Agriculture, mostly smallholder farming, constitutes approximately 38% of Malawi’s economy. Banks in
Malawi are unwilling, however, to lend to smallholder farmers, primarily because of the risk that they would not pay back their loans if there were a drought. As a result, prior to 2005, only 50,000 of the millions of smallholder farming households in the country were able to secure credit from formal financial institutions. Without access to loans, farmers could not purchase high quality seeds that would increase productivity and raise their living standards.
Traditional crop insurance is difficult to deliver in smallholder economies as it involves costly individual loss assessments and is prone to moral hazard and adverse selection. Index-based crop insurance, on the other hand, uses weather observations as proxies for
losses in production or quality and does not require loss assessments. Index-based crop insurance systems have lower administrative costs and are less technically complex than traditional crop insurance, but are exposed to basis risk (that is, mismatch between actual loss and insurance indemnity) and only cover selected perils.