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Handling the Weather: Insurance, Savings, and Credit in West Africa

27.07.2015Francesca de Nicola, Economist, The World Bank

Farmers in developing countries face severe uninsured production risks and consequently may largely benefit from the introduction of formal financial instruments that would help them to smooth consumption. To shed light on this issue, in a recent World Bank working paper, we consider three separate policy interventions and examine their impact on consumption, investment and welfare. Specifically, we studied stylized contracts for weather index-insurance, savings and credit accounts, based on the formal financial instruments available for the rural households living in Burkina Faso and Senegal. We started our analysis from benchmark scenarios and then progressively moved towards more realistic policy interventions that incorporate the different limitations that each financial product carries.

Let's first set the stage of the study.Droughts, locust invasions, storms and floods caused by insufficient drainage infrastructure or dam system failures are among the most frequent natural hazards in West Africa. These calamities have significant livelihood consequences as indicated by the staggering number of food insecure people in 2012 (18.4 million, including about 1 million children under the age of 5), because of low and uneven rainfall coupled with attacks on crops by pests and locusts (UNICEF, 2012). These dramatic consequences are linked to the fact that when on-farm work constitutes the main source of income, fluctuations in agricultural income may have sizeable repercussions on consumption. In the absence of improved agricultural practices and formal financial products, farmers need to rely on a host of informal strategies to shield their consumption. Since the seminal work of Townsend 1994, research indicates that these informal risk-coping mechanisms, however, offer at best imperfect protection against risks, and these solutions tend to perform even worse in the case of wide-scale events such as droughts or floods. Besides, uninsured income risk has also indirect negative impact on consumption. Rare but severe weather shocks may induce farmers to under-invest in high-return, but also high-volatility projects, further depressing potential consumption.

Can weather index-insurance, savings or credit accounts mitigate these negative welfare effects? Each of these financial products has the potential to improve farmers' welfare, yet none of them completely abstract from complications that may limit the extent of the gains achievable. For example, index insurance and insured credit may not be immune from basis risk, arising because of the imperfect correlation between the insurance payout and farmers losses; on the other hand, savings may be very expensive means to cope with large shocks, and rather ineffective against calamities that occur in quick succession.

Which of these financial instruments is more welfare-enhancing? To answer this question, we set-up a dynamic stochastic optimization problem of consumption and investment and perform counterfactual analysis. A key feature of the model is that on-farm investment is subject to multiple sources of risk, both idiosyncratic and covariant in nature, and that a large part of this uncertainty is covariant. This allows us to correctly model the basis risk inherent in some of the financial innovations available. We numerically solve the optimization problem using calibrated parameters based on crop model as well as existing evidence in the literature focusing on Burkinabe and Senegalese farmers. We then show the impact on consumption, investment and welfare from the separate provision of three financial instruments: weather insurance, savings and credit. As anticipated, we start our analysis considering the effects from the provision of the "optimal" contracts (from the farmers' point of view) and then relax these assumptions and investigate the impact from providing more "realistic" contracts. The results for Burkina Faso and Senegal are strikingly similar. In both cases, the provision of weather insurance as well as credit leads to an increase in consumption and a decline in precautionary investment in riskless return-free assets. While qualitatively similar, these choices are quantitatively different as captured by the vast differences in the level of welfare gains that can be achieved.

Irrespective of the wealth owned, weather insurance enables farmers to achieve larger welfare gains which are decreasing in wealth. Over time, farmers gain less and less from the provision of these financial instruments due to the fact that the initial increase in consumption is not compensated by a sufficient increase in on-farm production. As we move away from the benchmark scenarios it becomes clear however that the welfare gains from weather insurance are highly sensitive to its pricing and that offering a relatively small discount (fee), substantially increases (cut) the benefits achievable by farmers. The introduction of saving accounts on the other hand induces farmers to save more and eventually allows farmers to consume more. As a result the welfare gains are increasing both in wealth and over time. Richer farmers gain more as they can enjoy higher returns on larger endowments. The initial contraction in consumption combined with the increase in riskless investments leads to higher consumption in the future and consequently larger gains. In sum, the selection of the "optimal" financial instrument depends on the level of wealth of the households as well as the quality of contract offered. This study offers a simple framework to reflect on these issues and assess the quantitative welfare implications of the different instruments across level of wealth and over time.

This blogpost is based on the paper "Handling the weather: insurance, savings and credit in West Africa", prepared by Francesca de Nicola from the World Bank.

