Via Marginal Revolution:
The latest issue of Access Finance has a short note on an innovative index-based livestock insurance pilot in Mongolia. This project presents a unique opportunity to design and implement an original agriculture insurance program using a country-wide agricultural risk management model designed by the World Bank.
An index-based insurance product to indemnify herders based on the mortality rate of adult animals in a given area was recommended. The index-based livestock insurance (IBLI) policy pays indemnities whenever the adult mortality rate exceeds a specific threshold for a localized region...
The proposed insurance program… combines self-insurance, market-based insurance and social insurance. Herders retain small losses that do not affect the viability of their business, while larger losses are transferred to the private insurance industry and only the final layer of catastrophic losses is borne by the government.
The traditional individual livestock insurance (based on individual losses) was ineffective in Mongolia: high loss adjustment costs due to the spread of animals among vast areas, ex ante moral hazard inducing herders failure to take effective measures to protect their stock, and ex post moral hazard leading herders to falsely report animal deaths are among the key endemic problems that plague the traditional livestock insurance program in Mongolia.
This is a clever way to deal with moral hazard, but what about basis risk, the imperfect match between index payouts and individual livestock losses?