Bundling agricultural credit with agricultural insurance has emerged as a promising strategy to mitigate climate-related lending risks related to smallholders, according to researchers.
The bundling mechanism protects both the smallholders and the financial service providers by providing a means to offtake/offset the climate risks that both parties could potentially face. By reducing climate risk exposure, this approach aims to de-risk financial service providers, incentivising them to serve smallholders, say the authors of a blog posted on the website of the International Food Policy Research Institute (IFPRI).
Reduced climate risk could also reduce credit default rates and reduce or even eliminate collateral requirements for agricultural loans, potentially enhancing the risk-bearing capacity of smallholder farmers and enhancing both their credit uptake and willingness to increase their farm-related investments.
Risk contingent credit
Since 2017, IFPRI has partnered with various research organisations, and local and international service providers to develop and implement an insurance bundled credit product more popularly known as risk contingent credit (RCC). RCC is a linked financial product that embeds insurance protection within its structure, which, when triggered, offsets loan payments due to the lender. The triggering event is defined around the most significant climate risk (such as extreme drought or flood events), that is highly correlated with individual crop yields, such as the extreme drought that has devastated maize yields in Zambia, for example.
With RCC, farmers do not have to pay a premium up front. Instead, farmers obtain a loan that allows them to purchase improved farm inputs such as seeds, fertiliser, chemicals, and irrigation equipment, and when the embedded insurance mechanism is triggered, their repayment obligation is reduced. When the insurance is not triggered, they pay an extra premium making the contract actuarially fair for both parties.
RCC is more financially inclusive than conventional credit products because of its insurance component, which is a substitute for collateral, that allows marginalised smallholders, especially women farmers to not only access the credit market but also face a lower risk of falling into a credit-driven poverty trap. In addition, the product’s structure aligns the interests of diverse stakeholders, including research organisations, and local and international financial institutions to support the climate resilience and long-term farm productivity of smallholders.
Evidence from pilots in Kenya and Ethiopia indicates that farmers with access to RCC tend to demand more production credit and increase investments in both improved seeds and fertilisers.
Expanding reach through scale and commercial sustainability
Developing business models that align the interests of smallholders and financial service providers is crucial to not only scale up insurance-linked credit products such as RCC but to also ensure commercial sustainability. Commercial sustainability requires that financial service providers can offer these products profitably without relying on government subsidies or donor support.
However, several demand- and supply-side constraints hinder their widespread adoption and long-term viability. During the pilots and fieldwork, the financial service providers with whom the field team engaged illustrated challenges related to high transaction costs, large residual risks (such as pests and disease, and other perils not related to the index), and the lack of efficient distribution channels. Meanwhile, challenges on the demand side include limited farmer awareness and understanding, limited financial literacy, lack of trust, affordability issues, and discrepancies in individual losses and the amounts of payouts issued.
Forging partnerships
Scaling up RCC and achieving commercial sustainability requires innovative solutions such as, for example, strategic partnerships with existing government financing initiatives for smallholders.
Established in 1975, the IFPRI provides research-based policy solutions to sustainably reduce poverty and end hunger and malnutrition in developing countries.
The authors of the article are Ms Martina Mascarenhas who is ClimBeR communications lead; Ms Anne G Timu, an Associate Research Fellow with IFPRI’s Foresight and Policy Modelling (FPM) Unit; and Liangzhi You is an FPM Senior Research Fellow. The CGIAR Initiative on Climate Resilience, also known as ClimBeR, aims to transform the climate adaptation capacity of food and agricultural systems in low- and middle-income countries.