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Rural demand for drought insurance

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  • Gautam, Madhur
  • Hazell, Peter
  • Alderman, Harold

Abstract

Many agricultural regions in the developing world are subject to severe droughts, which can have devastating effects on household incomes and consumption, especially for the poor. To protect consumption, rural households engage in many different risk management strategies - some mainly risk-reducing and some simply coping devices to protect consumption once income has been lost. An important limitation of these traditional risk management strategies is their inability to insure against covariate risks and they are also costly.. The absence of formal credit and insurance institutions, which offer an efficient alternative by overcoming regional covariance problems and reducing the cost of risk management, amounts to a market failure. Past research has paid much more attention to the supply-side reasons for this market failure than to the demand side question of whether there exist financial instruments that farmers want and would be willing to pay for. The authors use a dynamic household model to examine the efficiency of drought management strategies used by peasant households. An attractive feature of the method is that it exploits actual production (input-output) data and does not deal with the usually unreliable data on household consumption and leisure activities. The model is applied to a two-year panel of data on households from five villages in Tamil Nadu (South India). The sample is small, but the data are special, as one of the two years was a severe drought year. The results indicate that agricultural households exhibit significant risk-avoidance bahavior, and that even though they may use a range of risk management strategies, there still remains an unmet demand for insurance against drought risks. The study did not estimate the likely costs of supplying drought insurance, but the latent demand in the study region is strong enough to more than cover the breakeven rate of approximately the pure risk cost (the probability of drought) plus 5 percent administration costs. The findings confirm the inadequacies of traditional strategies of coping with droughts in poor rural areas. Because of the catastrophic and simultaneous effects of droughts on all households over large areas, there is limited scope for spreading risks effectively at the local level. Either households must increase their savings significantly (a problem with low average incomes and an absence of safe and convenient savings instruments), or more effective risk management aids are needed that can overcome the covariation problem. Improved financial markets (with both credit and savings facilities) could be helpful, particularly if they intermediate over a larger and more diverse economic base than the local economy. Alternatively, formal drought insurance in the form of a drought (or rainfall) lottery might be feasible, and the results suggest that it could be sold on a full-cost basis.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1383.

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Date of creation: 30 Nov 1994
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Handle: RePEc:wbk:wbrwps:1383

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Keywords: Environmental Economics&Policies; Economic Theory&Research; Banks&Banking Reform; Services&Transfers to Poor; Safety Nets and Transfers;

References

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  1. Hayashi, Fumio, 1985. "The Effect of Liquidity Constraints on Consumption: A Cross-sectional Analysis," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 100(1), pages 183-206, February.
  2. Benveniste, L M & Scheinkman, J A, 1979. "On the Differentiability of the Value Function in Dynamic Models of Economics," Econometrica, Econometric Society, Econometric Society, vol. 47(3), pages 727-32, May.
  3. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
  4. Binswanger, Hans P, 1981. "Attitudes toward Risk: Theoretical Implications of an Experiment in Rural India," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 91(364), pages 867-90, December.
  5. Alderman, Harold & Paxson, Christina H & DEC, 1992. "Do the poor insure? A synthesis of the literature on risk and consumption in developing countries," Policy Research Working Paper Series 1008, The World Bank.
  6. Stephen P. Zeldes, . "Consumption and Liquidity Constraints: An Empirical Investigation," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 16-88, Wharton School Rodney L. White Center for Financial Research.
  7. Hakansson, Nils H, 1970. "Optimal Investment and Consumption Strategies Under Risk for a Class of Utility Functions," Econometrica, Econometric Society, Econometric Society, vol. 38(5), pages 587-607, September.
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Cited by:
  1. Geyser, J.M., 2004. "Weather derivatives: Concept and application for their use in South Africa," Agrekon, Agricultural Economics Association of South Africa (AEASA), Agricultural Economics Association of South Africa (AEASA), vol. 43(4), December.
  2. Skees, Jerry & Varangis, Panos & Larson, Donald & Siegel, Paul, 2002. "Can Financial Markets be Tapped to Help Poor People Cope with Weather Risks?," Working Paper Series, World Institute for Development Economic Research (UNU-WIDER) UNU-WIDER Research Paper , World Institute for Development Economic Research (UNU-WIDER).
  3. Osborne, Theresa, 2006. "Credit and risk in rural developing economies," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 30(4), pages 541-568, April.
  4. Pandey, Sushil & Bhandari, Humnath & Ding, Shijun & Prapertchob, Preeda & Sharan, Ramesh & Naik, Dibakar & Taunk, Sudhir K. & Sastri, Asras, 2006. "Coping with Drought in Rice Farming in Asia: Insights from a Cross-Country Comparative Study," 2006 Annual Meeting, August 12-18, 2006, Queensland, Australia, International Association of Agricultural Economists 25553, International Association of Agricultural Economists.
  5. Larson, Donald F. & Plessmann, Frank, 2009. "Do farmers choose to be inefficient? Evidence from Bicol," Journal of Development Economics, Elsevier, Elsevier, vol. 90(1), pages 24-32, September.
  6. Anderson, Jock R., 2003. "Risk in rural development: challenges for managers and policy makers," Agricultural Systems, Elsevier, Elsevier, vol. 75(2-3), pages 161-197.
  7. Sarris, Alexander, 2002. "The demand for commodity insurance by developing country agricultural producers - theory and an application to cocoa in Ghana," Policy Research Working Paper Series 2887, The World Bank.
  8. Paulson, Nicholas D. & Hart, Chad E., 2006. "A Spatial Approach to Addressing Weather Derivative Basis Risk: A Drought Insurance Example," 2006 Annual meeting, July 23-26, Long Beach, CA, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association) 21249, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
  9. Nicholas D. Paulson & Chad E. Hart & Dermot J. Hayes, 2010. "A spatial Bayesian approach to weather derivatives," Agricultural Finance Review, Emerald Group Publishing, Emerald Group Publishing, vol. 70(1), pages 79-96, May.

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