems that insurers face when marketing a insurance? If full loan recovery fails, the FSP will new product to a new customer. Moreover, the FSP need to post higher provisions, which will reduce may obligate the farmer to buy the insurance as a profits. What can it do to replace those lost profits? condition of the loan contract, and further reduce How will they manage internal liquidity problems in the potential for strategic default by requiring that extending new loans to current and new borrowers it be named as the first claimant on the insurance while also meeting saver demand for withdrawals? indemnity. As discussed in Section 6, the value of credit-linked insurance to an FSP is likely greatest For the Insurer in environments where borrowers’ risks are high and systemic, and where farmers have limited When the insurance is formally tied to credit and collateral to offer (Carter et al., 2016). the FSP serves as an aggregator and administers and markets the insurance, it could be attractive Although insurance linked to individual loans may, to the insurer by reducing its administrative costs, under certain conditions and done the right way easing its access to a new network of clients, and (e.g. see Carter et al., 2016), help reduce default creating a sufficiently large volume of premiums to risks and encourage FSPs to lend, it is no silver make the insurance worthwhile. If the insurance is bullet because FSPs must deal with several issues index based, the insurer can even avoid having to in marketing insurance and managing indemnity inspect farmers’ fields and assess damage before payments. Some examples follow. Will loan officers making payments to the farmer or FSP. If, as is be tasked with marketing insurance and will they the most common case, credit-linked insurance need to be compensated for this additional work for smallholders is subsidized by a government load? What training will be required so loan officers or donor, then the insurer may also benefit from will understand how the insurance works and 9 The difficulties facing FSPs when marketing insurance are illustrated by Gine and colleagues in a study of the Basix program in India. They found that credit officers, despite facing a range of clientele with different needs, always sold the same combination of weather insurance schemes, without using insurance to hedge the risk that particular farmers faced. Indeed, during the period of study, livestock insurance grew far more rapidly that weather insurance, basically because it was easier to sell than weather insurance, which was poorly understood even by the credit officers who were supposed to sell it (Gine et al., 2012). UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 10 subsidies that help cover administration and risk In principle, FSPs may prefer collateral and credit loading costs, and sometimes even by obtaining guarantees to insurance because they are available portfolio reinsurance on favorable terms. In the to cover default losses regardless of cause. While case of meso insurance where the FSP purchases collateral and credit guarantees do not directly insurance to cover its own aggregate portfolio risk reduce the probability of loan defaults, they do (see section 4), the insurer can benefit from selling at reduce the loss to the FSP when a default occurs. scale to a large client base rather than underwriting But from the borrowers’ perspective, insurance contracts for many individual borrowers. Moreover, may be preferable because in the event of a negative if the insurance is based on spatially defined yield or shock, they could either lose their collateral or, weather indices, the level of portfolio aggregation if they default, lose their credit rating and hence involved may be sufficient to avoid any significant access to future loans. However, there are examples basis risk. in which credit guarantees may substitute for, and/ or supplement insurance, and we consider these Major Unknowns options in Section 8. There are major unknowns about the necessary Many factors can affect the demand for credit and conditions under which some form of credit-linked insurance including the nature of the idiosyncratic insurance will be accepted and make a positive and systemic risks faced by farmers and their impact on unlocking credit. Several factors affect frequency, severity and geographic distribution, the supply of credit and insurance. One concerns and the poverty levels of the smallholders and the type of environment – agricultural, financial, the effectiveness of their traditional forms of risk and policy – in which the three parties to this type management. The impacts of climate changes on of arrangement will find it of interest to resolve the frequency and intensity of catastrophic shocks, some of their challenges. A second may be the and government and donor responses to them, will financial rules and regulations that promote or affect interest in testing insurance as an ex ante constrain agricultural credit and insurance such as solution. Another consideration affecting demand is interest rate controls, lending quotas, loan targeting, whether the insurable risks are the really important and regulations affecting how delinquencies and ones faced by farmers in terms of default risks or defaults must be handled. Third will be the type and income shortfalls. There is also the problem of capacity of FSPs that are already making or aspire determining the major constraint faced by specific to make agricultural loans. A fourth important factor farmers in their decision to adopt new products. is the nature and effectiveness of the collateral and Is it credit, is it insurance, or is it some of both? collateral substitutes including loan guarantees that Or is the problem one of accessing markets and are in effect to offset loan losses. modern inputs that requires a value chain approach to resolve? 3. HOW MIGHT CREDIT-LINKED INSURANCE RESOLVE SOME PROBLEMS THAT FARMERS, FSPS, AND INSURERS NOW FACE? 11 UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 12 4. Alternative Institutional Mechanisms for Providing Credit-linked Insurance There are three basic models for linking insurance and credit for smallholders. They are summarized in Table 1. One involves the insurer selling insurance directly to farmers, who can then offer the insurance as a form of loan collateral to FSPs. Another model involves directly bundling the insurance with loans, which are administered by an FSP or other aggregator. A third, referred to as meso insurance, involves directly insuring part of an FSP’s aggregate loan portfolio against systemic loan defaults. In addition to these three basic models, insurance linked credit may also play a role in promoting value chain financing. We discuss each in turn. Direct Farmer Insurance In this model, the insurer sells insurance directly to farmers, collects the premiums, and makes claim payments directly to them. Smart phones and internet banking have opened up new opportunities for insurers to work directly with smallholders in this way, at least for index based insurance products (Hess, Hazell and Kuhn 2016). A variant of this approach is Kilimo Salama, a specialized weather index crop insurance product embedded with credit, and sold directly to Kenyan farmers to insure purchased inputs for wheat and maize (Box 1). When farmers buy insurance directly and voluntarily, the link to credit arises only if the farmer informs the FSP of the insurance and offers it as proof of reduced risk exposure. It allows the farmers to buy the insurance coverage desired and utilize the indemnities as they choose. For the FSP making a loan, the problem is that even if the insured borrower is considered less risky, there is no way to compel the farmer to use claim payments toward loan repayment. This would require a side contract with the FSP in which the farmer offers the insurance as collateral and empowers the FSP to collect claim payments for debt repayment directly from the insurer. Without such an agreement, the borrower may be tempted to engage in strategic default and deliberatively not repay, concluding that defaulting and being denied access to a new loan is more 4. ALTERNATIVE INSTITUTIONAL MECHANISMS FOR PROVIDING CREDIT-LINKED INSURANCE 13 Box 1: The Kilimo Salama Program in Kenya The program, a partnership between Syngenta Foundation for Sustainable Agriculture, UAP Insurance, and telecom operator Safaricom, offers cover for financial losses due to drought or excess rainfall. It covers the inputs the farmer buys, not the harvests. It uses mobile phone technology to make enrollment quick and easy and reduces administrative costs. Farmers visit a certified agro-dealer, who offers insurance to cover the cost of inputs purchased. When the farmer buys the inputs, the value is entered using a phone application. The dealer is informed of the premium owed and the farmer pays for the goods and premium. The dealer registers the farmer’s details on his mobile phone and the farmer receives a text message with the policy number and coverage details. If there is a payout, the farmers receive a M-PESA payment on their mobile phones for the value of the seed purchased (Matul and Dalal, 2014). valuable to him/her than repaying and maintaining some cash payment that can be used for household access to formal credit in the future. The insurance- consumption until the next harvest. The farmer credit relationship becomes more formal in cases must evaluate if the extra costs of borrowing to buy where FSPs require farmers to buy insurance in the insurance, and paying the additional interest order to obtain loans. charges, is a superior way of obtaining protection compared to accumulating savings for this purpose. Credit-linked Insurance In the literature, a distinction is sometimes made The need for a closer contractual arrangement between ‘contingent credit’ in which the insurance between insurer and FSP underpins the more pays the