The Evidence of Credit and Insurance’s Role in Tackling Climate Change
Climate change is one of the most pressing global challenges of our time, affecting communities and ecosystems worldwide. In CGAP’s recent publication “8 Billion Reasons: Inclusive Finance as a Catalyst for Climate Action”, we argue that inclusive financial services are essential for addressing climate change effectively.
Yet, we must deepen our understanding of how to leverage inclusive finance more effectively for climate action. How can financial services be tailored to the realities of communities on the frontlines of climate change? What makes credit a reliable tool for resilience without deepening vulnerability? Why do some insurance products fail to incentivize climate adaptation while others succeed? What happens when you combine credit and insurance?
Climate change is one of the most pressing global challenges of our time, affecting communities and ecosystems worldwide.
The answers to these questions can help shape policies, investments, and innovations. CGAP’s Impact Pathfinder serves as a gateway to understand what the existing evidence tells us, while highlighting where further research is needed.
The Impact Pathfinder shows what we know about the role of financial services in supporting climate objectives, and the key knowledge gaps that need to be filled.
When does insurance drive adaptation and resilience to climate change?
Insurance is inherently designed to protect against major risks, making it a logical tool for dealing with climate change. However, its effectiveness in supporting climate resilience and adaptation varies significantly. A better understanding of these differences is essential for deploying insurance effectively in support of climate outcomes.
Insurance can enable people to invest confidently in their livelihoods despite climate risks. Research shows that insured farmers cultivate more land and are more likely to invest in seeds and fertilizers and adopt innovations like improved seeds or irrigation systems. These investments boost yields and incomes while fostering resilience. Insurance can also help households during and after a shock by providing the liquidity to stabilize consumption without resorting to negative coping strategies such as selling productive assets, reducing food consumption, or taking children out of school. For example, a study in Kenya concluded that insured households were 96 percentage points less likely to sell assets during droughts compared to uninsured households. Insurance with quick payouts can also help households recover after a shock through actions like replacing damaged inventory and replanting fields.
However, in giving people the confidence to invest in their existing livelihood in the face of climate risk, insurance can also delay the need to adapt that livelihood in order to reduce its vulnerability. Delayed, unreliable, and difficult-to-access payouts can also undermine trust and undermine the effectiveness of insurance in helping people cope with shocks and recover afterward.
Influencing factors such as design and delivery choices, customer attributes, and broader ecosystem factors, such as the regulatory environment, can strengthen or weaken the effects of insurance on climate adaptation and resilience. For instance, crop insurance policies that offer better coverage or lower premiums for farmers that use climate-resilient seed varieties or climate-smart farming techniques can help nudge policy holders toward adaptation rather than away from it. Quick, easy, and reliable payouts can help build the trust among policyholders that many of the positive behavioral effects are ultimately dependent on.
Credit: a powerful enabler when used responsibly
As shown in the Impact Pathfinder, there is strong evidence that suggests that in the short-term, credit helps rural households avoid resorting to negative coping strategies in the aftermath of climate shocks. These effects are diluted and can be negative if the events are severe, frequent, or covariate. In such cases, rural households are at greater risk of over-indebtedness and reverting to using negative coping mechanisms.
For individuals and communities facing climate impacts, access to credit can mean the difference between surviving and thriving. When designed well, credit can enable households to make investments in adaptations, resilient practices, and green livelihoods that are too large for them to make on their own. These investments help people adapt to new realities and prepare for climate shocks, reducing their vulnerability and increasing their ability to bounce back.
However, where offered irresponsibly, credit can also create new sources of fragility and undermine the resilience of climate-exposed populations. Loans offered at excessive interest rates and without regard to repayment capacity can lead to indebtedness that leaves fewer resources for dealing with shocks and can contribute to, rather than reduce, the need for negative coping mechanisms. This is particularly problematic for communities facing frequent or severe climate shocks. This makes it particularly important to offer credit responsibly and thoughtfully in such contexts.
As for insurance, the evidence points to concrete design and delivery choices that help shape whether lending has a positive or negative impact on climate objectives. For example, credit aimed at productive assets—such as irrigation systems, climate-resilient seeds, or adaptive technologies—tends to have a more reliably positive impact compared to credit used for consumption smoothing. It is particularly effective when combined with training on adaptive practices, such as soil and water conservation or crop diversification. Furthermore, repayment periods and flexible payment schedules make it easier for households to manage through a shock without the loan becoming an additional burden. There is some evidence to suggest that extending an additional credit line to clients facing a shock can be beneficial in multiple ways, especially if this is made known to clients well ahead of time when investment decisions are made.
For instance, farmers in Bangladesh that were pre-approved at the start of the growing season for an emergency loan linked to a flood index increased their land under cultivation by 18% and invested more in production, leading to 35% higher yields for the farmers who didn’t suffer flooding while also bolstering consumption for the ones who did.
Bundling financial services: an effective approach
The evidence across financial services suggests that bundling is a particularly effective approach to achieving climate objectives. For example, risk-contingent credit, where a portion of the credit liability is transferred to an insurer during climate shocks, can reduce the risk of over-indebtedness after a climate shock. Conversely, offering climate risk insurance becomes a more attractive proposition when bundled with lending for adaptation and resilience investments that reduce the risk and impact of climate change for the policyholder. Hence, offering these two services in unison can encourage greater investment in adaptive practices and reduce risk for clients while also strengthening the business case for both lenders and insurers.
The evidence across financial services suggests that bundling is a particularly effective approach to achieving climate objectives.
Turning evidence into action
By understanding the factors influencing the effectiveness of financial services, we start seeing when and how financial services can play an important role in building climate adaptation and resilience—a role which can be particularly important for vulnerable populations. The current literature points to a number of influencing factors that can bolster or weaken this effect—and in some cases determine whether impact is positive or not. This should give anyone involved in the climate agenda motivation to examine how inclusive financial services can best help in driving climate action at the grassroots level. The Impact Pathfinder provides financial services providers and their supporters important guidance on how best to design financial services for climate impact. It is now up to stakeholders in multiple arenas to absorb this evidence and start putting it into action.
As a community, we have answered some research questions, but others remain unanswered. For instance, what are the best ways to bundle financial services like credit and insurance services that truly meet the needs of poor and climate vulnerable communities? And what are the contextual variables for different segments that bolster the positive impact of credit in resilience building while minimizing the risks of over-indebtedness? Getting answers to these questions that can help shape the design and delivery of better financial solutions for climate vulnerable populations should be an urgent priority for the inclusive finance sector in years to come.
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