Basix Essay

Custom Student Mr. Teacher ENG 1001-04 28 September 2016


1. What fundamental problem do BASIX ‘s customers face? How exposed are they to weather risk and how do they cope with risk? BASIX has a huge rural agrarian client base. A major source of income of the clients came from agriculture. Agriculture, as an activity, greatly depends on the monsoons since alternative means of irrigation are not well developed in India. This makes their income highly vulnerable to weather conditions. The monsoons have been poor in the previous three years.

Most of the clients have limited wealth. They borrow to purchase various inputs for farming or basic needs such as food, clothing etc. A large part of the income of farmers from the harvest was spent in paying off these debts.

Not all farmers were eligible to receive finance from government agencies, and only those who were, received crop insurance policies. However, majority of BASIX’s clients remained ineligible to borrow and hence did not hold a policy.

Not all clients who had policies received insurance claims in case of losses, and those who were entitled to receive any compensation, did so after a long wait, even upto 2 years.

In order to cope with weather risks, given the aforementioned problems, farmers amassed wealth in the form of assets such as gold, livestock etc. that could be sold when the weather went against their crops and they did not realize enough income.

2. What is special about a rainfall shock and how well did BASIX’s earlier efforts to offer insurance fare? Why?

India, being an agrarian economy, a rainfall shock has a direct and a major impact on the economic performance. Variability in the levels of rainfall is an important consideration of how well the agricultural output will fare.

Different crops require different levels of rainfall, and if the rainfall did not follow the normal pattern, farmers were severely affected as loans were tied to levels of harvest.

BASIX’s initial insurance-model were not successful because of two reasons: * Higher administrative costs than anticipated * Farmers’ disinclination to pay high premiums on such policies

3. What is the difference between index insurance and traditional insurance? What are the advantages and disadvantages of each type of insurance?

Traditional Insurance Traditional Crop Insurance was offered by Government agencies. The company would set a target yield. The company would compare the yield in nearby farms, called “test farms” with the target yield. Any compensation would be based on the difference between the two.

Advantages: * Easier concept, hence, simpler to market to farmers * Compensation could be simply tied to a single number i.e. the percentage difference, rather than have a range of numbers, each for different crops.

Disadvantages: * The “test farms” are not the might not be adequate measures for target yields * Farmers, especially those with political ties, could misuse these policies * Since most of the tradionationl policies were supported by the government, red-tapism was common

Indexed Insurance Indexed Insurance was one in which the compensation was based on performance of an index, which in turn was developed from the average rainfall levels.

Advantages: * More accurate and unbiased, and a better measure to decide whether the farmer actually needed compensation or not * Specialized product, with a lower limit for rainfall and also a maximum compensation amount

Disadvantages: * Complex and therefore, difficult to explain to farmers * Necessary to design different policies for different crops * Farmers had difficulty in choosing in the appropriate product that often led to them selecting none * Higher administrative, service and travelling costs

4. Describe briefly what does a Monte Carlo simulation consists of and how BASIX will use it. What can the model tell you about the efficacy and pricing of the insurance contract being considered?

Monte Carlo simulation is a statistical technique. In this method, simulations are run multiple times and this makes it possible to ascertain, with greater accuracy, the probability of a certain event. The method stimulates random events and random outcomes. The idea is that if the simulation is run many times, one can get a measure of the probability of a certain event.

BASIX can use the Monte Carlo simulation to predict the probability of a certain level of rainfall in future, and hence, the probable gain or loss from its rainfall indexed insurance policy.

Efficacy and pricing of insurance contract The rainfall-indexed insurance policy pays out a compensation if the shortage in rainfall level falls between certain ranges. By employing Monte Carlo simulations, the probability of rainfall between range and therefore, the profit and loss from policy can be better predicted. This enables a better pricing of the policy.

5. What is the potential market size and should the farmers purchase the insurance policy as offered? If so, at what price?

The potential market size is measured by taking the population all the states in which BASIX operates and multiplying it with the share of population within 30km of rainfall station. This is because, since the indexed method needs the measure of rainfall, a station would be required.

Potential Market Size = 406 million x 23% = 93.38 million (From Exhibit 4, 406 million is the population in all states in which BASIX operates and 23% is the approximate share of population within 30 km of rainfall station).

The BASIX Insurance policy underwent a change from 2003 to 2004. The 2003 policy premium was based on the size of land while the 2004 policy incorporated three phases and the new premium was Rs. 125/contract.

