by Mosleh Ahmed FCA, Director,
The Professional Consortium, Colombo, Sri Lanka and CEO, Microinsurance Research Centre, St Albans, UK
Background
Climate and society are inextricably linked. For example, droughts and severe winters impact agricultural productivity and lead to food shortages. In Mongolia, the connection between climate, human, and animal populations is exceedingly clear. The land features a varying topography and an extreme continental climate, with long and harsh cold winters, short but very hot summers, and low annual precipitation. The country is vulnerable to extreme climate events and is often affected by episodes of extremely cold winters and droughts. Such climatic extreme events are particularly deleterious to livestock (goat, sheep, cattle, camel, horses), and often cause high mortality, and are known locally as dzud, a severe winter whereby the grazing land freezes hard combined with snow that makes it difficult for free range animals to access natural fodder, and consequently high levels of livestock mortality has a major impact on rural poverty. Dzud events occur approximately once every five years and result in the death of millions of the country’s livestock.
This term is unique to pastoral communities in Central Asia and can be caused by a combination of summer drought, heavy snowfall, and high winds in concurrence with extremely low winter temperatures which combine to cause unsustainable conditions for animal survival. The livestock that normally sleeps in open areas at night, exposed to bitter cold and high wind, which often brings the chill factor to as low as minus 50 degrees centigrade freezes to death. Mortality is caused by a combination of starvation because of being unable to graze and access fodder due to heavy snow, ice or drought, freezing due to extreme cold temperature, exposure to storms and the wind, and a weakened immune system due to exposure.
Livestock numbers in Mongolia rose precipitously following the collapse of the Soviet Union in the 1990s when with a population of just 2.1 million, it had a livestock population of nearly 33 million. Three events occurred in successive years between 2000 and 2002; during this period livestock numbers declined drastically, from over 33 million heads in 1999 to 23 million in 2003. This led many herders to migrate to urban centres and join the ranks of the urban poor. By 2007 Mongolia’s livestock population rose to over 50 million. During the exceptionally harsh winter of 2009 – 2010, livestock numbers were again severely impacted, and dropped by 9.7 million animals or 20% and in some areas, herders were left without a single animal.
In Mongolia, full-time herders with growing herds of between 200 and 500 animals, account for around 25 percent of herder households. These households are typically from middle or lower wealth levels. While herding can support the household, they are unable to increase herd numbers due to their limited capital and pastures. Full-time herders with fewer than 200 animals (and frequently less than 100) are considered poor households; they account for around 30% of herder households. They are often dependent on state support, and for them, herding may not be a preferred livelihood, but they have no other alternative sources of income. There are also periodic herders, usually with fewer than 200 animals, who come in and out of the livestock sector, depending on their economic circumstances. They account for around 20% of the herder households. For them, herding is often a safety net or fallback option. This group includes recent migrants to urban areas for whom the move may not be permanent.
Livestock based industries account for 87% of agricultural GDP in Mongolia and support at least half the population. The government has prioritised the livestock sector in response to a number of dzud disasters and has experimented with several programs of sectoral reform. The government’s main responses to the disaster have been through re-stocking programmes that have proved to be relatively inefficient and failed to provide the right incentives to herders.
The latest surveys show that in the past few years the percentage of rural poverty has increased to 43%, and now exceeds the 31% of urban poverty, partially contributed to by dzud. It is clear therefore that strengthened measures are needed to mitigate the socio-economic impact of livestock losses due to dzud and other causes in order to achieve Government policy objectives for poverty reduction.
Insurance sector in Mongolia
The Mongolian insurance sector is underdeveloped and under capitalised. Livestock insurance is a key element of risk mitigation but the conventional insurance approach, based on individual herder losses, is ineffective in Mongolian conditions and is limited to a small number of high-value livestock. It is unpopular with both insurers and herders; the cost of verification is high and moral hazard is quite rampant. High loss adjustment costs, spread of animals among vast areas, ex-ante moral hazard, ex-post moral hazard, herders failure to take effective measures to protect their stock, herders falsely reporting animal deaths are among the key endemic problems that plague Mongolia’s traditional livestock insurance sector. Monitoring individual herders in the vast territory of the country is a nearly impossible task. Dzud disasters of 1999 to 2002 and its effect on the country and it low-income population demonstrated that government alone cannot cope with the situation.
