Bundling Drought Tolerance & Index Insurance to Manage Drought Risk

Travis J. Lybbert & Michael CarterUniversity of California, Davis

Intl. Consortium on Applied Bioeconomy ResearchRavello, June 2013

Three Basic Ideas

1. Risk and vulnerability as experienced by poor households is often complex and nuanced

2. Reducing household vulnerability requires an appreciation of these complexities

3. Promising agricultural technologies may be necessary but are rarely sufficient

We illustrate these ideas using drought vulnerability and drought tolerance

The Smallholder Drought Burden

• Drought may be a universal lament among farmers, but spatial drought heterogeneity is massive

• A pure ‘subsistence burden’ is the exception rather than the rule

• Poorly functioning or missing credit / insurance markets therefore amplify drought vulnerability

• Drought events can harm the poor directlyAn obvious, ex post burden

• The threat of drought is like a bullyA hidden, ex ante burden Can outweigh the ex post burden!

Bundling Agronomic & Financial Innovation to Reduce Drought Vulnerability

• Recent innovation in both drought tolerance and index insurance Investments, hype, hope…some results

• In isolation, each has a limitationDT can’t tolerate extreme droughtFull DII may be too expensive for many

• Properly bundling the two may help resolve these limitations due to a natural complementarity

Drought Tolerance

• Longstanding breeding objective…with new tools, renewed promise and high hopes

• Massive private sector investments from Pioneer, Syngenta, Monsanto and others

• New DT seeds being released

US Drought Tolerance Prospects• The reported average DT maize yield benefit in U.S.

in 2012 was 5-10 bu/ac (5-17%)• This yield benefit is conditioned on drought severity

and is therefore ‘stochastic’

Drought Tolerance For Smallholders• Public research and development funding has prioritized DT

in a big way in the past decade• Drought as the universal lament of farmers

Public-private partnerships (e.g., Drought Tolerant Maize for Africa, Water Efficient Maize for Africa, etc.)

• But rich droughts and poor droughts are not alike

* Sort of.† Maybe.‡ Sometimes.

*†‡

DT Benefits & the Nature of Drought

50 bu/ac is the 90th percentile of maize yield in Ethiopia!

Moderate ExtremeSevereModerate

Non-Monotonic DT Benefits Reduce Value of DT to Smallholders and Slow Learning (Lybbert and Bell 2010)

Index Insurance

• Championed recently as a promising alternative to conventional crop insurance

• Contract tied to index that is correlated with individual outcomes to dodge moral hazard and adverse selection problemsBasis risk and transparency tradeoffs

• A growing set of experiences and rigorous evidence suggests that it may reduce both the ex post and the ex ante drought burden

• Unlike DT, drought index insurance payouts are monotonically increasing in drought pressure

Index Insurance Experimentation• Rainfall

China, India, Malawi, Nicaragua, Ethiopia• Satellite

Mexico, Kenya, Ethiopia• Satellite + Rainfall

Ethiopia, Kenya, Mali• Area-yield

Peru, Ecuador• ENSO

Peru

Drought Index Insurance (DII) Prospects

o Will smallholders pay actuarially fair prices?o How sustainable will index insurance markets be?

• In contrast to DT, the marginal costs of providing DII are high

Beyond pilots public support for DII will be limitedFinancial and commercial viability critical for DII

• Price elasticity of demand for DII is thus critical• Price has often limited uptake of index insurance

DT-DII Complementarity

Net Benefit

Calibrating a DT-DII Product: Ecuador

• Rainfed, drought-prone maize production in Guayquil (2001-2011)

• Assume DT maize confers yield benefit of 20% at ‘optimal drought’, which fades with less/more severe drought pressure

• Area-yield index insurance product calibrated and priced according to historic maize yield

• How would a DT-DII bundle compare to DT and DII in isolation?

Traditional v (Stylized) DT Maize Yield Distributions

Yield-Earnings Profiles

What’s a bundled DT-DII product worth?Ecuador Calibration Results

• Lessons from the “Biotech Yield Endorsement” pilot of USDA/RMA• Bundling with index insurance eliminates threat of audits and

monitoring – but other implementation challenges remain…particularly in developing countries

In Summary…• All farmers fear drought, but spatial heterogeneity implies

important differences in the drought burden• DT crops may partially lift the ex post drought burden, but

drought will continue to ‘bully’ many poor households• Index insurance is promising but can be expensive – and is

harder than DT to sustain through public support• A DT-DII bundle may resolve these limitations – now is the

time to calibrate, experiment and evaluate• Improving food security will require more than a

technocentric ‘build it and they will come’ approach – must appreciate the smallholder perspective on climate change adaptation and associated risks

Thank you