lender, and ‘bundled credit-insurance’ in conventional form of credit-linked insurance in which the insurer pays the borrower (Farrin and which the insurer uses the FSP as an aggregator to Miranda, 2015). But if the lender is administering bundle insurance with loans, essentially marketing all the transactions, then the two will seem the same and administering the insurance for the insurers. to the borrower unless, as in model B, there is some Two forms of credit-linked insurance are shown in claim payment left after the loan has been paid Table 1. They differ only in whether the insurance down. covers just the amount of the loan (model A), or When insurance is directly linked with credit, whether there is also an insurance component the FSP has the choice of making the insurance that provides the farmer with some cash for own compulsory for its borrowers, or allowing them consumption purposes (model B). Either of these to offer an alternative form of collateral. Making forms of linkage is beneficial to the insurer because the insurance compulsory has the advantages of all the administration is handled by the FSP through simplifying administrative arrangements for the its local branches, so it is relatively easy to scale FSP, reducing its lending risks, and avoiding adverse up sales. The insurer has to design and develop the selection problems for the insurer. Its drawback is insurance products, and ensure they are relevant for that for farmers who have other less costly ways of insuring the FSP’s loans while also creating value managing their risk, or who face basis risk when the for smallholder borrowers. This is why model B insurance is index based, the insurance simply adds may be more attractive than A for smallholders to the cost of the loan without adding commensurate because when they incur a loss they receive at least benefits, making the loan less attractive. If the FSP UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 14 actively markets insurance, it needs to explain the made to farmers with bank loans. The scheme is events in which farmers will have to repay the loan heavily subsidized. The WBCIS is priced at actual fully, partially or not at all depending on the size of actuarial rates, but with the gap between premiums the insurance payout. paid by the farmers and actual premiums being met by the central and state governments. The total When the credit and/or insurance is subsidized premium subsidy can be as high as 75 percent. by governments, the insurance is typically made The program covers over 25 million farmers and compulsory for all borrowers in selected FSPs. The the government has now increased the subsidies largest compulsory bundled crop insurance program for borrowers and non borrowers to 98% under is the Weather-Based Crop Insurance Scheme the new scheme - PMFBY (Prime Minister Fasal (WBCIS) in India. For specified crops in preselected Bima Yojana) - effective the 2016 monsoon season locations established by state governments, the (Prashad, 2016).10 scheme is mandatory for commercial bank loans. It is also open to non-borrowers who can purchase Non-bank companies, including agrodealers, the insurance from a network of banks, insurance agricultural coops and other value chain agents, can intermediaries and authorized representatives of the also offer credit-linked insurance. Two examples insurance companies, but the majority of sales are are given in Box 2. 10 A compulsory scheme is also used for cattle loans. IFFCO-Tokio, a cooperative insurer in India, offers credit-linked cattle insurance through cooperative banks which farmers are required to purchase for their cattle loans to protect the banks from default risk in the case of cattle deaths. The introduction of radio frequency identification chips accelerated claims processing which improved product viability and value for the farmer borrowers (Matul and Dalal, 2014). 4. ALTERNATIVE INSTITUTIONAL MECHANISMS FOR PROVIDING CREDIT-LINKED INSURANCE 15 Box 2: Examples of Non-bank FSPs: PlaNet Guarantee in Burkina Faso and the Zambia Lima Credit Scheme A Burkina Faso index-based insurance scheme issued by PlaNet Guarantee, covers drought risks for maize. The insurance is provided by Allianz Africa and reinsured by Swiss Re. The system involves several MFIs. Although the insurance is optional, credit agencies are becoming more stringent in requesting it and insured farmers without credit are rare. The payouts for the index insurance are triggered by an index of evapotranspiration11 and are made via the credit agency but are withheld if the credit is not repaid. The pilot was launched with 194 producers during the 2011 season and grew to 2,072 producers by 2013/2014. In 2013 the scheme was extended to cotton production, and 446 producers adopted it. No data were reported about the impact of the scheme on the MFIs or the insurer. The Zambia Lima Credit Scheme (LCS) is a quite complicated indemnity-based crop insurance program. Maize was the only crop eligible for the scheme in the beginning. Farmers participating in the scheme are members of the Zambia National Farmers’ Union (ZNFU). One of ZNFU’s objectives was to provide access to finance to 10% of its members (i.e. 35.000 farmers) by 2015. It provides smallholders without collateral access to commercial agricultural credit based on a group savings and loans approach. Loans are provided by the National Commercial Bank Limited (known as ZANACO). The District Farmers Associations (DFA) have to co-guarantee the loans. The Agrisure policy issued by the Zambia State Insurance Company (ZSIC) is mandatory. The program targets farmers who organize themselves into groups of 10-20 farmers based on mutual trust, reputation and commodity focus. A smallholder deposits 50% of the value of his/her total input requirements in a fixed term collateral account. Perils covered include crop damage or destruction caused by natural events such as drought, lightning, flood, hailstorm and fire, and the insurance indemnifies the cost of inputs for which credit was obtained. The insurance company performs pre-harvest assessments and the farmer is informed of the improved farming practices to be followed. In case of a claim, an inspector checks if the recommendations were implemented and declares the claim ineligible if they were not followed. Launched in the 2008/2009 crop season, the number of farmers granted credit by the 2013/2014 season had increased to 16,780 cultivating 36,700 hectares. The scheme has recorded almost a 100% recovery rate on loans. The interest rate started at 26%, soon declined to 21% and then to 14%. But these rate changes seem to be driven mostly by a pricing formula in which the bank adds 2% to the base rate determined by the Central Bank. ZNFU pays for all support needed to make this scheme functional and has been exploring ways to make it self-sustainable. The variety of ways that the lender is protected against default suggests that it is extremely cautious regarding lending to farmers (Van Asseldonk, et. al. 2013, 2015). 11 Evapotranspiration is the process by which liquid water becomes water vapor. UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 16 A potential downside with embedding insurance as a regional drought index or an El Nino type of and credit is that the lender may not be given any massive flood. The insurance premium is paid by discretion about how to handle individual loan the FSP, which may recover all or part of this cost delinquencies, especially if banking regulations by charging its borrowers higher interest rates. An stipulate how they should be used. Normally, if an interesting aspect of meso insurance is that the insured farmer is entitled to an indemnity payment, lender has full discretion about what to do with any those funds must be used by the FSP to write down insurance indemnities received, subject to the rules her loan. This can be a problem if there is basis risk of regulatory authorities. By removing some of the so the claim payments are not highly correlated systemic weather risk in the lending portfolio, meso with the actual losses experienced by individual insurance may enable the lender to take on more risk farmers. The loan might sometimes be paid off with and expand its lending to smallholders. A unique an indemnity even if the farmer has not experienced feature is that the lender may be induced to expand a loss and is capable of repaying her loan. The its lending, even though little is done to insure opposite can also happen; the farmer may incur a the risks of individual farmers. Another attractive loss but the insurance does not pay out, in which feature is that by insuring a lending portfolio at a case the farmer still has to repay the loan plus the regional level, there is less basis risk associated insurance premium. This result stemming from the with an insurance contract used to manage portfolio basic nature of basis risk in index insurance may risk. Meso-index insurance products can be more cause farmers to doubt the integrity of the payout complex than micro-products, allowing indemnity process and contribute to lack of voluntary uptake.12 schedules to be designed to more precisely capture the complex relationship between weather and “Meso” Insurance policyholder losses (Miranda and Farrin, 2012). The third type of linkage between credit and Many ideas about meso insurance are being insurance is called “meso” insurance. It breaks the developed and tested based on El Nino weather link between insurance and individual farm loans, events and their impact on FSPs in Peru. They focus and instead insures FSP loan portfolios at a more on how FSPs react to extreme weather events with aggregate level. Agricultural intermediaries can be and without insurance. Collier and Skees (2012) any institution, not just FSPs, along the agricultural showed that the marginal cost of insuring against value chain that is exposed to agricultural risks, extreme weather events in Peru would be lower including agricultural input suppliers, producer than strengthening other risk management practices organizations, or agricultural traders. The insurance so that insured FSPs could re-optimize their risk is used as an internal risk management tool to management strategies by using insurance as a cover default risks arising from large and systemic substitute. Improved efficiency could translate into agricultural shocks. This might take the form of a better financial performance, expansion of banking single insurance policy that pays the policyholder services, lower interest rates, and reduced volatility a lump sum when an insured event occurs, such in access to credit. In another study, Collier and 12 The DHAN Foundation, a development organization in India, improved transparency by providing members with information about how claim payments are made for its index crop insurance product. Data from rainfall gauges are available to the insured daily, and consolidated data are also sent to village information centers. This enables clients to check whether the claims payments received are consistent with the rainfall data (Matul and Dalal, 2014). 