Gravatar: Enrique Gelbard, Mumtaz Hussain, Rodolfo Maino, Yibin Mu, and Etienne B. Yehoue

Status and Development of Islamic Finance in Sub-Saharan Africa

09.03.2015Enrique Gelbard, Mumtaz Hussain, Rodolfo Maino, Yibin Mu, and Etienne B. Yehoue

The Islamic finance industry has been growing rapidly in various regions, and its banking segment has become systemic in some countries, with implications for macroeconomic and financial stability. While not yet significant in Sub-Saharan Africa (SSA), several features make Islamic finance instruments relevant to the region, in particular the ability to foster SMEs and micro-credit activities. In a recent paper, we provide a survey on Islamic Finance in SSA where on-going activities include Islamic banking, sukuk issuances (to finance infrastructure projects), Takaful (insurance), and microfinance. Should they wish to develop the market, policy makers could introduce Islamic financing windows within the conventional system and facilitate sukuk issuance to tap foreign investors. The entrance of full-fledged Islamic banks would require addressing systemic issues and adapting crisis management and resolution frameworks.

The financial sector in SSA has been growing rapidly in the past two decades. New products have been introduced and financial institutions are playing an increasing role in financial intermediation, including cross-border financial intermediation.

However, Islamic finance remains small, although it has potential given the region's demographic structure and potential for further financial deepening. As of end-2012, about 38 Islamic finance institutions-comprising commercial banks, investment banks, and takaful (insurance) operators-were operating in Africa. Out of this, 21 operated in North Africa, Mauritania and Sudan, and 17 in Sub-Saharan Africa.

Botswana, Kenya, Gambia, Guinea, Liberia, Niger, Nigeria, South Africa, Mauritius, Senegal and Tanzania have Islamic banking activities. There is also scope for development in Zambia, Uganda, Malawi, Ghana and Ethiopia, as all but Zambia has relatively large Muslim populations-Zambia is interested in using Islamic finance instruments to fund investment in the mining sector. In Uganda, the central bank has started the process of amending its banking regulations to allow for the establishment of Islamic banks and three Islamic banks have applied for a license.

Islamic finance is still at a nascent stage of development in SSA. The share of Islamic banks is small, and Islamic capital markets are virtually non-existent (there were small Sukuk issuances in Gambia and Nigeria). At the same time, the demand for Islamic finance products is likely to increase in coming years. At present, about half of the region's total population remains to be banked. Furthermore, the SSA Muslim population, currently at nearly 250 million people, is projected to reach 386 million in 2030 and financial activities are expected to rise as a share of GDP. Many countries are expected to introduce Islamic finance activities side-by-side conventional banking. Opportunities for the development of Islamic finance are expected to comprise retail products to small and medium-sized enterprises. The sub-continent's growing middle class, combined with its young population is an opportunity for Islamic finance to expand its services. SSA's large infrastructure needs will also provide an opportunity for Sukuk issuance to channel funds from the Middle-East, Malaysia, and Indonesia. For example, recent issuance of a Shari'ah-compliant bond by Osun state in Nigeria and South Africa could start a trend in favour of sukuk, especially if planned sukuk by Senegal.

Developing Islamic Finance in Sub-Saharan Africa

The development of Islamic Finance could increase the depth and breadth of intermediation, extending the reach of the system (e.g. extension of maturities and facilitation of hedging and risk diversification). At the same time, the much larger non-Muslim population could find Islamic financial instruments attractive in broadening the range of available options, particularly for SMEs and micro-credit. Moreover, financial deepening and inclusion could be further enhanced if new instruments are inspired from Islamic finance, but without necessarily being Shari'ah certified. The development of partial risk guarantees, as in Mauritius, could be seen as an example.

In addition, SSA countries could tap into growing Islamic financial markets to meet infrastructure financing needs. By opening doors to Islamic finance, SSA can seek to attract capital from Muslim countries whose savings rates are high and projected to grow. In particular, sukuk financing, which is expanding in other countries, could be a useful tool to finance infrastructure investments.

Lastly, Islamic financing can help develop small and medium enterprises and microfinance activities, given those African households and firms have less access to credit from conventional banks compared to other developing regions. Islamic banks can tap a segment of depositors that do not participate in interest-based banking. They can also promote SMEs' access to credit through expanding acceptable collaterals by extending funds on a participatory basis in which collateral is either not necessary or includes intangible assets.

Through its different forms-windows, full-fledged banking, investment banking, and Insurance-Islamic finance activities ensure appropriate leverage and help limit speculation and moral hazard. It should be noted, however, that they are also subject to constraints and risks, most notably the difficulties and costs involved in supervising and monitoring and the reputational risk implicit in some products that are not properly certified as compliant with Islamic principles.

For countries that want to develop Islamic finance in their jurisdictions, a strategy could contemplate the following steps: launching a public awareness campaign, providing the needed infrastructure (i.e. amending as needed laws and accounting and prudential frameworks), building capacity at the central bank (especially on supervision), and considering the need to set up an appropriate liquidity management framework and introduce adequate monetary operations instruments.

This blogpost is based on the academic study "Islamic Finance in Sub-Saharan Africa: Status and Prospects", prepared by Enrique Gelbard, Mumtaz Hussain, Rodolfo Maino, Yibin Mu and Etienne B. Yehoue.

Microinsurance in Africa: Dramatic growth but still challenges ahead!