Research showed that an index-based insurance product to indemnify herders based on the mortality rate of adult animals in a given area would be more suitable. A weather index-based product was considered as the first alternative to individual insurance because Mongolia has reasonable historical livestock mortality data to support the risk analysis. However, the infrastructure of the weather system is not well developed; there are very few weather stations and they are far apart, limiting the availability of information required for weather-based insurance products. Furthermore, Mongolian weather patterns are complex – the summer to winter temperature varies from + 50 degrees centigrade to – 50 degrees centigrade. The dzuds are sudden, lengthy and complex events, consisting of multiple weather phenomena over a period of time, and sometimes non-weather factors, making the classification of risk highly problematic.
In 2001, the Government of Mongolia requested assistance from the World Bank to address the ageless problem – frequent and high death rates in the livestock population. The country had a social livestock insurance program during the communist period but several attempts to pass a livestock insurance law since then have failed. Mongolia looked for a collective system for indemnifications; an indemnity payment based on a transparent index designed to reflect the loss incurred by the herders; such as index-based insurance (e.g., area-yield insurance, weather index-based insurance). Such a scheme has some advantages (e.g., reduction of moral hazard and adverse selection, lower administrative costs), but their main impediment is that the index payout may not exactly match the individual livestock loss; a challenge called the ‘basis risk’.
Basis risk in index insurance arises when the index measurements do not match an individual insured’s actual losses. There are two major sources of basis risk in index insurance. One source of basis risk is poorly designed products, and the other is geographical. Product design basis risk can be minimised through robust product design and back testing of contract parameters. Geographical basis risk is a factor that arises due to the distance between the index measurement location and the production field. The greater the distance between the measurement instrument and the field, the greater the basis risk. Some households that experience loss may not receive compensation while others that experience no loss may receive payments. Basis risk is reduced when the area covered by the index is homogeneous both in terms of weather and in terms of farming techniques. Therefore, as the density of weather stations and satellite pixels is increased, basis risk is minimised.
Based on significant concerns regarding informational asymmetries and extreme monitoring costs that could accompany a traditional livestock insurance program in the vast open spaces of Mongolia, the World Bank recommended an index-based insurance program using mortality rates by animal species and aimags (provinces). The World Bank also recommended a combination of self-insurance by herders, market-based insurance with private insurers and social insurance by the government. Given that this is an innovative approach to a significant problem in Mongolia, and the first developing country in the world to try it, the Government of Mongolia was persuaded by the World Bank to begin a three-year pilot program in three aimags – Bayankhongor, Uvs and Khenti, with substantial funding from the World Bank.
Index-based Livestock Insurance Programme (IBLIP)
In 2005 the Government entered into a credit agreement with the World Bank to implement the Index-Based Livestock Insurance Program (IBLIP), which is an index-based insurance program based on livestock mortality rates by animal species and three aimags rather than an individual’s livestock mortality. It incorporated “risk-layering” whereby the herders bear the cost of small losses that do not affect the viability of their business; larger losses are transferred to the private insurance industry and the final layer of catastrophic loss is borne by the Government. Insurance is provided through partnering with local private insurance companies. The pilot project began in 2006 and was implemented into three of Mongolia’s 21 aimags and following the pilot program’s success, IBLIP received further funding from the World Bank to expand to all of Mongolia’s 21 aimags by 2012. Mongolia actually accomplished this target by 2010 – a very creditable achievement.
While not formally designated as “microinsurance”, the IBLIP provides access to much-needed insurance for a segment of the population that would not otherwise have access to it. While many of Mongolia’s herders would not be considered low income, they are at considerable risk of losing most of their assets and income potential during a dzud. In 2010, approximately 22% of the livestock in Mongolia perished due to the dzud that occurred that winter. Without insurance coverage, all herders are vulnerable to financial insecurity as a result of livestock losses due to severe weather conditions.
Since inception in 2006, IBLIP premium has been increasing every year. From 2006 to 2010, the total premium income of IBLIP was MNT 1.4 billion, MNT 963 million was allocated into the Livestock Indexed Insurance Program (LIIP) account, and a total MNT 2.7 billion of indemnity payment was distributed to insured herders. As of 2013, 19,447 herder households (13.5%) out of a total 144,512 herder-households from 21 aimags voluntarily took part in the IBLIP and paid a total premium of MNT 1.8 billion in 2013.