4. ALTERNATIVE INSTITUTIONAL MECHANISMS FOR PROVIDING CREDIT-LINKED INSURANCE 17 Table 1. Types of Insurance-credit Linkage Arrangements and Their Characteristics Characteristic Type credit insurance Direct Farmer Credit-linked A Credit-linked B Meso Insurance Purchase (Loan Only) (Loan Plus) Who pays for Farmer pays premium Farmer typically pays Farmer typically pays FSPs, aggregators pay the insurance directly premium through premium through FSP insurer directly, but to insurer FSP farmer pays through higher interest rate Who administers Insurer FSP FSP Insurer the insurance What is insured Some share of Only the loan Loan plus some cash Some share of loan production portfolio Who gets the Farmer FSP or farmer FSP plus farmer gets FSP claim payments depending on residual cash regulations and agreements between FSP and farmer How is the Farmer pays insurer Added to loan Added to loan amount FSP pays premium amount collected Voluntary Farmer chooses what Insures value of loan Insures value of loan FSP chooses level of component to insure and how plus interest plus plus interest plus coverage and what much premium premium plus some risks to cover cash amount for farmer May be compulsory May be compulsory but not cash part Who bears Insurer FSP but possibly FSP but possibly Insurer administration shared with insurer shared with insurer costs of the insurance Advantages Protects overall debt No liquidity No liquidity Leaves FSP with repayment capacity of problem for farmer. problem for farmer. discretion about how the farmer Administration costs Administration costs to handle individual Direct insurance can reduced by bundling reduced by bundling loan delinquencies reduce admin costs if with credit with credit No basis risk the product can be sold Low administration through the FSP sales costs for the insurer channel Potential Basis risk for farmers Basis risk for farmers Basis risk for farmers Farmers may still Challenges for index insurance. for index insurance for index insurance retain risks (affecting Potential liquidity FSPs not given any FSPs not given any their demand) and problem for farmer discretion about how discretion about how to uncertainty of what to handle individual handle individual loan happens if they High cost (to insurer) cannot repay of administering the loan delinquencies delinquencies insurance Demand for meso level insurance depends on FSP diversification UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 18 De Los Rios (N.D.)13 argued there are two benefits Credit-linked Insurance in Value of designing index insurance to be sold to lenders. Chain Financing First, designing insurance products for lenders tends to reduce some aspects of basis risk. Second, In addition to the three types of insurance-credit portfolio insurance can help manage credit risk linkages arrangements summarized in Table 1, that will translate into increased investment and there are also possibilities for linking insurance and economic growth in vulnerable economies. credit in value chain financing. In recent years, the value chain financing approach has emergedas an Collier, Miranda, and Skees (2013) utilized a additional way to reduce the barriers for agricultural model to test lender management of equity capital, finance. Agricultural value chain finance includes and applied it to a micro-finance institution (MFI) both the informal financial flows among actors vulnerable to El Nino related flooding in Peru. The within a value chain and the formal financial flows results showed that disasters lead to large loan losses from outside the chains to agents within the chains causing lenders to contract credit after the event, (Miller and Jones, 2010; Quirós, 2010). These thereby slowing recovery for the affected economy. financial arrangements parallel the emergence of An insurance-like mechanism was introduced to tightly organized agricultural supply chains created transfer part of the MFI’s disaster risk. A key result in response to higher quality standards demanded showed that insurance prevents the contraction of by domestic supermarkets and export markets. The credit during the period following the disaster. It success of these chains is often due in part to the not only reduced its current vulnerability, but the efforts of agents or promoting organizations that MFI plans to increase financial inclusion in this train and mobilize farmers to participate, supply the vulnerable region. In another model tested with necessary inputs, and ensure that quality standards Peruvian MFIs, Collier (N.D.) argued that disasters are met. They also help organize and coordinate the may influence lending through three channels by services supplied by other actors within the chain changing: demand, the willingness of lenders to located between farmers and consumers. lend, and/or the capacity of lenders to lend (due to capital or liquidity constraints). His model results Credit-linked insurance can play a role in value showed that lenders with the lowest pre-disaster chain financing for farmers in two basic ways. capital ratios significantly reduce lending in the One way is for it to encourage financing between year a disaster occurs and in the following year. agents within the chain, such as contract farming Through the use of borrower grace periods, some and other schemes in which input suppliers offer lenders may be able to delay loan write-downs and in-kind and cash credit to producers, and buyers restructuring, so the full effect of capital losses due provide pre-harvest loans to secure output from to disasters may be delayed until the following growers. The agents can be cooperatives and farmer year. Transferring disaster risk for the FSP through associations, agribusinesses, and lead firms in the the modeling of purchased El Nino insurance chain. Various arrangements can be used such as produced results showing an increase in credit tripartite agreements between FSPs, anchor firms supply during non-disaster conditions and reduced and farmers. Anchor firms could provide some credit contraction following disasters. partial first loss guarantees to FSPs, and FSPs can 13 The two undated papers authored or coauthored by Collier cited in this section are under review so the results summarized here may be revised in the final publications. 4. ALTERNATIVE INSTITUTIONAL MECHANISMS FOR PROVIDING CREDIT-LINKED INSURANCE 19 grant credit only to farmers whose loan payments insurance offered as part of a package of inputs are deducted from the value of the products they supplied to farmers along with assured access to deliver to the firms. Loans made for value chain markets. Adding credit-linked insurance to the purposes are generally limited to amounts equal to value chain financing system can then be viewed as the total value of the services and goods provided yet another way to reduce credit risks. by the value chain lender with nothing left over to A good example of using insurance within a value assist the borrowers’ non-value chain needs. The chain approach is a contract farming program second way is through loans from FSPs outside the offered by PepsiCo in India that is insured by chains to farmers participating in the chains. FSPs the ICICI Lombard General Insurance Company may react especially favorably to credit-linked (Box 3). Box 3: Insurance in a Contract Farming Setting: PepsiCo’s Program in India PepsiCo in India offers voluntary index insurance to farmers participating in its potato program. The insurance is based on humidity levels and temperature14 and is sold through the ICICI Lombard General Insurance Company, the largest private sector, general insurance company, and managed by Weather Risk Management Services (WRMS), a private broker and weather station operator. PepsiCo added voluntary weather index insurance to its farming package to limit farmers’ weather risk, establish long- term relationships with farmers and limit the risk in its supply chain. Insurance plays an important role in a package of services and information for smallholders that includes: high quality potato seed; access to fertilizers, pesticides, and other chemicals; technical advice on production practices; fixed purchase price and incentives from the beginning of the season; weather information and advisories via mobile phone Short Message Service (SMS); and insurance. It sets a base buy-back price for its contract farmers at the beginning of the season and offers incremental price incentives according to: (i) quality of the potatoes; (ii) use of fertilizers and pesticides; and (iii) purchase of index insurance. The main drivers influencing a farmer to purchase index insurance include an assured buy-back price from PepsiCo, ability to finance the premium and other production costs through a loan, trust in the various actors involved in the supply chain, demonstration of timely payouts in previous seasons, and perceived need to mitigate the risk of losing the significant upfront costs of production, in part to cover the production costs for the following season. PepsiCo also encourages the purchase of index insurance through client education. Among the 24,000 PepsiCo contract farmers across nine state locations, around 50–60 percent elected to purchase index insurance — a high proportion driven in part by price incentives and conditions on state bank loans that require insurance. By 2013, the contract farming program was expected to reach 30,000 farmers. The program has provided claim payouts in almost all state locations over the last 5 years, with farmer retention rates in excess of 90 percent (IFC, 2012). 