One of the biggest problems that farmers face in crop production is the volatility of weather patterns. A sudden drought, be it due to climate change or the whims and fancies of the gods, can lead to huge losses in crop yield and therefore income. As such, farmers require protection against the sheer unpredictability of weather – the so-called random acts of God that we are yet to fully predict or understand. The solution to this, many feel, lies in Weather Index Insurance.

Weather Index based Insurance is one of the new forms of Agricultural Insurance in India that holds much promise for overcoming the flaws of previous yield based schemes. This particular form of Insurance uses a specific parameter of weather in a given area, usually rainfall, as a proxy for the crop yield of the farmer’s landholding. Taking rainfall as the parameter, if net rainfall in a given season varies from an established level, the farmers will be compensated based on variance of the present rainfall from the established level of required rainfall.

This method holds many important advantages to area yield based schemes. First of all, it is far easier to calculate the indemnity payout in weather index based schemes, as it doesn’t necessitate actual assessment of yields in multiple tiny plots in remote rural areas. All that is required is to make a payouts based on the variation of the rainfall in a given area with an accepted standard level. This accepted standard level is calculated by comparing historical rainfall levels with crop yields and assessing the correlation between the two variables. Now, the advantage behind this form of insurance is that it is extremely transparent as the information required can be easily publicized and the method for calculating payouts is simple to understand. Moreover, as this index doesn’t require actual field based evaluation, the insurer is subject to far less information asymmetry leading to a reduction of moral hazard and adverse selection. These are particularly important considerations as they allow the insurers to dramatically reduce the premiums on the insurance products.

Finally, Weather Index Based Insurance has a much lower administrative cost leading to greater efficiency for both the insurer and the insured. The insured particularly benefits from this as the lower administrative costs and lower time lag allow for quicker claims payouts, which can be hugely important in times of severe income shocks. Thus, Weather Index Insurance has largely been seen as a more effective form of insurance than what has been provided in the past.

However, even this form of Insurance suffers from many important drawbacks that we must consider. To begin with, the weather in a given area may not always be representative of the weather in the entire area due to fluctuations in weather over small areas. This could lead to policyholders receiving inadequate compensations for their losses. Another important consideration is that the weather collection infrastructure in India is currently quite poor, leading to a lack of reliable data in remote rural areas. This can cause significant inaccuracies in production estimates due to the potentially significant proximity between a weather station and a given landholding.

An example of a simple weather station

Furthermore, historical weather data, needed to create models to estimate production yields, are also hard to come across, and when they are present, the costs of acquiring them are very high. Such data collection issues lead to imprecise payouts, with a variation of up to 40% between payouts and actual losses. In addition, the uncertainties caused by such data force insurers to higher premiums to compensate for what is known as ‘uncertainty loading’. Therefore, we find that a Weather Index based Insurance solution may not be the ideal solution either for providing Agricultural Insurance for farmers in rural areas. In the face of such problems, another new solution has been proposed which we shall proceed to see in the next blog entry.