Statistics used to measure livestock mortality
The government has been conducting an annual census of animals in Mongolia for more than 50 years. The procedures are well established and have numerous laws that attempt to protect the integrity of the process. Nonetheless, there are potential problems with these data once an insurance product is developed to pay compensations based on the mortality rates. New systems to track the same families are be developed continuously at the National Statistics Office (NSO).
To assure a timely payment, a new animal census was conducted at the end of May and at the end of December 2006. Mortality rates of adult animals are now based on the May and December Census. The U.S. Department of Agriculture Statistics Service provided special technical assistance during the census. This assistance was targeted at a lower cost and more accurate procedure that will use sample survey techniques. At the end of the census, an evaluation was made about the sustainability and reliability of alternative methods for estimating mortality rates and all concerned parties were satisfied. A robust and reliable database of livestock mortality now exists in Mongolia. A paradox, while the country does not reliable human mortality table, it has a very reliable and robust livestock mortality table going back to almost 50 years.
How does IBLIP work?
IBLIP 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 the final layer of catastrophic losses is borne by the government.
The index-based livestock insurance (IBLI) policy pays indemnities whenever the adult livestock mortality rate exceeds a specific threshold for a aimag. This system provides strong incentives to individual herders to continue to manage their herds so as to minimise the impacts of major dzud events. Under this programme, a better-managed herd would have no loss or lower loss, whereas a badly managed neighboring herds would have large losses; the better herder would be rewarded for the extra efforts made by him/her and receive a payment based on the area losses while he/she may not have suffered any loss at all.
Herders pay a premium based on the value of their animals reported and the relative risk in the aimag that they select. The aimag is selected based on herder knowledge of where his animals are most exposed during the first six months of the year. Herders are able to ensure between 25% and 100% of the estimated value of their animals. Payments begin once the predetermined threshold of mortality for the aimag (called strike rate) and the animal species is exceeded. The payment rate is capped once the mortality rate exceeds the exhaustion point (called cap rate). BIP payments are the product of the payment rate times the value insured. DRP payments use the full value of animals. The DRP pay for losses beyond the exhaustion point.
As an example, consider a herder who has 50 sheep where the value of a sheep is MNT 25,000. The herder decides to insure the total value = MNT 25,000 x 50 = MNT 1.25 million. Supposing the premium rate for the BIP, with a strike at 7% and a cap at 30%, is 1.4 %, the herder would pay a premium of 1.4 x .01 x 1,250,000 = MNT 17,500 per annum.
The Base Insurance Product (BIP) is a commercial risk product, sold and serviced by insurance companies. Herders pay a fully loaded premium rate for this product. This product pays out when the sum mortality rates exceed specified strike rate, (7% in this example). Based on analysis of historical livestock mortality data, the maximum payment for the BIP would be when mortality rates reach a specified “exhaustion point” (30% in this example).
The Disaster Response Product (DRP) is a social safety net product financed and provided by Government, which begins payments at mortality rates exceeding the BIP exhaustion point. Herders who purchase the BIP are automatically registered for the DRP on the same animal species at no additional cost. Without the purchase of at least the minimum value of BIP, herders must pay a small fee for DRP administrative cost. The payout structure for DRP is the same as the BIP.
Taking the above example, if the mortality rate in the herder’s aimag during a bad dzud year equals 35%, the payment rate for the BIP is equal to 30% -7% = 23 %, and thus the BIP payment is 23% x 1,250,000 = MNT 287,500. Payment for the DRP equals (35%- 30%) x 1,250,000 = MNT 62,500. The farmer would receive a payout of MNT 287,500 from the insurer + MNT 62,500 from the government under the IBLIP policy = MNT 350,000 irrespective of the loss he has suffered, which could be more or less than this amount.
On the other hand, if the mortality rate in the herder’s aimag is 7% or less, he or she would not get any compensation from IBLIP, BIP or DRP irrespective of the loss suffered by he or she and the total loss, if any, would have to be borne by him or her.
