Basis Risk Effects on the Demand for Index Insurance

Index Insurance constitute an alternative to providing risk management to small agricultural producers. Its lower premium costs and immunity to moral hazard and adverse selection are advantages over traditional insurance. Nonetheless, index insurance suffers from basis risk: the risk that indemnities are not recognized under the presence of yield losses. Although this does not prevent the correct design of a policy, basis risk is one of the main suspects of the lower than expected take-up levels of index insurance in many contexts. The inherent difficulties in getting reliable basis-risk data limit the scope of empirical research. In this paper, the authors use a lab-in-the-field experiment to provide evidence on this topic. They elicit, for coffee growers in Colombia, the effects of basis risk on demand for index insurance. They distinguish between two different sources of basis risk and test for their effects in a framed yield-insurance game. Their results show a reduction in take-up when participants confront design basis risk; this follows other results in the literature. The authors also find evidence of a positive effect on take-up when the level of non-insurable risk increases, another source of basis risk that has had fewer discussions in the index insurance literature.