Essay On Advantages And Disadvantages Of Index Insurance

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MEMO #2 TO: National Farmers’ Bank FROM: Yuxiao (Sophy) Yang DATE: March 24th, 2014 SUBJECT: Advantages and Disadvantages of Index Based Insurance Introduction: For those whose livelihoods are closely linked to their environment such as farmers, a variable and unpredictable climate can critically limit development. A type of insurance, called index insurance, can help farmers tremendously as a climate-risk management tool in developing countries. Index insurance is different from a loss adjusted insurance in that it uses a weather index, such as rainfall, temperature, or humidity, to determine payouts. In rural parts of developing countries, traditional insurance is sometimes unworkable due to certain issues and index insurance resolves that. Weather index can only be used for risk that can be measured by an index. For example, we can use the rainfall index to determine whether or not there was a drought. A weather variable that can form an index must be observable and easily measured, objective, transparent, independently verifiable, reported in a timely manner, consistent over time, and experienced over a wide area. Advantages: Before, with traditional insurance, banks might be unlikely to lend to farmers if they think a drought will cause widespread defaults, even if the farmer could eventually pay back the loan. The farmer’s lack of access to loans limit their ability to invest in improved inputs. Farmers in poor rural areas are not only at direct risk from weather events but even if there was no bad weather, they’re also at a disadvantage because lenders might not extend credit to them due to the possibility of a risk. Research shows that farmers often sacrifice 10-20% of income when using traditional risk management strategi... ... middle of paper ... ...dressed. Basis risk is a huge disadvantage of this insurance, in order for the index insurance product to be successful, its payouts must be closely correlated with agricultural yields, especially in catastrophe-prone countries. We should offer lower premiums for it to be a more attractive product to consumers. However this puts more costs on the bank. But without the need for field assessors, a lot of money from that cost is being saved. It is very hard to come up with an insurance product that both parties much better off due to the fact that weather extremes can be highly unpredictable and there are so many factors associated with crop loss. However, weather based index insurance does make both parties better off even though there are extra costs added into it. Overall, it would improve the livelihood of farmers as well has be financially sustainable for our bank.

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