Reducing climate risk for micro-insurance providers in Africa: A case study of Ethiopia

Recurrent climate hazards challenge subsistence farmers in developing countries. Reliance on various diversification strategies and traditional risk sharing among kin and families has serious limitations, such as the problem of covariate risk within such networks. Index-based crop insurance could help to reduce people's climate-related risk, but raising the necessary capital to make insurance schemes financially secure is difficult for micro-insurance providers. We examine the extent to which spatial pooling of micro-insurance schemes could reduce these capital requirements. We simulate a hypothetical insurance market operating in Ethiopia, using rainfall data and yield estimates for 15 stations. By performing a Monte Carlo analysis, risk capital required to keep the probability of financial ruin below a threshold value is identified. We investigate the marginal benefits of pooling increasing numbers of sites, as well as the relationship between the benefits of pooling and the spatial covariance of rainfall. We find spatial diversification to offer considerable savings in required capitalization with as few as three sites pooled, as well as a weak but significant relationship between rainfall covariance and those benefits. The results suggest that spatial pooling may be an attractive option for micro-insurers, worthy of a detailed case-by-case analysis when designing index-insurance schemes.