Index Insurance & Compound Risk Aversion: Evidence from a Willingness to Pay Experiment in Mali

• Development Workshop

Date and Location

Monday, April 15, 2013, 4:10 PM - 5:30 PM
ARE Conference Room, 2102 Social Sciences and Humanities

Abstract

In this paper, we present a novel way to understand the low uptake of index insurance using the interlinked concepts of ambiguity and compound lottery aversion. We begin our analysis by looking at index insurance from the farmer's perspective, noticing that index insurance is a compound lottery. We use the smooth model of ambiguity aversion developed by Klibanof, Marinacci, and Mukerji (2005) to derive an expression of the willingness to pay to eliminate basis risk (WTP). Empirically, we implement the WTP measure using framed feld experiments with cotton farmers in Southern Mali. In this 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 then simulate the impact of basis risk on the demand for an index insurance contract whose structure mimics the structure of an actual index insurance contract distributed in Mali. Compound-risk aversion decreases the demand for index insurance relative to what it would be if individuals had the same degree of risk aversion but were compound-risk neutral. In addition, demand declines more steeply as basis risk increases under compound-risk aversion than it does under risk neutrality. Our results highlight the importance of designing contracts with minimal basis risk when potential buyers are compound-risk averse. This 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.