Livestock Insurance Indemnity Pool
Even with the DRP social product that pays for extreme local losses, there are significant risks associated with the commercial BIP product as mortality rates are highly correlated across regions in Mongolia. Given concerns about financing extreme losses, the pilot design involves a syndicate pooling arrangement for insurance companies – Livestock Insurance Indemnity Pool (LIIP). Herder premiums are deposited into the LIIP until the settlement period. Thus, indemnities are fully protected under this scheme. The LIIP ring fences this line of business and thus protects the domestic insurance market against any financial contagion caused by extreme livestock losses as the government fully covers insured losses beyond the financial capacity of the pool through an unlimited stop loss reinsurance treaty.
In the syndicated pooling arrangement, participating insurers share their underwriting gains and losses based upon the share of herder premium they bring into the pool. Each insurer also pays reinsurance costs that are consistent with the book of business they bring into the pool. The reinsurance payments are protected and build from year to year to give the opportunity to build up reserves for the overall activity. The reinsurance reserve pays for the first layer of losses beyond the stop loss. Once the reinsurance reserve is exhausted, the Government of Mongolia can call upon the World Bank contingent debt to pay for any remaining losses.
The LIIP has several major advantages:
- It fully protects other lines of insurance, as the insurance industry in Mongolia is still under-developed;
- It fully protects the indemnities needed to pay for losses under the IBLIP, thus eliminating any risk of default on payments;
- It allows the insurance companies to pool their livestock insurance portfolio in different regions; and
- It facilitates collaboration about the insurance companies selling the commercial product BIP.
Given that BIP is a standard product that involves the same premium rates from all companies, the issue of trust and due diligence of the underwriting skills of participating insurers is greatly reduced. This is important as typical pooling arrangements among insurance companies are generally very difficult to organise given the high transaction costs needed to perform due-diligence on underwriting skills of the participating insurers.
The longer-term vision is that the pooling mechanism created in the pilot can be well positioned to find risk-sharing partners in the global community quickly as the pooling arrangement is both risky and profitable. Reinsurers might be willing to provide capital and enter quota-share arrangements on that risk. To the extent that the risks within the pool are standardised, using the same measures and procedures, one can also envision this mechanism serving as a means to securitize the livestock risk. Finally, the design also offers the opportunity to transition the system to the market, should herders find the BIP an acceptable product and demonstrate a willingness to pay the fully loaded premiums.
Government fiscal exposure
The Government of Mongolia is double exposed to livestock risk under the IBLIP. First, it covers losses exceeding a specific threshold through the DRP. Second, it acts as a reinsurer of last resort for the insurance companies selling the BIP through an unlimited stop loss reinsurance treaty sold to the LIIP. This double exposure needs to be adequately financed by the World Bank to avoid an increase in the fiscal burden of the Government of Mongolia.
The financing of the Government’s potential losses during the pilot phase relies on a combination of reserves and a US$5 million IDA contingent credit provided by the World Bank. Once the reinsurance reserves are depleted, the Government will call the contingent debt facility. This facility can potentially provide the Government with a lower cost capital relative to the accumulation of reserves, but the major disadvantage is that once disbursed this facility could exacerbate the debt burden of the country. The effectiveness of this facility would thus depend on the country’s post-disaster financial profile and more specifically on its post-disaster ability to service debt. A grace period of several years will allow the Government to recover an acceptable fiscal situation before starting to reimburse the contingent debt.
Index-Based Livestock Insurance Project 12
As of November 29, 2013, a Draft IBLI Law with enabling legislation for the program was placed before cabinet and it is anticipated that it will be sent to parliament and passed by 2016. The project is no longer a pilot since it was restructured in 2010 and is now available nationwide. Seven insurance companies are offering IBLI to all aimags.
What is the difference between IBLIP and microinsurance?
Microinsurance is the protection of low-income people against specific perils in exchange for regular premium payments proportionate to the likelihood and cost of the risks involved. This definition is exactly the same as one might use for regular insurance except for the clearly prescribed target market: low-income people. Given its focus on low-income people, microinsurance usually differs from regular insurance in terms of types of risks covered, types of delivery channels, premiums level and types of claims documentation requirements.
Microinsurance can cover a variety of risks, including death, illness, property, or livestock and crop losses. When index-insurance like IBLIP is sold to low-income people such as small farmers, herders or micro-entrepreneurs, it often takes the form of microinsurance with business models explicitly targeting the low-income population. Sometimes, index-insurance regulations are part of the microinsurance legal and regulatory framework. The thin line between index-based insurance aimed at small farmers or herders and microinsurance is often difficult to differentiate and the expressions are easily interchanged.