Promoting financial security and resilience in a fragile land
If you ask farmers how they view the future, their responses usually don’t overflow with optimism.
That’s especially true for those working on small plots of land, and for good reason: Being a smallholder farmer has always been an exceptionally daunting proposition. In addition to the long hours and hard – and often dangerous – physical labour involved, they must surmount multiple challenges and risks to harvest a profitable crop.
Financing for seeds, fertilizers and equipment is frequently scarce. The market prices their crops fetch at harvest can be volatile and unpredictable. Then there are the vagaries of the weather, always the scourge of farmers throughout history. And today, climate change is generating more and more of the kinds of unusual and extreme weather events that threaten widespread havoc among smallholder farmers. Too much or too little rain, prolonged heat or cold, hail storms, high winds; any of these can affect a harvest that falls short of expectations or fails entirely.
It’s not an easy living.
Nonetheless, smallholder farmers are a significant part of national economies around the world, and they often play vital roles in supporting local economies within their countries. Also, because their livelihoods depend on it, most smallholder farmers are capable stewards of the land.
Economically important agriculture
The challenges and risks noted above are even more pronounced for smallholder farmers in Nicaragua, a politically, economically and environmentally fragile country. With a turbulent history marked by political unrest and civil strife, Nicaragua is the most impoverished country in Central America and the second poorest in the Western Hemisphere. And in addition to earthquakes – the capital city, Managua, was destroyed by a massive tremor in 1972 – Nicaragua experiences tropical storms as well as prolonged droughts, weather extremes that are becoming more commonplace due to climate change.
Farming, most of which is done on small plots, is a substantial contributor to the Nicaraguan economy. Its crop exports – including coffee, nuts and bananas – were worth US$ 850 million in 2017, representing almost 16 percent of the country’s overall exports. (In comparison, crops raised in the U.S. and Canada, most of which were produced by large industrial agriculture operations, accounted for 5.1 and 5.8 percent of overall exports, respectively.) Moreover, agricultural production has grown substantially in Nicaragua; the value of its coffee exports alone, for example, rose more than fourfold from 1995 to 2017.
Boosting local resilience
Incofin Investment Management is an impact investor with a history of investing in financial institutions and the agricultural sector in emerging markets. The firm is keenly interested in solutions that boost the resilience of smallholder farmers, particularly given the varied weather-related risks that threaten agricultural production and rural livelihoods in fragile countries like Nicaragua.
This led Incofin, along with AXA XL, an external consultant and a local Nicaraguan insurance company Iniser, to develop a novel parametric insurance programme for smallholder farmers in Nicaragua. Launched last year in collaboration with two Nicaraguan microfinance institutions (MFIs), Micrédito and Fundenuse, this programme helps protect 6,000 coffee and grain farmers, more than 90 percent of whom possess fewer than 10 hectares of land. The scheme covers both excessive rainfall and prolonged drought, and payouts are activated when precipitation data from satellites record values that exceed or fall below pre-established region- and crop-specific rainfall triggers.
The team developing this programme had two overarching objectives that were reinforced by the Nicaraguan bank regulator. The first was limiting the potential for basis risk, and the second was ensuring that smallholder farmers benefit directly from any payouts. The solution: subdivide the country into twenty zones with separate indices for each zone, and apply a distribution protocol that targets payouts to those most affected by excessive rain or prolonged drought.
Minimizing basis risk
Basis risk refers to the possibility that an index doesn’t accurately reflect the actual situation on the ground; it can be either positive or negative. For example, drought-like conditions may affect some farmers even though the precipitation data doesn’t show that drought has occurred. Or the opposite: payouts may be made to farmers who nonetheless brought in reasonable harvests.
Basis risk is magnified in places like Nicaragua that contain many different microclimates and where farmers grow a variety of crops. In Nicaragua, for instance, coffee is grown in mountainous districts that are cool and wet, while grain farms occupy the warmer, drier coastal areas. A single index for the entire country, or even four or five indices covering different regions, could have led to considerable basis risk.
In this case, basis risk was minimized by splitting the country into twenty units based on their similar geography, climate conditions and crops. Although that meant creating separate models for each zone, the index values derived from these individual models are highly correlated with particular outcomes in these smaller, more homogeneous areas.
