Most Indians accept it as fate that if the monsoon is poor in any given year, it will have a significantly negative impact on the lives of millions living in India. Some lives, such as those of farmers, are affected directly because of poor crop yield; others are affected indirectly as the economic growth slows down. Similarly, the years with good monsoon bring smiles and prosperity to the lives of many. For instance, India recorded a sharp jump in its rate of growth after years of middling performance in recent years. One does not need to be a rocket scientist to infer this recurring pattern year after year; from the fiction of Premchand to Bollywood movies such as Lagaan, anyone growing up in India is imprinted with the picture of this unfortunate cycle meted out to millions of the poor and the hapless.

But it need not be this way. In the jargon of financial economics, monsoon risk is a diversifiable risk. In other words, it is an insurable risk. Though, one might wonder, who will provide the insurance against poor monsoon if everyone is adversely affected by poor monsoon? The answer is the international investor; most people in India might be adversely affected but most people in the rest of the world are hardly affected by poor monsoon in India. What seems like a huge aggregate uncertainty when seen from the point of view of a country is in fact merely a trickle when seen from the point of view of well-diversified international investors.

In practice, individuals have traditionally relied on informal mechanisms to protect themselves against the vicissitudes of nature. These informal mechanisms usually take the form of saving for the (non)-rainy day, transfers from family members less affected by these adverse outcomes, charitable donations by more fortunate members of society, government relief aid in various forms (e g, waiver of debt payments, free electricity, water and food for affected people, etc). At the level of the entire country or a state, relief may come from foreign aid and charity mobilised by relief organisations across the world. Even though, such informal risk-sharing mechanisms are important in a civil society, they bring their own uncertainty, are not very reliable and are generally limited to a local area international aid and support arrives only for extremely visible calamities. We should be able to do better than that.

Fortunately, a combination of formal insurance mechanisms using modern financial instruments, along with informal risk-sharing arrangements may provide a more reliable and more satisfactory solution to such recurring problems. Here is a simple blueprint of how this can be implemented in practice.

Large institutions, such as self-help groups; local banks and cooperatives; temples, churches, mosques, gurudwaras; even state and central governments; can enter formal insurance contracts against aggregate risks drought, floods, earthquakes, etc in the international financial and insurance markets. This can be accomplished either by buying insurance contracts from international insurance and reinsurance companies or by entering into financial derivatives whose payoffs are contingent on a publicly observable and non-manipulable index such as the average rainfall, or the average temperature, in a given period at any given location. So, say the average rainfall turns out to be disappointing affecting many people in a given village, the local institutions will get a cash infusion from their financial contracts. Conversely, if the rainfall is particularly good in a given period, the local institution will make a net payment to the (international) counter-party entering this transaction. The local institutions can then use their informal mechanisms to help the people adversely affected in their area. This eliminates the need for (or supplements) the uncertain and unreliable foreign aid that may or may not materialise when needed.

Derivatives on indices such as the average rainfall, or average temperature have indeed been debated from time to time. As far back as in the 1970s, Richard Sandor, widely recognised as a founder of the interest rate derivatives markets now traded worldwide, then at the Chicago Board of Trade, described the Indian situation with the monsoon as the most perfect opportunity to design a derivatives product! The securities legislation in India presently prohibits cash-settled products on anything thats not a deliverable security. So its not possible to launch a monsoon index futures contract until the regulators in India recognise and appreciate the fact that such derivative instruments can, in fact, provide effective risk-sharing mechanisms. 1

Weather insurance products for farmers have also been introduced recently. 2 For instance, ICICI Lombard, in a World Bank, IFC-supported initiative, conceptualised and modelled the rainfall insurance policies and sought out reinsurance. BASIX, one of Indias largest microfinance institutions, sold policies last year to groundnut and castor farmers in Andhra Pradesh through its Krishna Bhima Samruddi Local Area Bank. 3 Other insurance products implementing a hedge against an undesirable weather outcome in lending products that have rainfall insurance built in it have also been discussed recently. For example, the interest payments on a loan can be indexed to rainfall in such a way that a low rainfall obligates the borrower to pay a smaller interest on its loan and vice versa. Such innovative contracts are a big improvement over the failed crop insurance schemes that were tried in the past. Such insurance products are aimed at the individual directly.

What I am suggesting, however, is that formal insurance products not just against poor monsoon but many other risks that could be diversified away internationally must be targeted to institutions the self help groups, the temples, the local governments, etc rather than individuals. This will allow us to exploit economies of scale, minimise transactions costs, erect effective safeguards against improper use of financial derivatives and instruments, and at the same time more effectively deal with adverse selection and moral hazard issues that typically plague individual insurance contracts, often rendering them infeasible. These institutions, in turn, can use the informal mechanisms to insure individuals against diversifiable risks more effectively. For instance, rainfall may be related to farmer income only imperfectly. A farmer buying rainfall insurance directly will still be subject to residual risk caused by imperfect correlation between her income and rainfall. 4 Informal risk-sharing mechanisms may thus work better at the individual level.

Some institutions have already made a beginning in this direction. In a first such deal in India, a few weeks ago, BASIX bought a portfolio hedge from ICICI Lombard General Insurance Company against the risk of shortfall in rain during July 1 to September 30, 2004 in Adoni, (in the western part of Kurnool district), Anantapur and Khammam districts with 285 mm, 165 mm and 405 mm rain in the July 1-Sep 30 period as the payout triggers. ICICI Lombard has in turn reinsured it in the international weather risk market.

BASIX will be paid a compensation of Rs 20,925 (US $ 465), Rs 19,575 ($ 435), and Rs 22,050 ($ 490) per mm of shortfall below the respective trigger, for increase in their portfolio risk as a result of rain failure. The maximum rainfall cap has also been fixed at 50 mm per day for calculating the claim eligibility.

BASIX has made a payment of Rs 7.49 lakh ($16,660) for a maximum sum insured of Rs 70 lakh ($ 1,55,000). BASIX is proposing to disburse a total of Rs 180 lakh ($ 4,00,000) crop loans in the above three units. 5

Markets work well at larger scales and at a distance. Informal mechanisms work well at smaller scales and locally where information problems are resolved more effectively using social networks. An appropriate combination of the two can raise social welfare immensely. We must put our minds to it and, to use the phrase popularised by Nike, just do it.

Notes

1 I am grateful to Ajay Shah for bringing this to my attention.

2 It was encouraging to hear the finance minister Chidambaram mention the current governments interest in weather insurance in his union budget speech this year.

3 Details of this scheme are discussed in a working paper by Sidharth Sinha: Agriculture Insurance in India: Scope for Participation by Private Insurers, IIM Ahmedabad.

4 See Jonathan Morduch, 2001, Rainfall Insurance and Vulnerability: Economic Principles and Cautionary Notes, Working paper, New York University.

5 I am grateful to Vijay Mahajan of BASIX for providing me with this information

H T Parekh Finance Forum is being managed and edited by Errol DSouza, Shubhashis Gangopadhyay, Subir Gokarn, Ajay Shah and Praveen Mohanty. We are grateful for their involvement and assistance in bringing out this regular feature.