14 Insurance is especially important because of the risk of potato blight, which totally destroys the crop for processing purposes when it occurs. The blight is induced by warm humid weather, so the nature of the insurance index and the value of forecast information on temperature and humidity conditions are important design features for blight. UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 20 There are limitations, however, to how far the objective relative to other agents within the chains. Third, of creating competitive and comprehensive rural value chain finance focuses on the relatively narrow financial systems will be served if FSPs limit loans to investment and working capital requirements of only those farmers who participate in value chains. producers rather than the broader financial needs First, only a relatively small share of smallholders of farm households. For these reasons credit-linked currently participates in tight value chains and they insurance offered as part of a value chain financing are often the more commercially oriented farmers system may be important for the success of farmers that are more credit worthy.15 Second, there are in the chain, but will likely have limited spillover doubts about how much smallholders actually effects outside this relatively narrow market niche. gain financially from participating in such chains It is estimated that only 35 million of the world’s 500 million smallholder farmers participate in tight value chains, meaning that they 15 are generally less poor, operate at least two hectares of land and take a more business-like approach to farming than other smallholders. See Christen and Anderson (2013). 4. ALTERNATIVE INSTITUTIONAL MECHANISMS FOR PROVIDING CREDIT-LINKED INSURANCE 21 UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 22 5. What situations May not be Well Suited for Credit-linked Insurance? Like most innovations, credit-linked insurance is not a universal silver bullet to use for improving smallholder access to formal finance. Some examples of potential limitations follow. One of the important discoveries of microfinance was that, contrary to the hype, most market-oriented MFIs do not reach the poorest with microcredit, and perhaps they should not try to do so. Some households are so poor that they are best aided first with a transfer of assets, often coupled with training, technical assistance and conditional cash transfers, so they can make investments, generate income and eventually develop the capacity to repay high interest rate MFI loans. CGAP and the Ford Foundation conducted several field experiments that produced guidelines for implementing subsidized programs for the extreme poor prior to lending to them (de Montesquiou, et. al., 2014). This idea is closely related to the recognition that poor smallholders earn income from multiple sources, and often the income earned from crop and livestock enterprises is a relatively small share of total household net cash income.16 Therefore, subsidies spent on increasing their agricultural income may be used more productively if invested in other interventions. Many poor smallholders living in poor-resource areas may earn low rates of return on their resources and may not have access to better projects, so are not able to pay the high interest rates charged by sustainable FSPs. Some live in such risky environments (e.g. flood plains or drought prone areas) that actuarially fair insurance will be extremely expensive without huge subsidies. Even new agricultural projects may generate comparatively low rates of return in these environments so other forms of social assistance may be far more cost effective than crop insurance programs. A broader, largely ignored, issue concerns the role of savings in financing agricultural projects. Just as access to credit, especially for consumption 16 For a sample of smallholder families, the median proportion of household net cash income (i.e. revenue less any associated expenses, such as stock purchases for side businesses) from nonagricultural production sources was 93 percent in Mozambique, 74 percent in Tanzania, and 58 percent in Pakistan (Anderson and Ahmed, 2016). 5. WHAT SITUATIONS MAY NOT BE WELL SUITED FOR CREDIT-LINKED INSURANCE? 23 smoothing, serves as an insurance substitute, prior to the next planting season and on agricultural savings can also be a substitute for insurance (Farris inputs used in the next planting season. FSPs are and Miranda, 2015). If FSPs provided smallholders generally eager to attract new savings customers with better savings options, they could build up a but the literature is filled with explanations about financial reserve enabling them to avoid default the factors that affect the ability of poor people to in bad years. Savings would be less costly than accumulate savings in large enough sums to self- insurance, though not necessarily as effective, finance major projects, or to simply accumulate for because a) poor farmers might not be able to afford self-insurance purposes. to build up a sufficient reserve to cover their loans, In another recent study, Carter et.al. (2016) conducted and b) unlike insurance, their reserve would not be a randomized experiment in Mozambique exploring large enough in the early years to pay off a loan or the interaction between subsidies for technology to repay in the event of a serious loss, or back to (mostly fertilizer subsidies) and savings interventions. back losses. It tested the theory that combining temporary Savings to self-finance projects is far less risky technology subsidies with savings interventions for the poor than borrowing, since savings can be could either promote technology adoption (dynamic used to offset any losses and not just those that arise enhancement), or reduce adoption by encouraging from insurable risks. Savings may be less costly to savings accumulation for self-insurance and other subsidize than is insurance so it may be a far better purposes (dynamic substitution). Recipients that source of project financing for some of the poorest received only fertilizer subsidies increased fertilizer compared to a credit dependent strategy. Some use in the subsidized season and in two subsequent recent evidence on the role of savings for financing unsubsidized seasons. Consumption rose but they agricultural projects is emerging. For example, also experienced higher consumption risk. When Brune et. al. (2016) found in a Malawi study that the subsidies were paired with savings interventions commitment savings accounts for smallholder cash (mainly financial education and matched savings), crop farmers had substantial impacts on savings the subsidy impact on fertilizer use disappeared. UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 24 Instead the households accumulated bank savings savings. Depositors who held minimum balances of which lowered the price of self-insurance so the US$60 each month were granted free life insurance insurance price effect dominated the input price with benefits up to US$180. Five months after effect. Interventions that alleviate savings constraints product launch, bank deposits had increased by 19 could lead to the dynamic enhancement of subsidies per cent and deposits from clients with balances and higher persistent use of fertilizer once temporary below US$60 increased by 207 per cent. Although subsidies end. the reasons are not entirely clear, anecdotal evidence from interviews suggested that many Creative ways of bundling savings with insurance customers saved more because of the free insurance may create value for both clients and providers. (Matul and Dalal, 2014). Similar attempts to bundle For example, evidence from MicroEnsure in Ghana savings with agricultural insurance have yet to be shows that bundling savings and life insurance reported, but would seem worth exploring. can increase insurance penetration and stimulate 5. WHAT SITUATIONS MAY NOT BE WELL SUITED FOR CREDIT-LINKED INSURANCE? 