In this scheme, any payouts go to the MFIs; they act as the policyholders and risk aggregators and use the funds to restructure loans to farmers affected by the particular event.
After a payout is triggered, the MFIs first analyse their loan portfolios for the affected area(s) to identify the loans most at risk of default. Their next important step is to survey the situation on the ground to determine where and how the payouts can best help the farmers most in need; this approach also helps to curtail basis risk.
Based on these assessments, the MFIs use the payouts to grant grace periods, provide exemptions from interest payments for specified periods, or extend the terms of the loans. Whatever modifications are made, farmers who otherwise would be forced to sell some capital assets to satisfy their creditors – if not abandon farming entirely – now have the financial resources they need to plant new crops.
Ensuring that payouts have demonstrable and measurable social impacts was a core demand of the regulators. In fact, whenever payouts are made, the MFIs are obligated to file reports with the regulators detailing which loans were restructured and how. They also have to provide details on, for instance, the number of beneficiaries who are farming on less than two hectares, who rent rather than own land and who are women.
Not just for catastrophes
As is often the case when designing parametric programmes, another critical consideration was where to set the threshold levels – the point when payouts are triggered – for each zone. Lower threshold levels provide protection for more frequent events and typically are more expensive. Conversely, higher thresholds protect against less common threats and often are relatively less costly.
After extensive discussions with the MFIs and a survey of three thousand smallholder farmers, we set the threshold levels for both excess of rain and drought events to cover not only catastrophes but also what we characterize medium-magnitude events. For excessive precipitation, payouts are triggered even when the rainfall totals are only about 50 percent above average; for drought, they are made when the lack of rain is only slightly below average values.
Basing the thresholds on more frequent but still destructive medium-magnitude events has proven to be quite effective in fostering greater resilience and stability in rural parts of Nicaragua (the insurance has already generated two payouts, one for an extended drought and another for excessive rainfall). Historical analysis indicates that the performance of an unprotected portfolio won’t necessarily deteriorate markedly after damaging but less-than-catastrophic weather events. That’s evidently because many farmers avoid defaulting on their loans by selling capital assets or taking out second loans. The downside is that the impact of the next damaging event is amplified because individual farmers are in more precarious states due to ramifications from the last one.
One of the as-yet-unanswered questions about programmes like this is what effect they could have in boosting confidence among MFIs to invest in the challenging agricultural sector. A related issue is whether the increased protection that parametric-based coverages deliver will help attract additional private investment in areas that are now more economically stable and secure.
While time will tell, history suggests that a country is more likely to slip into debilitating decline if smallholder farmers with limited financial resources aren’t buffered from extreme weather conditions. Conversely, parametric programmes like the one described here hopefully will help create and nurture progressively greater economic growth and stability: a decidedly positive outcome for a fragile country like Nicaragua.
Finally, following AXA’s acquisition of XL Catlin, the AXA XL team can now leverage AXA Global Parametrics’ expertise and capabilities in developing parametric solutions for governments, private investors, NGOs and corporations to help bolster resilience in countries around the world.
About the authors:
Viktoria Popova is the Technical Assistance Manager at Incofin. She is in charge of the global portfolio of projects aimed at strengthening the capacities of Incofin portfolio companies in improving the wellbeing of rural entrepreneurs and smallholder farmers in emerging markets. Through the provision of technical assistance, Incofin helps to maximize the potential of its investments to generate social impact and to promote inclusive progress.
Niklaus Lehmann is a Senior Agriculture Underwriter with AXA XL’s International Reinsurance business. Nik holds a Ph.D. in crop modelling from ETH Zurich and is always open to discussing new insurance solutions for protecting agricultural production. Contact him at Niklaus.Lehmann@axaxl.com.
About Incofin IM
Incofin Investment Management manages impact investment funds and is a global leader in rural and agricultural finance. It is an AIFM licensed fund manager, advising and managing US$ 1 billion in assets. Headquartered in Belgium, it has a network of four regional offices and representations, and a team of 50 experienced staff with in-depth knowledge of rural finance and private equity.