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How a new type of insurance helps to relieve poverty in Ethiopia

Livestock owners in Ethiopia are in a hugely vulnerable position. Their livelihood is highly dependent on weather patterns and a drought could lead to catastrophic herd loss, potentially pushing them into extreme poverty. Livestock owners are currently unable to mitigate these risks since traditional insurance markets are overpriced and underprovided due to issues of moral hazard and adverse selection. However, a new form of index based livestock insurance (IBLI) addresses these issues by issuing indemnity payments based on objectively verifiable climatic reasons. In IBLI’s case the insurance pay-out is ingeniously based on vegetation levels as seen by remote satellite imagery which can be used to estimate livestock mortality rates.

This blog is based on Chris Barretts work in the Borana region of Ethiopia and the Marsabit region of Kenya.

How does Index Based Livestock Insurance (IBLI) work?

The median household in the Borana region of Ethiopia derives all their income from livestock and livestock products. Additionally, having more livestock is closely interlinked with being wealthier since the Boran hold their wealth almost entirely in the form of cattle. Drought is the single biggest risk that livestock owners face and IBLI gives them the option to insure their livestock against this risk. In Ethiopia, IBLI’s indemnity payments are triggered by changes in a Normalised Differenced Vegetation Index (NDVI) which acts as an indicator of available vegetation for livestock to graze on. If vegetation coverage is below a set level estimated to cause significant livestock mortality on the agreed date of the contract, payments are automatically sent to those that have bought insurance. Payments can be sent relatively easily since a cash transfer program had already been implemented in the region with the goal of reducing food insecurity. This established delivery infrastructure can also be used to offer IBLI contracts and register indemnity payments when necessary.

By paying out automatically once a certain critical limit has been reached, this type of insurance avoids the individual filing of claims, solves the problem of moral hazard and lessens adverse selection. As a result of this, IBLI insurance providers can provide a fairer market for the insurance and IBLI will be cheaper and more widely available than traditional insurance. This will enable livestock owners to use the insurance payments to protect themselves against catastrophic herd loss in unpredictable drought conditions.

Why is this important?

The reason why this is significant is twofold: the presence of a poverty trap for livestock owners and the paradox of social protection. A poverty trap exists whereby above a certain threshold level, dynamic herd size converges to a high level equilibrium (found in various studies to be between 30 and 45 livestock) yet below this threshold herd sizes diminish to a low level equilibrium below the poverty line (often just one milk cow). Protecting the ‘middle classes’ vulnerable to asset shocks is necessary in order to provide protection for the most vulnerable members of society in the future. This is the paradox of social protection.

The NDVI index

The index insurance calculation has been developed based on a Normalised Differenced Vegetation Index (NDVI). This is measured by satellite imagery which indicates the photosynthetic activity of the vegetation in a given location. This is used as a proxy for available biomass for livestock to graze on. By comparing the current vegetation covering to normal levels one can estimate how severe the drought is and the expected livestock mortality rate. If the vegetation coverage is below a certain level on the expiry date of the insurance contract, such that livestock mortality is estimated at 15% or above, indemnity payments are issued immediately. For more information about the creation of the index, click here.

Effectively, the livestock owners buy a European put contract on the vegetation level for a pre-designated set area within the region. The vegetation level is the strike and the contract pays out if the vegetation coverage is below the set strike level at the time of expiry. The idea is that livestock owners buy the contract for the area they most commonly migrate around and therefore their animals would be most impacted by if that region were to experience a drought.

Fascinatingly, this contract expiry date does not have to be set at the end of the rainy season. If rainfall has not come by a set time through the rainy season, the model can estimate with enough significance that there will be a drought that year. Therefore, if the livestock owners receive the insurance payment at this point, instead of at the end of the season when the livestock have already died or are really struggling, they can use the money to implement preventative measures to reduce livestock mortality such as buying livestock inputs or further migration.

Droughts have existed for centuries, why is insurance only necessary now?

Pastoralist livestock owners have evolutionarily adapted to a certain climate regime. However, with climate change increasing both the likelihood and severity of droughts, this system has become very fragile. In the past with droughts on average occurring once every seventeen years, one could reasonably expect good rainfall in the years following thus building their herd up again. If the drought risk doubles from this rate due to climate change, the pastoralist system collapses completely. There would no longer be a high equilibrium herd size resulting in all livestock owners being stuck in a low equilibrium poverty trap.

How does IBLI prevent poverty traps?

Droughts have the potential to push livestock owners into a poverty trap. If a severe drought causes a large proportion of their herd to die and they fall below this high equilibrium, their herd size would diminish to the low equilibrium level and it would take an external push or investment to move back to the high level.