25 UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 26 6. Impacts of Credit-linked Insurance on Credit Markets The three most obvious positive changes in formal agricultural credit that advocates for credit-linked insurance hope for are 1) increases in the amount lent to farmers in the market segments already being served, 2) expansion of credit to farmers currently excluded or underserved, and 3) improvements in the terms and conditions for credit granted to all market segments. These changes are expected due to the possible decline in loan default rates that could be associated with insurance indemnity payments. However, there could be several other changes, some of them more subtle, in the terms of credit offered and/or how it is delivered. Some could directly benefit the FSPs, while others might have greater benefit for the borrowers and thereby stimulate a greater demand for loans. Little evidence has been reported to demonstrate that these changes are actually occurring, but they need to be recognized as possibilities in future impact analyses. Otherwise, the benefits of credit-linked insurance might be underestimated. Some examples of other potential benefits of credit-linked insurance include the following. Some FSPs that hesitate to lend to agriculture might be induced to begin to do so because of insurance. Some FSPs might increase average loan sizes (average loan/asset ratios). Others might reduce the amount of physical collateral required and/or begin to accept more collateral substitutes for loans. Some might expand beyond joint liability group lending and begin to offer more individual loans granted with repayments scheduled according to the borrower’s projected cash flow. They might also offer longer-term loan maturities and more loans with fewer payments and/or more one-time balloon payments. With insurance as back up for repayment of delinquent loans, FSPs might introduce more flexibility in managing delinquencies with the hope that more delinquent borrowers would eventually repay. The fact that many changes that occur in FSP products and procedures could be attributed to credit-linked insurance makes it difficult to demonstrate that any one change was especially critical or represents clear evidence of impact. Many things can happen simultaneously in credit markets over time so it is difficult to assess the impact of any particular one. 6. IMPACTS OF CREDIT-LINKED INSURANCE ON CREDIT MARKETS 27 Most empirical case studies of credit-linked when bundled with insurance in a random control insurance fail to address these issues and simply trial in Malawi. There was suggestive evidence describe the primary characteristics of the scheme, that reduced uptake of insured loans was due to the major agents involved, and perhaps the number farmers already having implicit insurance through of smallholders that participate. Normally, only a the limited liability clause in their loan contracts. small amount of information is provided about the Another random control trial conducted in Ghana financial environment such as the ability to utilize by Karlan et. al. (2011) found insurance made no collateral or collateral substitutes to enforce loan difference to the demand for credit. One explanation contracts. A further limitation of most studies is for this result could be that the observed high rates that they provide only limited information about of loan default may indicate that the FSPs already the benefits to farmers and FSPs, and virtually none effectively had in place a flexible “loan forgiveness” provide evidence about the value to insurers. program, so that additional indemnification had The insurance literature has identified the limited little impact on farmer behavior. Mishra et. al. demand by small farmers for insurance products (2017) found some evidence among rural banks unless heavily subsidized (e.g., Binswanger- in Ghana that insured loans have a significant Mkhize 2012), so it should not be surprising if impact on loan applications, especially increasing they are also less than enthusiastic about having the likelihood of loan applications among female to purchase similar types of insurance bundled farmers. Basis risk can also undermine farmer with their loans. What might make a difference perceptions about the value of the insurance and is if the loan is attached to an investment project debt repayment discipline18. As Clark (2011) has that gives borrowers access to a game changing shown, farmers can even be made worse off buying technology or marketing package that raises their insurance if there is basis risk, since there may be expected income by far more than the value of the years when they experience bad losses but do not risk reducing aspects of the insurance (Hess, Hazell get indemnified, yet have to repay the loan plus the and Kuhn, 2016; Carter, Cheng and Sarris, 2016). A insurance premium. review of available studies provided mixed results The impact of credit-linked insurance on FSPs can regarding the impact of credit-linked insurance on also be ambiguous. A simulation model analysis the use of or supply of credit17. For example, in an by Miranda and Gonzalez-Vega (2011) found early Indian study, Mishra (1994) found there was a that mandatory, unsubsidized index insurance for significant increase in the flow of credit to insured individual farmers can diminish a bank’s internal farmers after the introduction of the Comprehensive rate of return because the high costs borrowers Crop Insurance Scheme. But Gine and Yang (2009) must pay for unsubsidized insurance discourages found that farmer demand for credit actually fell 17 A recent review (Marr, 2016) concluded that limited empirical research had been conducted on the impact of bundled credit products. The authors asserted that it is unknown to what extent credit suppliers would react to the insured status of farmers or what the preferences of farmers are when it comes to a mix of financial products. 18 One case was found in India concerning the bundling of microfinance with health insurance. A large (16 percent) of the borrowers were willing to give up microfinance to avoid purchasing the health insurance, and the majority of these clients ended up losing access to microfinance altogether (Banerjee, et.al. 2014). UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 28 them from repaying loans20. In a later simulation and hence technology uptake, whereas stand-alone model, Farris and Miranda (2015) showed that insurance may have little impact. The impact of banks earn higher profits through lower default rates credit-linked insurance is greatest in environments when they utilize contingent insurance contracts where risk is high and largely covariate, and where in which insurance premiums are deducted from farmers have limited collateral. the borrower’s loan and the indemnities are paid Based on the paucity and weakness of available directly to the bank in the event of losses. Carter, impact studies, it is hard to draw firm conclusions Cheng and Sarris (2016) developed inter-linked about the effectiveness of credit-linked insurance theoretical models of farmers’ demand for credit in achieving its stated objectives. What can be to adopt an improved technology, and of the concluded is that there is a real need for more willingness of lenders to supply it. They find that comprehensive evaluation studies and which ought there are reasonable circumstances under which to be built into the design of future credit-linked yield or weather index insurance formally linked insurance programs or projects. with credit may lead to additional farm lending 19 In their paper, contingent credit refers to a loan coupled with an index insurance contract that covers the value of the loan upon maturity. The premium is deducted from the loan value before it is disbursed. The bank is the insured agent but passes on the insurance costs to the borrower through a higher interest rate on credit. The bank receives any indemnities from the index insurance contract, which allows it to forgive the borrower’s debts when adverse weather conditions occur (Miranda and Gonzalez-Vega (2011), p. 200). 6. IMPACTS OF CREDIT-LINKED INSURANCE ON CREDIT MARKETS 29 UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 30 7. Constraints on the Development of Credit-linked Insurance If credit-linked insurance is seen by many as a win-win-win arrangement that is mutually attractive to farmers, FSPs and insurers, then why is it not developing spontaneously and more rapidly in many market-driven developing countries? An obvious reason is that farmers may be skeptical about the merits of their investment “projects” unless undertaken within a tight value chain that provides training and reliable access to inputs and markets, without which insurance alone will not ensure success. Another reason is that coordination and market failure problems may constrain the parallel and complementary development of agricultural credit and insurance markets. Both FSPs and insurers face set up challenges when launching new business models for smallholders. This is because of asymmetric information about smallholder problems and their likely debt repayment behavior, uncertain knowledge about the risks that smallholders face and which can be insured, few local branches to market and administer credit or insurance, high transaction costs serving smallholders, and systemic risk that requires building up a sufficiently large and diversified lending or insurance portfolio. There may also be coordination problems between insurance and credit. Lenders will be reluctant to lend to smallholders unless there is insurance, but getting insurers up to speed may take much longer and require public sector support in the form of investments in weather stations and data systems, farmer education, and even temporary subsidies to overcome some of the initial market failure problems (Hazell, Sberro-Kessler, and Varangis, 2017). The initial set up costs for credit-linked insurance can be considerable for both FSPs and insurers. The costly process and subsidies involved in setting up and operating greenfield banks in Sub-Saharan Africa to serve clients generally ignored by existing banks provides insights into the high operating costs faced by large banks in developing countries (Earne, et.al. 2014). The complex process of transforming urban-oriented MFIs to successfully make agricultural loans has also been discussed (Meyer, 2013). This process frequently involves switching from the highly standardized group lending model used with urban clients to individual lending so credit terms and conditions can be adapted to the cash flow needs and capabilities of smallholder households. Hiring specialized loan officers with agricultural backgrounds and modifying management information 7. CONSTRAINTS ON THE DEVELOPMENT OF CREDIT-LINKED INSURANCE 31 systems (MIS) are also key changes. Acceptable until the insurers have an established track record collateral substitutes need to be identified, and then for a new product and related delivery system. alternative credit-linked insurance arrangements Even when