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In our previous blogs for this series, we explored the potential for meso-level insurance through the lens of sector experts. We also explored the attitudes of private insurers for administering such a product and finally looked at the benefits of meso-level risk management for Farmer Producer Organizations(FPO) acting as aggregators. This piece explores another type of intermediary, financial service providers, as potential beneficiaries of meso-level insurance.

Globally, over the past decade and more, a variety of index-based insurance products have been designed to offer solutions for farmers to mitigate the risks such as those from extreme weather events. However, farmers in developing countries have been slow to purchase these products as stand-alone. Existing evidence points to weak demand as a contributing factor in low take-up, as the products are perceived as expensive, poorly understood by the target segment, or not tailored to meet the needs of famers. Making insurance work for the poor has largely involved bundling it with credit-based products which resonate stronger with the needs of poorer populations such as smallholder farmers.

In India too, under the Pradhan Mantri Fasal Bima Yojana (PMFBY), the emphasis has been on loanee farmers until recently, when opt-in was made voluntary. This is a case with microinsurance where the financial service provider (FSP) offers a bundled insurance product directly to the farmer. In such an arrangement, when farmers buy insurance directly, the linkage to credit arises only if the farmer offers it as proof of reduced risk exposure to the FSP. It allows the farmers to buy the insurance coverage that they need, and utilise the payouts as they choose. For the financial institutions offering loans, the problem is — even if the insured borrower is considered less risky, there is no way to compel the farmer to use claim payments toward loan repayment. A potential down-side to this arrangement is the high-basis risk for the insurers, where the claim payments are not in line with the actual losses experienced by individual small holder farmers. The loan can be paid off with an indemnity even if the farmer has not experienced a loss and is capable of repaying their loan. The opposite can also happen; the farmer may incur a loss but the insurance does not pay out, in which case the farmer still has to repay the loan in addition to the insurance premium. This is what causes the farmers to doubt the genuineness of the entire payout process while also contributing to lack of voluntary uptake of such insurance products.

An alternate arrangement, at the meso-level, can potentially overcome this issue. A meso-level arrangement insures the financial institution’s loan portfolio at a more aggregate level. The insurance is used as an internal risk management tool to cover default risks arising from large and systemic agricultural shocks. It might take the form of a single insurance policy that pays the policyholder a lump sum when an adverse event occurs, such as a large flood or prolonged droughts. The insurance premium in such a case is paid by the financial institution, which may recover all or part of this cost, by charging its borrowers higher interest rates. An interesting aspect of meso insurance is, that the lender has full discretion to utilise the insurance payouts, subject to the rules of regulatory authorities. By removing some of the systemic basis risk in the lending portfolio, meso insurance may enable the lender such as microfinance institutions or regional rural banks to take on more risk and expand its lending to smallholders. An important feature in this case is that the lender may be incentivised to expand its lending, even though little is done to insure the risks of individual farmers. Globally, testing of such arrangements has yielded positive results. In relation to El-Nino related flooding events in Peru, Collier, Miranda, and Skees (2013) tested a portfolio insurance-like mechanism to transfer part of a local MFI’s disaster risk. A key short-term outcome showed that insurance prevented the contraction of credit during the period following a disaster. In the medium to longer term, the MFI not only reduced their vulnerability to risks from loan defaults, but also enhanced financial inclusion in the concerned region. Another experimental study from Ghana examined how bundling index insurance with agricultural production loans for smallholder farmers affects the demand and supply of credit. The two treatment arms consisted of 1) farmers who were direct policy holders with autonomy on using any indemnity that arises (micro insured loans) and 2) farmers who were not direct policy holders but the indemnity would be used to service the loans (meso insurance loans). A key result was that while bundling index insurance with agricultural loans did not significantly increase loan applications submitted by farmer groups, it significantly increased the proportion of loan applications approved by lenders in the case of meso insurance loans.

While much of the gains from such arrangements hinge on careful regulatory oversight, bundling credit and insurance at the meso-level for financial service providers who work with farmers is worth exploring further as it offers a pathway to tackling the twin objectives of enhancing farm income as well as managing risk effectively.

This research was developed as part of the Bharat Inclusion Research Fellowship.