Price Determination: 1. As per the Information given in page 6(as per Food and Agricultural Organization), for good crop yield the average rainfall required is 500-700 mm. but as per the details of policy for 2004, given in Exhibit 5, the total rainfall accounted as per the “normal index” is 75 + 110 + 75 = 260 mm. Hence, the risk coverage as per the proposed policy is much lower than the actual requirement for good yield. Note that even policy for 2003 was having an index target of 653 mm. Therefore; the new policy is providing significantly less protection

2. From Table A, in page 6, it is clear that the loss in yield is higher if the rainfall is less during the “Crop Development” and “Mid-season”. But, the risk coverage for shortfall of rain during these periods (10 Rs/mm and 5 Rs/mm respectively) are less than that for the initial period (15 Rs/mm). Hence, it is not covering the risk properly. Note that the policy for 2003 was having higher “relative weight for Rainfall index” during the second and third period.

3. It is indicated that premium is Rs 125/-. It is not clear whether it is for 1 acre or per person. It may be per acre as the insurance is for crop not for individual. During the phase1, if there is a 10 % less rainfall, as per Table A in page 6, there will be 2 % loss in yield. As per the information given in page 3, 3 acres of land may give a yield of 1000 kg as indicated at a rate of Rs 30/- per kg, it works out to 30,000 Rs. If there is 10 % shortfall in rain during initial phase (Phase-1), as per the Ky, it may result in a loss of Rs 600/-. For 3 acre land the farmer might have paid 3 x 125 = Rs. 375/- for policy. As per the terms of the policy, the farmer will get 7.5 X 15 = 112.50 as compensation. It is very negligible compared to the extra amount he paid for the policy and the loss he incurred due to the shortfall in rain. The situation will be worse, if the shortfall comes in phase 2 or 3 as ky is higher for these phases.

4. There are other risks such as loss of crop due to heavy rainfall (more water in the farm land will damage the crops due to flooding). From the graphs that show the distribution of rainfall, it is clear that there is considerable probability for extra rainfall than required. The mean rainfall for each phase when added (115 + 191.1 +209.7 = 515.8 mm), we get almost the required rainfall for a good yield.

5. From the data of distribution of rainfall, it can be seen that the “normal index” indicated in the policy is kept at 0.7 to 1.4 times sigma lower than the mean rainfall, for all the 3 phases. This difference will cover about 25 % to 40 % of shortfall in rain. Definitely, this is advantageous for BASIX. But, for the policy takers, it is no coverage of risk.

6. Also there can be losses due to attack of crops by pests. Even though rainfall was normal, the farmer may incur loss due to uncontrolled attack by pests. The risks are not covered under the policy.

7. Also, according to the new policy, the rainfall in phase 3 should be less than 75, so that the farmer gets some insurance. This is unjustifiable considering that the mean during this period (from 1951-2003 data) is 209.7. As seen in the graph, 75 is far to the left. Very evidently, BASIX has a huge advantage in this period. From, all these points it can be concluded that BASIX has considerably high advantage. However, this can be justified to a great extent, considering the following facts: * Rainfall has been less during previous 3 years

* Administrative costs of BASIX are significant. Therefore, it might not be worth for farmers to buy these policies, with the current premium of Rs125 and current terms of insurance. The price should be lowered to make it fair for the farmers. Also, probably the terms of the insurance (the normal level and payment) should be modified to better protect the farmers when crop yields are low.

6. What should BASIX do?

The weather index insurance market in India is the world’s largest, having transitioned from small-scale and scattered pilots to a large-scale weather based crop insurance program covering more than 9 million farmers.1

Given the complexity of the rainfall-indexed insurance policy, it was difficult for BASIX to explain to the clients the characteristics of the product and its potential benefits. That is why the product had a development and administrative cost, as well the cost of time invested by the agents. Innovations and improvements in delivery mechanisms to reduce costs would be suggested.

Simplification in the insurance product so that they are better understood by farmers.

BASIX’s coverage is restricted by weather stations. It could set up more stations in order to reach a wider farmer-base.

BASIX’s market penetration was still weak when it began in 2003. Changes were made in the policy based on the feedback from farmers. As of 31st Dec, 2009, 8,948 customers were outstanding on the weather insurance.

BASIX should continue to incorporate changes to suit the needs of famers and include a wider portfolio of crops within the weather insurance product. As seen above, the weather insurance product does not adequately cover the risk faced by farmers. There should be product efficiency as well as innovation to not only cover different risk areas but provide a comprehensive coverage too.

BASIX has tie-up with ICICI Lombard, a private insurance company. These insurance policies were reinsured and BASIX is only acting as an agent. There is always a risk that the insurance company does not align its pricing policies in line with BASIX’s social objectives. They should be vigilant about it.

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