This Research Paper was written for the International Master in Microfinance for Entrepreneurship at the Universidad Autónoma de Madrid, under the direction of Paloma Pérez Castañares (M.Sc.) and Claudio González-Vega (Ph.D.). The research has attempted to answer the question: until what point and in what ways can the supply of indexed insurance at the meso level contribute to financial inclusion in the rural areas of developing countries?

Rural financial deepening in developing countries faces several barriers, leading to imperfect or missing markets. These market failures hinder financial inclusion, rural development, climate change adaptation, and food security. One of the many barriers that explain missing or imperfect markets is related to the challenges of risk management. Indeed, natural catastrophes, such as a flood or a drought, can not only devastate an entire region, but they may also lead to the collapse of local financial institutions.

In this scenario, insurance appears as a tool that, by reducing the farmers’ risk exposure, helps financial institutions in their risk management and diversification. This tool enables the institutions to reduce their operating costs and losses and, therefore, create new matches between the supply and demand of financial services. Traditional insurance does not seem, however, to be most appropriate to ensure this outcome, due to its high operating costs and its inability to cope with covariant risks. For this reason, index insurance, delivered at the meso level, emerges as a potential solution to both high costs and catastrophic risks. Index insurance, by relying on a predetermined index, compensates losses without requiring an assessment of damages in the field. In this way, the insurance institution can significantly reduce its operational costs and offer more affordable premiums to farmers and to financial intermediaries and other parties engaged in risky transactions with farmers. In turn, a supply at the meso level has the potential to allow the insurer to reach sustainability, as it helps institutions to reduce their costs, increase their pool of clients, and diversify their risks better.

While insurance appears as a convenient tool to increase financial deepening, a holistic approach is required to cope with the different challenges faced by rural farmers.  Approaches that also take into account ex ante risk management activities, operating cost reductions, and value chain strengthening have to be considered while developing new schemes. A favorable regulatory framework and the right definition of the role of the state will be critical.