all these supply side constraints to need to be tested for their impact on smallholder credit and insurance can be overcome, insurers uptake and loan recovery rates. face potentially low smallholder demand for their The set up costs for insurers include things such products (Binswanger-Mkhize 2012). Developing as: a) cost of researching and designing insurance credit-linked insurance may then require that contracts that are attractive and affordable to insurance be made compulsory, or else heavily farmers, b) cost of setting up and testing delivery subsidized, at least in the early stages until costs systems, c) uncertainties about the risks to be can be brought down. insured, especially when there are limited weather Left to market processes alone, there are cases in stations and records (insurers handle this problem by which neither credit nor insurance may develop adding a risk load to the premium, which hopefully at a sufficient pace and scale to meet most farmer goes down over time as they learn about the real or societal needs, and there may be openings probabilities), and d) the costs of obtaining some for proactive agencies and public policies and form of reinsurance, which can be difficult to obtain investments to help kick start the process. UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 32 8. The Role of Supportive Agents and Government Policies Overcoming the constraints discussed above requires proactive agencies and supporting public investments and policies to help kick start the development and growth of credit-linked insurance. Of course, any public interventions should be guided by good ex ante evaluations demonstrating that the programs to be promoted are a worthwhile way to spend public funds for addressing small farm problems. Supportive Agencies Besides the FSPs and insurers that are directly involved in the design, testing and implementation of credit-linked insurance systems, there are many agents and organizations that can encourage or constrain success and help overcome coordination problems. First, as noted earlier, there is the important role played by value chain promoters. They may be unsubsidized such as private sector lead firms, cooperatives and farmer associations, and agribusinesses. But they may also be subsidized sources such as government extension workers, NGOs, and other providers of public goods helpful to farmers, FSPs, and insurers. In many of the case studies reviewed for this study, credit-linked insurance was initiated by third party agents, including international development agencies, donors, and foundations. Public Investments and Services Public investments play a key role in helping to establish an enabling environment for credit-linked insurance, and in overcoming some set up problems. For insurers, some key areas of public spending include: building and maintaining weather station infrastructure and data systems; supporting agro-meteorological research leading to product design; and educating farmers about the value of insurance. Private insurers are willing to make some of these investments themselves, but there is an inherent problem in that they may not be able to recoup their investment costs given the ease with which competitors can use the same knowledge and services once established. This is a classic ‘public goods’ problem that inevitably leads to insufficient private investment, and hence a need for complementary public spending. 8. THE ROLE OF SUPPORTIVE AGENTS AND GOVERNMENT POLICIES 33 Similarly, important sector-wide public goods Subsidies investments are needed to improve the financial infrastructure in many countries that will aid Temporary subsidies can sometimes play an FSPs to reduce credit risks and lending costs. For important role in helping to launch or speed up example, several Sub-Saharan African countries the development of credit-linked insurance. For have recently created collateral registries and credit example, temporary subsidies might be justified bureaus, and have strengthened warehouse receipts when farmers, FSPs or insurers are initially systems. Some countries are attempting to formalize uncertain about a new type of credit linked insurance land titles so they have more value and can be more product because they have insufficient knowledge easily transferred, even though it is recognized that to assess its real risks and benefits. In such cases, land reforms, such as in Kenya, have not yet made a premium subsidy might encourage farmers to a major impact on using land as collateral for loans purchase and experiment with a new insurance (Meyer, 2015).20 product about which they have no prior experience, much as seed companies sometimes give out free trial seed packets. Another example is when an Regulations insurer initially charges a high-risk loading for a There is need for an enabling regulatory environment new line of insurance because it has inadequate for finance and insurance if credit-linked insurance data to properly assess the actuarial risks, and the is to prosper. A fundamental requirement is the risk loading is expected to fall once the insurer has establishment of a legal and regulatory environment acquired additional data over time. In this case the for enforcing contracts that both buyer and seller government might want to subsidize part of the risk can trust. For example, farmers and FSPs need loading cost, or offer subsidized reinsurance during to know that insurers will fulfill their obligations an initial learning phase (Carter et.al, 2016). to pay all claims due when an insured event has occurred. Additionally, laws and regulations need Subsidies might also be warranted when credit- to be consistent with international standards to linked insurance enables poor farm households improve the chances of insurers gaining access to access credit and game changing technologies to global markets for risk transfer. Unfortunately, that can lift them out of poverty. In this case the in many countries, regulations are simply not in underlying problem is often an inability of many place to accommodate the development and use poor farmers to bear the initial risk of adopting such of index insurance products that are often key to innovations without subsidized insurance, and/or an credit-linked insurance for smallholders. Worse, in inability to access credit without insurance because some countries regulatory agencies are re-imposing they are perceived to be high-risk borrowers by interest rate caps that will discourage FSPs from financial institutions. It is usually hoped that once serving high-cost, high-risk smallholders. Human they have successfully adopted the new technology capacity building and technical assistance are often and achieved a higher and sustained income, the essential for preparing the legal and regulatory subsidy can be phased out. However, for many environment to govern credit-linked insurance and of the poorest smallholders, this may be a forlorn related products. 20 Boucher et. Al. (2008) argue that risk rationing is an important reason for the limited impacts of land titling programs on investment and credit market participation in Latin America. UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 34 hope and the subsidy may have to be sustained over practice, even when they have accomplished their longer periods of time21. initial objectives. To ensure subsidies are achieving their intended purpose, it is important to establish Care is needed in the design and implementation good monitoring and evaluation (M&E) systems, of subsidies to avoid inadvertently creating and undertake periodic evaluations. disincentive problems that lead to significant economic costs and inefficiencies (Hazell, Sberro- Beyond these general recommendations, specific Kessler and Varangis, 2017). Considerable thought recommendations for subsidizing financial services has been given to how best to design subsidies include: for extending financial and insurance services • Reduce distortions by subsidizing the institution into rural areas and to serve more smallholders.22 and not the borrower; A key starting point is to select capable partner • When subsidizing institutions, consider the institutions for implementing the subsidized interest rates to be charged relative to competing credit and/or insurance. Adding a subsidy to an institutions so that competition is not undermined; already badly performing insurance, credit, or • Subsidies that create public goods to benefit the NGO program or project may make things worse, entire financial sector may generate higher returns not better. Moreover, if the subsidy is intended to than subsidies for specific institutions; give a segment of poor farmers access to credit- • Subsidies for institution-building are easier linked insurance for the purpose of adopting game to justify if there is a natural positive spillover changing technologies and modern inputs, then the to other institutions in the same network or to insurance should be channeled through credible nonsubsidized institutions; and institutions that can a) link the insurance to credit, • Indirect subsidies that benefit many borrowers b) ensure that access to credit also means access may generate more total benefits than direct to complementary inputs, and c) can identify interest-rate subsidies to borrowers. and efficiently reach the intended target group of farmers. All credit and insurance subsidies should Specific recommendations for insurance subsidies be carefully rationalized with key policy makers, include: and the subsidies either need to be time-bound with • Wherever possible, avoid using the subsidy to explicit exit strategies, or there should be a longer- lower the cost of insurance to farmers below the term plan in place for containing and financing actuarially fair (pure risk) premium rate. If the the subsidy. Too often, subsidies lead to a political insurance is targeted at commercial farmers, then dynamic that makes their removal very difficult in 21 A similar problem arose with subsidies to help launch microcredit for the poor. It was initially thought that poor borrowers who demanded credit had the willingness and capacity to repay high interest rate loans, and temporary subsidies were needed only to assist with start-up costs. Once the MFIs demonstrated their sustainability, commercial capital was expected to largely finance the sector (Cull, et.al. (2009). A recent analysis now casts doubts on that proposition. The study utilized proprietary data on 1,335 MFIs between 2005 and 2009 serving 80.1 million borrowers to calculate the costs of microfinance and the subsidies received by the MFIs (Cull, et. al. 2016). The results revealed that subsidies continue to be important in microfinance, even for older institutions. Unfortunately, the results were not calculated separately for rural/urban or agricultural/nonagricultural borrowers, but the general suggestion is that subsidization may be a permanent rather than a transitory feature for an industry dedicated to reaching poorer market segments. This implication needs further analysis but it is sobering for those who hoped that the spread of unsubsidized MFIs would eventually reach many smallholders. 