Establishing a Complementary Risk Fund for Index Insurance

Index insurance is a powerful financial tool that provides climate risk protection to low-income farmers in developing countries. However, under traditional index insurance offerings, farmers continue to face basis risk; where payouts triggered by the index fall short of covering their losses. The Capstone team was tasked with developing a methodology for determining the optimal size of a complementary risk fund that would help farmers expand their existing coverage under index insurance.  

The team built on the work of last year’s SIPA Capstone project that quantified the historical mismatch between weather-based index insurance payouts and farmer needs to inform the design of a complementary fund. Using the data from the World Food Programme's R4 Rural Resilience Initiative in the Amhara region of Ethiopia, the team illustrated the overarching approach and methodology that quantified the size of the complementary fund. The analysis indicated the high potential of using a complementary risk fund to bridge the gap between index-insurance payouts and losses incurred by farmers. The proposed approach allowed farmers to benefit from the diversification effect, resulting in a significantly lower premium when compared to their individual risk. Moreover, this report shed light on the cashflow sustainability of the complementary risk fund. Additional external sources of funds may only be required in salient years, which rarely occur, such as 1984 in Ethiopia where recurring drought and civil war triggered larger losses. Finally, the time-series analysis of Ethiopia data revealed that the earlier decades exhibited more severe damage compared to the recent years post-2000.