Compound-risk Aversion and the Demand for Microinsurance: Evidence from a WTP Experiment in Mali

• Development Workshop

Date and Location

Thursday, October 17, 2013, 4:10 PM - 5:30 PM
ARE Conference Room, 2102 Social Sciences and Humanities

Abstract

Index insurance has been faced with an unexpectedly low uptake, despite efforts to promote it as a tool for poverty alleviation. This paper offers new insights into the behavioral impediments to the uptake of index insurance, and proposes an alternative approach to designing insurance contracts. Beginning from the observation that an index insurance contract appears to the farmer as an ambiguous, compound lottery, this paper argues that the expected utility perspective may systematically overstate the desirability of index insurance and its expected impacts (given the presence of substantial basis risk). Using framed field experiments with 334 cotton farmers in Southern Mali, we elicit the coefficients of risk aversion and compound risk aversion. In the sample, 57% of the surveyed farmers reveal themselves to be compound-risk averse to varying degrees. Using the distributions of compound-risk aversion and risk aversion in this population, we simulate the magnitude of the impact of basis risk on the demand for an index insurance contract. If basis risk were as high as 50% (a not unreasonably high number under the kind of rainfall index insurance contracts that have been utilized in a number of pilots), expected demand would only be 35% of the population as opposed to the 60% of the population that would be expected to demand insurance if individuals were expected utility maximizers. Our results highlight the importance of designing contracts with minimal basis risk under compound-risk aversion. Such a reduction in basis risk would not only enhance the value and productivity impacts of index insurance, but would also assure that the contracts are popular and have the anticipated impact.