22 See the general discussion of subsidies and grants for agricultural finance in Meyer (2011) and more specific information regarding supporting agricultural and rural finance in Sub-Saharan Africa in Meyer (2015). See also a recent review paper by Hazell, Sberro-Kessler and Varangis (2017) on the rationale and guidelines for subsidizing agricultural insurance. 8. THE ROLE OF SUPPORTIVE AGENTS AND GOVERNMENT POLICIES 35 it is best if the subsidy is limited to the insurer’s approach is the use of credit guarantees. Guarantees administration and development costs, including and insurance face some common challenges any high-risk loadings due to inadequate data but they also have some different advantages so, about the risks involved. As such, the subsidy depending on the situation, they can be complements could be paid directly to the insurer rather than or substitutes. used to subsidize premium rates, or, if the aim Just as insurance can be designed to cover specific is to subsidize high-risk loadings, offer the enterprises for specific risks, credit guarantees can insurer subsidized reinsurance. If the insurance be designed to cover different types, purposes, and is targeted at a specific segment of poor farmers, sizes of loans for specific categories of borrowers then the subsidy will likely have to cover part, if and regions. But guarantees have an advantage in not all, of the pure risk premium. that they can cover a wide variety of reasons for • Wherever the subsidy does include part of the borrower inability to repay while insurance covers pure risk cost, then practices should be adopted only specific insurable events. Both can be tied to to reduce disincentive problems. These include individual loans, as with credit-linked insurance, restricting the amount of subsidized insurance or they can be tied to an FSP’s aggregate loan farmers can buy for each insured crop, and portfolio, like meso insurance. structuring the subsidy in ways that respect the Both face potential moral hazard problems and relative risk levels across insured activities. can dampen borrower willingness to pay when When the insurance is targeted at poor farmers, they know their loan is coved by insurance or a they could be asked to pay an in-kind premium guarantee. For this reason, lenders have to decide by working on community projects that build if they are going to inform borrowers that their loan resilience. is included in an insurance or guarantee package. • Wherever possible, and especially for subsidized Both must be designed so they are cheap enough insurance intended for commercial farmers, to encourage borrowers and FSPs to use them but the subsidy should be used in ways that crowd not so cheap that they will be abused. For example, in private insurers and encourage competition it is often recommended that for guarantees, a among them. substantial portion of the credit risk should remain • To avoid adverse distributional outcomes, cap the with the FSP, often recommended at 50 percent, to amount of subsidized insurance available to each avoid moral hazard and to incentivize the build-up farmer. of good credit practices (Zander, et. al., 2013). Some reviews of guarantee schemes have arrived Alternative Policies at negative conclusions, especially about their As with all public interventions, some thought cost-effectiveness and impact on additionality in should be given to alternative ways of achieving lending. In the past, many guarantees have been the same objectives, and whether those alternatives poorly designed and managed, and as a result have might be easier or more cost effective. We note that not been sustainable without large subsidies. Large there has been little comparative work on how well losses encourage guarantee administrators to drag credit-linked insurance stacks up against alternative their feet and delay payments to FSPs for losses, policy instruments for achieving the same purposes but this undermines credibility and discourages of reducing borrowing risks for smallholders and participation. Moreover, many impact evaluations FSP risks for lending to them. One alternative of guarantees have been too poorly designed to UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 36 clearly demonstrate whether or not there was any floods. Either the guarantee fund needs to have additionality in lending, and this has helped feed some form of reinsurance or guarantee of its a cynical view that guarantee schemes have often own, or the FSPs need to back up the guarantee been developed as part of a show of political by purchasing insurance of their own or ask its support for borrowers or FSPs without giving much borrowers to buy their own insurance against such attention to designing the guarantee in ways that systemic risks.  For example, in Sri Lanka, under promotes efficiency and sustainability (Honohan, the “New Comprehensive Rural Credit Scheme” 2010; Meyer, 2011). or NCRCS, FSPs are backed by a guarantee in case of default by farmers. However, if a borrower On the other hand, many guarantee schemes have experiences difficulty repaying a loan because of operated successfully for years. For example, an crop damage caused by a natural calamity such as a FAO study reviewed credit guarantee schemes for flood or drought, then the defaulter is classified as small and medium sized enterprises (SMEs) and a “non-willful” defaulter and the FSP is expected farmers in India, Nigeria, Estonia, and Mexico. to reschedule the loan rather than start legal action The analysis of these four countries (plus 13 other and claim the guarantee. In this situation, FSPs shorter case studies) led to the conclusion that they can benefit from a combination of guarantee and are “neither the panacea nor the preferred option for insurance, where the insurance covers loan losses development finance that bankers tend to portray due to natural calamities. Also, borrowers may them as; however, neither are they doomed to fail, have their own incentive to purchase insurance as their critics would suggest when referring to since this could help them avoid defaulting in the the disadvantages of the public funding and start- face of a natural calamity and having to restructure up subsidies that are usually involved” (page viii, their loan, which may have negative effects on their Zander, et. al., 2013). Design and implementation future credit rating.  The Central Bank of Sri Lanka arrangements matter for guarantees, and need to be provides credit guarantees under the NCRCS “… adapted on a case by case basis.23 as a facilitation for the liquidity shortages that A combination of insurance and partial credit arise due to the non-payment of the expected loan guarantees might be a preferred alternative when repayment installments…”. The arrangements agriculture is subject to large exogenous shocks of how guarantees are handled for willful and and loan portfolios are concentrated in small unwillful defaulters are described in the Operating geographical areas.  In such situations, guarantee Instructions manual for the New Comprehensive funds may be too exposed if they protect FSPs Rural Credit Scheme of the Regional Development from all sources of default, especially defaults Department, Central Bank of Sri Lanka. due to systemic risks like regional droughts or 23 The World Bank and FIRST Initiative established a set of 16 Principles for Public Credit Guarantee Schemes for SMEs in 2015 to guide the design and operation of guarantees (World Bank, 2015). 