Insurance allows livestock owners to prevent against catastrophic herd loss by receiving a pay-out in the event of drought. The livestock owners can then use this payment to ensure they do not lose all their livestock in one bad rainfall year and fall into a low-equilibrium poverty trap.

How does IBLI compare to other responses to drought?

Two of the most popular responses to drought in the past have been measures of post-drought restocking and food aid. These, however, have faced much criticism recently for being futile at low levels and being slow, expensive, reinforcing sedenterization and leading to excess mortality of both livestock and humans. IBLI’s marginal impact on income per dollar has also been 6-45 times as impactful as cash transfers.

The advantages of IBLI are also clear when compared to traditional insurance in the context of a less economically developed country like Ethiopia:

IBLI Traditional Insurance

IBLITraditional Insurance
+ Prevent downward slide of vulnerable population into low equilibrium poverty trap+ Prevent downward slide of vulnerable population into low equilibrium poverty trap
+ Crowd in investment from livestock owners to reach high equilibrium+ Crowd in investment from livestock owners to reach high equilibrium
+ Enables you to focus humanitarian resources on most needy+ Enables you to focus humanitarian resources on most needy
+ No transaction costs– Very high transaction + audit costs with little financial intermediation available
+ No moral hazard (preserves effort incentives)– Moral hazard
+ Reduced adverse selection– Adverse selection
+ Cheaper to purchase– More expensive to purchase
+ Potential to operate on widespread scale since the index measure is objectively verifiable and would not need major administrative costs– Expensive to scale up since each livestock owner would need to be audited on a case by case basis.
– Basis risk (potential for catastrophic herd loss and livestock owner to not get pay-out)+ Pay-out perfectly correlated with individual losses

Potential Scope of IBLI

In addition to IBLI being available in the Borana region of Ethiopia, the Kenyan government has taken IBLI nationwide with their ‘Livestock Insurance Program’. IBLI pilot studies have taken place in Zambia and Sudan with feasibility studies planned in South Sudan, Uganda, Somalia as well as plans to move into western Africa in Niger and Mali. Over 350,000 km2 are already covered by the insurance scheme with around 100,000 livestock units insured. However, expansion should not be rushed and instead should be carried out steadily. In each new region it is still vital to take the time to achieve the criteria for the creation of an objectively verifiable index, generate a reliable delivery channel for the insurance contracts and indemnity payments at a low cost as well as there being informed effective demand for the product.

Final thoughts

Even with IBLI it is important to note that livestock owners still hold the majority of the risk. There is also a non-zero probability that an agent buys insurance, suffers a catastrophic herd loss and does not get a pay-out. This is the nature of index insurance which can be a big problem for consumers and should be a key ethical consideration for humanitarian agencies. Despite this, IBLI undoubtedly mitigates some risk of catastrophic herd loss due to drought. The quick, objectively verifiable, immutable measure of satellite data in the public domain enables a trustworthy insurance market to be more fairly priced to a wider array of livestock owners.

This increased ability to manage risk helps livestock owners to avoid poverty traps, increases economic growth in the region and ensures aid is better directed to the most vulnerable members of society in the future, therefore decreasing extreme poverty. As a result of this, IBLI undoubtedly merits greater attention from insurance companies, humanitarian agencies and policymakers in order to provide index insurance on a wider scale in the future.

References

Pauly, M. V. (1968). The economics of moral hazard: comment. The american economic review, 58(3), 531-537.

Pauly, M. V. (1978). Overinsurance and public provision of insurance: The roles of moral hazard and adverse selection. In Uncertainty in economics (pp. 307-331). Academic Press.

Ikegami, M., Carter, M. R., Barrett, C. B., & Janzen, S. (2017). Poverty traps and the social protection paradox. The economics of poverty traps, 223-256.

Nikulkov, A., Barrett, C. B., Mude, A. G., & Wein, L. M. (2016). Assessing the impact of US food assistance delivery policies on child mortality in northern Kenya. PloS one, 11(12), e0168432.

Mude, A. G., Chantarat, S., Barrett, C. B., Carter, M. R., Ikegami, M., & McPeak, J. G. (2010). Insuring against drought‐related livestock mortality: Piloting index based livestock insurance in northern Kenya. Available at SSRN 1844745.

Wright, I. A. (2019). Importance of livestock production from grasslands for national and local food and nutritional security in developing countries.

Lybbert, T. J., Barrett, C. B., Desta, S., & Layne Coppock, D. (2004). Stochastic wealth dynamics and risk management among a poor population. The Economic Journal, 114(498), 750-777.

Barrett, C. B., Bezuneh, M., Clay, D. C., & Reardon, T. (2001). Heterogeneous Contraints, Incentives, and Income Diversification Strategies in Rural Africa (No. 642-2016-43959).

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