Policy Brief: Altering Poverty Dynamics with Index Insurance in Northern Kenya

farmer in Kenya

The Hunger Safety net Program (HSNP), sponsored by the Government of Kenya and the United Kingdom’s Department for International Development, will provide reliable monthly cash transfers of approximately US$15 to households that live in extreme poverty in northern Kenya. These cash transfers should improve the capacity of beneficiary households to meet immediate, essential needs.

PDF imageYet will these transfers place households on a footing from which they can craft a pathway from poverty? If the processes that cause destitution in the first place are not altered, it is unlikely that HSNP transfers will, by themselves, generate sustainable poverty reduction.

Risk and realization of droughts and other large shocks in northern Kenya drive households into extreme poverty and make it difficult for them to escape once they are destitute. Mitigating risk should help alter these dynamics. Augmenting the HSNP program with an insurance-based productive safety net should offer the following three key effects.

Stem the downward spiral of vulnerable households. Because it provides indemnity payments after a shock, insurance should help stem the collapse into extreme poverty of vulnerable but non-poor households following a drought or related crisis. Insurance can help safeguard HSNP resources for the most needy by keeping their ranks from swelling to the point that they overwhelm the program following a crisis, when HSNP transfers are most needed.

Stabilize pathways from poverty through asset accumulation. By protecting assets against catastrophic loss, insurance strengthens incentives for HSNP-eligible households to build their asset base. If limited asset accumulation among the poor in northern Kenya is due not only to insufficient access to cash (which the HSNP can help resolve) but also due to the high risk of investment in this setting (which the HSNP cannot address), then insurance that mitigates these risks should provide a helpful stimulus for households to climb out of poverty.

Crowd-in finance for investment and growth. Private creditors that presently do not finance potentially high-return ventures due to drought risk might become willing to lend if the assets that secure loans could be insured. Insurance can thereby “crowd-in” much-needed credit for enterprises in the region without leaving poor residents excessively vulnerable to losing assets when nature fails them.

While this risk mitigation logic is clear, less clear is how to actually implement the needed insurance mechanism. Working with the HSNP team, BASIS researchers are creating and piloting a program that adds an index insurance mechanism to the HSNP cash transfer program in an effort to fundamentally alter poverty dynamics. We call this effort HSNP+.

Feasible Risk Mitigation through Satellite-based Index Insurance

At the heart of HSNP+ is an index insurance contract based on data routinely collected through satellite-based imagery. Conventional insurance contracts require measurement and calculation of individual losses and indemnities. In contrast, index insurance contracts are innovative financial instruments that can be implemented in the remote areas of northern Kenya where it would be prohibitively costly to observe, verify, and indemnify the losses experienced by specific households.

The idea of index insurance is straightforward. Payouts are not based on individual outcomes but on an aggregate index (for example, average livestock mortality rates) that is correlated with individual outcomes. Because this correlation is likely to be imperfect, index insurance covers only a fraction of the risk that the individual producer faces. The uncovered risk is referred to as “basis risk.”

Using an index that is based on data that is promptly, reliably, and inexpensively available (and not manipulable by either the insurer or the insured), the insurance contract makes compensation payment to insured beneficiaries whenever the data source indicates that the index reaches the insurance activation level, or “strike point.”

In northern Kenya, BASIS researchers have found that satellite-based measures of vegetative cover can be used to precisely predict the average livestock mortality experienced by local communities. Importantly, the quality of that prediction is highest for more catastrophic events. Provisional predictions have 85- 88% accuracy for average losses of 20% or more, climbing to 95-98% accuracy for average losses of at least 40%.

A predicted livestock mortality index based on vegetative cover indices is under development and will be used as the basis for an index insurance contract offered as a supplement in HSNP cash transfer program areas. A broad range of households should benefit from this index insurance contract: HSNP-eligible households that need a feasible incentive to help in the effort to escape destitution, vulnerable households at risk of a collapse into destitution, and betteroff, HSNP-ineligible households. National insurance companies and international reinsurance companies have shown high initial interest in this new product.

HSNP+ for Smarter Development

While there are strong theoretical arguments supporting the claim that insurance mechanisms can alter poverty dynamics, there is little direct empirical evidence. In cooperation with the HSNP team, BASIS researchers are implementing a rigorous impact evaluation to test hypotheses about the effectiveness of index insurance in altering poverty dynamics in risk-prone environments subject to widespread extreme poverty.

An important aspect of this evaluation will explore whether or not the asset accumulation and productivity effects of insurance are sufficiently robust that they create a case for subsidizing insurance premiums as an alternative to cash transfers or food aid. Background subsidies also will be used to explore the sensitivity of insurance demand to price. The initial rollout of the insurance is programmed for late 2009, and initial learning from this pilot project should be available by early 2010.

 

Further Reading

Barnett, B.J., C.B. Barrett and J.R. Skees. 2008. “Poverty Traps and Index-Based Risk Transfer Products.” World Development 36(10): 1766-85.

Carter, M.R., C.B. Barrett, S. Boucher, S. Chantarat, F. Galarza, J. McPeak, A. Mude, and C. Trivelli. 2008. “Insuring the Never before Insured: Explaining Index Insurance through Financial Education Games.” BASIS Brief 2008-07. Madison: University of Wisconsin.

Chantarat, S., C.B. Barrett, A.G. Mude and C.G. Turvey. 2007. “Using Weather Index Insurance to Improve Drought Response for Famine Prevention.” American Journal of Agricultural Economics 89(5): 1262-68.

 

This report is made possible by the generous support of the American people through the United States Agency for International Development (USAID). The contents are the responsibility of the Feed the Future Innovation Lab for Assets and Market Access at UC Davis and do not necessarily reflect the views of USAID or the United States Government.

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