8. THE ROLE OF SUPPORTIVE AGENTS AND GOVERNMENT POLICIES 37 UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 38 9. Key Lessons The literature consulted does not provide enough detail about similar cases in different circumstances to permit the development of a simple list of conclusions and good practice recommendations. There is a great deal of information about the limited uptake of crop insurance and the reasons for it. Several models have been created to show how FSP might benefit from credit-linked insurance but little data is available about what actually happens in practice. There are data about insurance costs and subsidies but little about the profits of insurers, the costly process of creating and testing products, building relations between FSPs and insurers, and the minimum scale of insurance required for viability. The literature does provide us with insights about issues facing the three parties so we offer here some preliminary conclusions or working hypotheses. What is clear is that the design of any scheme has to deal simultaneously with the interests of smallholders, financial service providers and insurers. Subsidies seem to be necessary at least to help cover startup costs, but the limited uptake by smallholder farmers may suggest the need for permanent insurance subsidies which raises the logical question, is this likely to produce the best return on scare resources? Value to FSPs in offering credit-linked insurance. Obviously, the key reasons for FSPs to offer crop insurance is to reduce default risks, reduce the use of costlier and less efficient risk management techniques, reduce interest rates, raise profits, attract more clients, reach poorer smallholders, compete better with competitors, etc. Insurance helps credit in environments where the main default risks are due to specific systemic risks (e.g. weather), insurance contracts can be accurately designed and implemented to cover such losses, and borrowers lack other means of posting acceptable collateral for FSPs (Carter et al., 2016). Marketing insurance for insurers may also generate fee income. But if the FSPs administer the insurance as part of their loan process, they will also have to train and monitor loan officers or others who explain and market the product to smallholders, and provide incentives to staff members who take on additional tasks related to insurance.24 If the FSP already sells 24 Zimmerman, et. al., (2016) report the results of a study on the impact of different approaches used by a MFI to sell insurance. 9. KEY LESSONS 39 or requires other types of insurance, say credit life, Credit offered by FSPs versus by agents it will have to spend much more time educating within value chains. Agents within value chains smallholders about this more complicated and have some advantage over FSPs in lending to expensive product. If index insurance is used, it farmers and this may make them less interested will have to explain the concept of basis risk, and in selling insurance. First, they gain information effectively handle complaints from smallholders from operating in another market (e.g. as input who experience losses but do not receive payouts. suppliers or purchasing output from smallholders) And it will have to deal with the potential defaults that is useful for credit screening and evaluating by those borrowers. An alternative to linking the creditworthiness of smallholders, while FSPs individual loans with insurance is for the FSP to have to engage in costly methods of acquiring and purchase meso insurance for portfolio coverage evaluating such information. Second, since they to hedge its exposure against systemic risks that simultaneously operate in other markets, they may can cause many of its clients to default. The FSP be able to exert market power and enforce loan would not need to cover each and every loan with contracts with smallholders dependent on them for such insurance (or hedge), the insurance would access to scare inputs or product markets. However, be cheaper (no need to retail it and does not cover there are limits to such power as competition grows every loan), and would have the discretion to use with the entry of new firms, which can lead to side the insurance compensation as need be. Two main selling by producers. Third, agents have a more caveats exist. One is that we do not have yet many holistic relation with farmers as they deal with experiences in such meso-level insurance schemes both physical purchases and financial transactions, to understand how well they might work. Second, which enables them to reduce costs and risks. is that the individual borrower could still default Insurance can be part of a holistic package of access or have his/her loan restructured which may have to markets, credit, inputs, and technical assistance negative impacts on the borrower’s good credit that raises the level of technology, productivity standing and/or the borrower may still lose his/her and income. Insurance being part of such package collateral. (e.g. contract farming) offers significant advantages to both agents (e.g. agribusinesses) and farmers. Use of insurance payouts by FSPs. If smallholders However, such schemes are often limited to farmers voluntarily buy insurance, then indemnities should within specific value chains and their scalability be paid directly to them unless they have an and replication may be limited. Fourth, compared agreement that the FSP should be the first claimant. to FSPs, agents are active in the field and are better Otherwise the smallholders would be reluctant to able to closely monitor their farmer borrowers. buy and to pay for it. If the insurance is embedded with the credit, then the FSP has more flexibility A problem faced by some value chain agents is is deciding how to use the indemnities, subject to that they are undercapitalized themselves and limitations established by banking regulations. If prefer to invest in their own businesses rather the FSP buys meso insurance, it should have more than make loans to farmers. Therefore, traders or flexibility to manage problem cases, to decide buyers may enter into formal purchasing contracts which loans to forgive or write down without with smallholders, which can serve as collateral eroding clients’ loan repayment culture, and to substitutes for smallholders to use in obtaining FSP manage customers most affected by basis risks for loans. Another limitation of agents is that they are index insurance. primarily interested in fulfilling the financing needs of farmers related to producing the main crop the UNLOCKING SMALLHOLDER CREDIT: DOES CREDIT-LINKED AGRICULTURAL INSURANCE WORK? 40 agent handles. Farmers, on the other hand, have Mandatory versus voluntary insurance coverage. other financial needs beyond production loans When insurance is directly linked with credit, that agents do not fulfill. Input suppliers that make the FSP has the choice of making the insurance loans to farmers would probably be less interested compulsory for its borrowers, or allowing them in credit-linked insurance unless they sell large to offer an alternative form of collateral. Making amounts of inputs used in just one type of enterprise the insurance compulsory has the advantages of in a small geographic area. Large product buyers simplifying FSP administrative arrangements, or agribusinesses, however, that process and sell reducing lending risks, and avoiding adverse large amounts of production, and have contracts to selection problems for the insurer. Its drawback is fulfill, would likely be more interested in requiring that it may discourage farmers from seeking loans. their borrowers to purchase insurance because This could happen for example with farmers who their entire businesses can be impacted by a have other less costly ways of managing their risk, widespread shock affecting their sources of supply. or who face basis risk when the insurance is index Likewise, a large FSP with a large portfolio of loans based, or who simply cannot afford insurance. In concentrated in one or a few commodities might be all cases the insurance might well be perceived by more interested than a small MFI with a few loans farmers as adding to the cost of their loan without to highly diversified smallholders. offering any commensurate benefits. Another key difference between mandatory versus voluntary Ability to enforce formal loan contracts. The insurance coverage is how it may affect farmer environment within which FSPs operate can make behavior. When farmers must purchase insurance a difference to their interest in insurance. If FSPs to get credit, they may be less aware of it and may operate where correlated risks are significant, they behave as if they are not insured. need substantial collateral to mitigate credit risks, and where other forms of collateral are not available, Investments and costs for the insurers. The insurance might serve as a useful substitute. When insurers that participate in a credit-linked program there are attractive opportunities to raise smallholder have to develop an insurance product that will productivity, insurance may encourage farmers to stimulate high borrower uptake, train the FSP to borrow and adopt higher yielding technologies, and effectively market it, educate smallholders about insurance may give the FSPs an additional nudge its value, and perhaps pay the FSP an incentive to lend to them. When the FSP can effectively because credit bundled with insurance will add to its and efficiently enforce loan contracts through the workload and costs. Unless it is an index product, use of collateral or collateral substitutes, it will the insurer will have to monitor smallholder likely be less interested in credit-linked insurance behavior to reduce moral hazard, assess damages, than one operating in an environment that does and determine the amounts of compensation to be not meet these conditions. Likewise, a FSP that is paid to the insured. Some of these costs might be under government pressure to lend, to be lax about covered in a subsidized insurance program if it was loan recovery, or to participate in loan forgiveness evaluated as meeting a social objective. programs will likely be interested in obligatory Impact of credit-linked insurance. In reviewing credit-linked insurance if it has the authority to the available literature and evidence on credit- utilize indemnities as it chooses to do. However, linked insurance, we are struck by how little is using it to selectively write off defaulted loans really known about its effectiveness in overcoming could destroy incentives for borrowers to repay. credit constraints for smallholder farmers. A proper 9. KEY LESSONS 41 evaluation would need to show how the insurance which are not adequately addressed in the available impacted the lending practices of FSPs, and how empirical case studies of credit-linked insurance. this in turn impacted farmers’ access to and use This leads us to one general recommendation: there of credit and the consequent impacts on their on- is a real need for more evaluations and impact farm investments, productivity and income. 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