Strengthening Local Credit Markets Through Lender-Level Index Insurance

Abstract

This paper considers lender-level index insurance as a means of expanding access to credit in disaster-prone communities. In this approach, the lender transfers the disaster risk of loans in its portfolio by contracting on an observable measure of the catastrophe. I develop and calibrate a dynamic, stochastic model using data from a community lender in Peru that is vulnerable to El Niño-related flooding. The modeled lender can insure against El Niño using an index-based product that is available for purchase by financial intermediaries in Peru. I examine how premium rates, basis risk, and background risk may in influence the lender's insurance decision and credit supply. Overall, the results suggest that lender-level index insurance holds promise for reducing disaster-related credit supply shocks and expanding credit access in vulnerable communities.

Keywords: catastrophe insurance, index insurance, basis risk, background risk, credit shocks