Climate change is resulting in an increased frequency and severity of droughts in countries such as Senegal and Ethiopia. For smallholder farmers who are dependent on rainfed agriculture and have limited protection from climate impacts, climate change has the potential to devastate livelihoods, perpetuating the cycle of poverty in rural communities. Climate-smart agriculture offers the potential to increase the adaptive capacity of farmers while increasing incomes. However, climate-smart investment entails risks and costs that oftentimes risk-exposed farmers are unwilling or unable to manage.

Along with climate-smart agriculture, index-based insurance has attracted considerable attention and shown promise as a tool to help reduce investment risk. The two work in complementary ways, and insurance has the potential to reduce investment risk under certain conditions. The conditions under which insurance incentivizes climate-smart investment, however, have not been adequately addressed in the existing body of literature. Informed by lessons learned from two projects in Senegal and Ethiopia, the Capstone team posited that the appropriate combination of tools for reducing investment risk depends on a range of factors, including 1) weather and basis risk, 2) the technology’s cost, profitability, and protection, and 3) risk exposure and loss.

The team developed an interactive risk analysis framework that simulates the farmer’s decision- making process for various investment options given a set of parameters, using stylized inputs based on approximate costs and prices for a smallholder farmer in Senegal. The model confirmed that insurance’s ability to de-risk investment depends largely on the interaction between the three aforementioned factors. At lower levels of climate risk, farmers may not need both technology and insurance to cover productive risk. In such a case, subsidizing technology rather than insurance may be more effective. At higher levels of climate risk, farmers may need both technology and insurance to manage productive risk. Under these conditions, it may be better to subsidize insurance rather than technology, and insurance may function to mitigate the residual risk that technology is unable to mitigate.