03.06.2013Claudia Huber

The importance of risk management mechanisms and with it microinsurance has grown tremendously over the past couple of years. Whereas all different stakeholders involved in financial sector development have focused on credit in the earlier days and later on as well on savings and payments, nowadays insurance is generally mentioned at the same time with the more traditional financial services and products. Its importance for poor people’s lives and in the alleviation and prevention of poverty has been recognized widely.

The emerging stage of development of microinsurance and its complexity make it difficult to get an overview of what is happening in microinsurance in Africa. The Landscape of Microinsurance in Africa 2012, a new study by Making Finance Work for Africa (MFW4A) and the Munich Re Foundation, supported by the African Development Bank, ILO’s Microinsurance Innovation Facility and the Microinsurance Network, is an effort to take stock of the current state of and recent trends in the microinsurance market in Africa. The study identifies gaps in the access to and the supply of microinsurance, an emerging industry in Africa that involves many stakeholders ranging from insurers to delivery channels, policy makers, regulators, and donors.

The research finds that at the end of 2011 more than 44 million people or properties are covered by microinsurance products. Compared to 2008, the African microinsurance industry has grown by 200%. In other words, microinsurance products were accessed by 4.4% of all Africans. Still, a huge challenge remains: 38 million insured people are concentrated in Eastern and Southern Africa, while in Central and North Africa the microinsurance sector remains rather limited. South Africa alone accounts for 60% of coverage and only eight more countries cover more than one million lives each. Together, these nine countries account for approximately 90% of total coverage in Africa. West Africa has experienced the highest growth rate since 2008, growing by more than 250% to cover 4.4 million.

Due to the culturally-rooted widespread use of funeral insurance in Southern Africa, life insurance still dominates the market, covering 34 million people. Additionally, credit life products cover almost 9 million lives, showing some growth, although slower than before. Health microinsurance coverage has mostly stagnated with just 2.4 million Africans covered. Though still in a nascent stage covering 1 million people only, property and agriculture products have experienced important innovations. Contrary to the supply analysis, focus group studies show that the demand people express centers around health, agriculture, accident and property—demand that is largely unmet.  

More than three quarters of all microinsurance risk carriers are community-based organizations. However, they only account for 9% of all covered lives and properties identified. The second most common type of microinsurance providers are regulated commercial insurers (13% of organizations identified). Yet, they account for 78% of all covered lives and properties. These numbers show that massive growth in the microinsurance sector will need to come from the commercial insurance industry, whereas member groups remain the largest channel assuring outreach to otherwise uncovered customers.

The major growth experienced in microinsurance in Africa, should however not hide the fact that over 650 million Africans live in countries where microinsurance products are either absent or coverage is below 1% of total population. There is massive potential for microinsurance to expand across the continent, not just in terms of volumes but also in terms of innovative products offering both real value to clients and a business case for insurers. The research carried out shows that:

·         New distribution channels, such as life insurance products embedded into savings accounts or bundled into mobile phone subscriptions, have helped microinsurance to grow in terms of covered lives in the past two years. These types of developments hold great potential to dramatically increase coverage, but also raise questions from the perspectives of consumer education, protection, and regulation.

·         While the collected data do not allow for sophisticated client value analysis, the reported loss ratios seem to offer ample room for improved products if the microinsurance industry is truly to serve the low-income population effectively.

·         Although microinsurance regulation does not seem to have driven market development, the absence of clear legal frameworks has been identified as a barrier for expansion. Some African countries are currently developing legal frameworks specific to microinsurance, however, there is room for increased attention to this area. Clarity in the microinsurance legal framework is an important component to insurers’ having the confidence to invest in the paradigm shift needed for microinsurance success. Legal ambiguity is holding back innovative expansion.

·         Microinsurance providers were confident about the past and future short-term growth of the sector but expressed concern regarding consumer knowledge, their own knowledge of the low-income population’s needs, and product affordability.

·         The maturation of the microinsurance “industry” is evolutionary. Good examples are seen by others. They get copied, sometimes improved. Slowly but surely the industry progresses, more people are covered, better products are offered, and clients, insurers, distribution channels and others benefit. Continued and expanded inputs from donors, governments and others should help to accelerate the rate of microinsurance expansion – in terms of volumes, products and value.

If you want to find out more about microinsurance in Africa check out the interactive map and the Comprehensive Study as well as short Briefing Notes in English and French on www.mfw4a.org or www.microinsurancelandscape.org.

Claudia Huber is advisor in Financial Systems Development at the Gesellschaft für Internationale Zusammenarbeit (GIZ), where she is responsible for the microinsurance component within the team managing the German contribution to the partnership Making Finance Work for Africa (MFW4A). Claudia is a member of the Advisory Committee of the Access to Insurance Initiative (A2ii) and a member of the Joint Working Group on Regulation, Supervision and Policy of the IAIS and the Microinsurance Network.

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