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The role of index insurance in Agriculture in the face of Climate Change

13th of December 2023

index insurance image © Ales Krivec Photography from The Noun Project

In a changing climate, where dealing with the consequences of extreme weather events requires substantial financial efforts to compensate for losses, insurance emerges as an attractive tool for climate risk management. Beyond its traditional role of financial assistance, insurance is a strategic player in reducing risk and bolstering resilience1 Using insurance in adaptation to climate change, European Union, 2018. ISBN 978-92-79-77288-7 .

The agricultural sector is becoming progressively vulnerable to the impacts of climate change, with effects on crops, livestock, soil and water resources, rural communities, and farmers. In traditional crop insurance, often referred to as indemnity insurance, farmers receive compensation for crop damage caused by severe meteorological phenomena such as drought, floods, hail, or frost, including so-called "multi-risk" crop insurance2 Antoine Leblois, Philippe Quirion. Agricultural insurances based on meteorological indices: realizations, methods, and research challenges. Meteorological Applications, 2013, 20 (1), pp.1-9. DOI: 10.1002/met.303.hal-00656778 .

© Drought (left-hand-side panel) and floods (right-hand-side panel) of an agricultural field.

The predominant form of indemnity insurance, known as multi-risk crop insurance , relies on assessing the shortfall between actual and expected yields at the individual farm level3 Remote sensing for index insurance 2017 International Fund of Agricultural Development (IFAD). ISBN 978-92-9072-772-9 . This type of insurance is based on the direct measurement of the loss or damage suffered by the farmer, a process which is often expensive or complicated.

Index insurance: benefits and challenges

In recent years, index insurance (often called parametric insurance) has been piloted as a risk management solution. Unlike traditional insurance models, based on the assessment of actual losses, index-based products provide a payout based on the trend of an index closely correlated to actual losses.

In weather index insurance, for example, the indemnity is not triggered by direct crop damage but by reaching a specific threshold in a meteorological index. Since the index is strongly associated with crop yield or loss, there is no need for a detailed on-site damage assessment. In addition to reducing complexity and costs, the system enables rapid indemnity payments.

Typically, all farmers in a specific area acquire the same policy at a uniform price and receive identical payouts when the index is triggered. The reduced administrative procedures and strong automated claims processes make index insurance strong more accessible, particularly for smallholder agriculture.

A key challenge associated with index insurance is the basis risk, characterised by the discrepancy between the actual losses and the compensation provided. For example, a farmer may suffer a loss of yield but not receive a payment, or conversely, a payment may be triggered without any loss having occurred. Another challenge is the limited availability, accessibility, quantity, and quality of weather and climate data, which makes it difficult to design reliable and scalable products for some areas and countries.

Weather index insurance in Europe: practical examples and applications

When designing a weather index insurance product, it is important to create a set of indicators that accurately capture the impact of the weather variables on the potential crop loss or yield. The goal is to establish a structure that optimally delivers payouts when losses occur4 Weather Index-based Insurance in Agricultural Development - A Technical Guide. 2011 by the International Fund for Agricultural Development (IFAD). ISBN 9789290722762 .

When designing a weather index insurance product, it is important to create a set of indicators that accurately capture the impact of the weather variables on the potential crop loss or yield. The goal is to establish a structure that optimally delivers payouts when losses occur .

Several weather variables can serve as components in the index, such as precipitation, temperature, wind, solar radiation, soil moisture, or their combinations. Among the rainfall-related indices, the simplest and most frequently used is the cumulative rainfall, which typically addresses both the drought and heavy precipitation risks. For example, extreme droughts during the growing season cause stressful conditions in European grasslands5 Finger, R., Gilgen, A.K., Prechsl, U.E. et al. An economic assessment of drought effects on three grassland systems in Switzerland. Reg Environ Change 13, 365–374 (2013). https://doi.org/10.1007/s10113-012-0346-x . In this context, weather index insurances are designed to insure against lacking precipitation and the payoff occurs whenever the index estimating dry conditions falls below a certain threshold. Vice versa, in case of excess rainfall, the indemnity is paid whenever the value of the index exceeds the pre-determined threshold.

Together with drought, heat events are also major drivers of losses in agriculture, especially when they are concurrent6 Haqiqi, I., Grogan, D. S., Hertel, T. W., and Schlenker, W.: Quantifying the impacts of compound extremes on agriculture, Hydrol. Earth Syst. Sci., 25, 551–564, https://doi.org/10.5194/hess-25-551-2021, 2021. . However, unlike drought insurance, the availability of heat index insurance in Europe is not as extensive. In this type of insurance, the indemnity depends on a meteorological index, such as cumulated temperatures (e.g. Growing Degree Days), which indicate by how much and for how long the temperature exceeds a predefined temperature threshold. For instance, an Austrian heat insurance accounts for heat stress focusing on days with temperatures above 30 °C7 Vroege, W., Dalhaus, T., & Finger, R. (2018). Index insurances for grasslands – A review for Europe and North America. Agricultural Systems, 168, 101-111. https://doi.org/10.1016/j.agsy.2018.10.009 .

The occurrence of compound events can be effectively addressed using combined indices. An example of such an index suitable for designing parametric insurance is the Extreme Climate Index (ECI). The ECI describes the nature of compound extreme climate events by including multiple standardized single-hazard indicators representing different climatological variables, such as:

  • The Standardised Precipitation Index (SPI)8 McKee, T.B., Doesken, N.J. and Kleist, J. (1993) The Relation of Drought Frequency and Duration to Time Scales. Proceedings of the 8th Conference on Applied Climatology, Anaheim, California, 17-22 January 1993, 179-184 , which describes drought events
  • The Standardised Heat Index (SHI), monitoring heat waves
  • The Standardised Wind Index (SWI), an indicator for windstorms

The ECI enables to detect the number of extreme climate events and to monitor variations in the frequency and magnitude of extreme weather events, indicating potential shifts to new climate regimes in a particular area9 eXtreme Climate Facility (XCF) - Index Design and Risk Modelling Policy Brief - Summary for Policy Makers 2018 . In the context of weather index insurance, the contract triggers payouts whenever ECI exceeds a predefined threshold.

Index insurance in the PIISA framework

In the context of PIISA project, the various pilots will evaluate the feasibility of insurance in multiple European countries, including both the enhancement of existing insurance schemes and the development of new insurance models.

For instance, the pilot related to Food and Agriculture will investigate the potential of weather index insurance, which is currently uncommon or absent in Finland but is gaining significance in other European countries. The project partners will collaborate closely with farmers, engaging in a co-development process to create a weather index insurance system that is not only efficient but also understood and accepted by end-users.

Additionally, the Forestry pilots will both explore and enhance existing insurance structures, including indemnity, index, and hybrid insurance as well as develop innovative wildfire insurance.

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Laura Trentini, Data Scientist