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MEMO #2 TO: National Farmers’ Bank FROM: Yuxiao (Sophy) Yang DATE: March 24th, 2014 SUBJECT:

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MEMO #2
TO: National Farmers’ Bank
FROM: Yuxiao (Sophy) Yang
DATE: March 24th, 2014
SUBJECT: Advantages and Disadvantages of Index Based Insurance
Introduction:
For those whose livelihoods are closely linked to their environment such as farmers, a variable and unpredictable climate can critically limit development. A type of insurance, called index insurance, can help farmers tremendously as a climate-risk management tool in developing countries. Index insurance is different from a loss adjusted insurance in that it uses a weather index, such as rainfall, temperature, or humidity, to determine payouts. In rural parts of developing countries, traditional insurance is sometimes unworkable due to certain issues and index insurance resolves …show more content…

Field loss assessment is a challenge for any insurance program because of the need to use a large number of skilled assessors therefore using an index insurance can significantly reduce administrative costs by reducing the need of fiend assessment. The chance of dispute between the farmers and assessors will also not exist. Another great advantage of index insurance is the fact that there would be less adverse selection and moral hazard. With traditional insurance, there might exist conditions where farmers may actually prefer their crops to fail so that they can receive a payout. However, with index insurance, payout is not linked to the crops survival or failure so the farmer has the incentives to make the best decisions. This greatly reduce moral hazard. For adverse selection, with index insurance, farmers are more likely to buy insurance if they have a higher risk. Due to index insurance, the terms, conditions, and payout scale is predetermined in their area which basically eliminate the adverse selection problem. With index insurance, farmers will feel safer and more likely to take loans from the bank which they will be able to pay back due to the insurance policies way of reducing risk greatly.
Disadvantages:
One of the biggest disadvantage of index insurance is the concept of basis risk. The basis risk is the difference between the payout measured by index and

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