Basis Risk and the Welfare Gains from Index Insurance: Evidence from Northern Kenya

Abstract

Index insurance products circumvent many of the transaction costs and asymmetric information problems that obstruct provision of low value conventional insurance policies in developing countries. Recent years have seen tremendous growth in index insurance pilots in developing countries, but there has been little progress in our understanding of the quality of those products. Basis risk, or remaining uninsured risk, is a widely recognized, but rarely measured drawback of index insurance that carries significant implications for the quality of any such product. This research uses a rich longitudinal household dataset to examine basis risk associated with an index based livestock insurance (IBLI) product available to pastoralists in northern Kenya since 2010. We find that IBLI coverage reduces downside risk for most households when purchased at actuarially fair premium rates and has net utility benefits for most even at commercial rates. Examining the components of basis risk, we find that IBLI reduces exposure to covariate risk due to high loss events by an average of 62.8%. The benefits of reduced covariate risk exposure are relatively small, however, due to high exposure to seemingly mostly random idiosyncratic risk, even in this population often thought to suffer largely from covariate shocks. Depending on covariate region, IBLI policy holders are left with an average of between 62.3% and 76.7% of their original risk due to high loss events. This research underscores the need for caution when promoting index insurance as a tool for reducing exposure to risk and the importance of ex post product evaluation.

Index Insurance and Cash Transfers: A Comparative Analysis from Northern Kenya

“…Those that purchase IBLI take advantage of their reduced risk exposure by drawing down their herd size and increasing investments in the productivity of their livestock, therefore increasing milk production and income. Although Jensen, Mude and Barrett (2014), find that HSNP participation increases the likelihood of IBLI uptake, such interactions do not produce statistically significant impacts on the welfare measures considered here.…”

Adoption and impact of index-insurance and credit for smallholder farmers in developing countries

“…Interlinked contracts also perform better than standalone insurance contracts, as interlinked 36 contracts lead to better technology use for both low and high levels of collateral, whereas Most studies find a positive relation between access to credit and insurance demand. 48 Several studies report that access to credit leads to larger willingness-to-pay (Bogale, 2015; The effect of insurance on credit is contested.…”

Review of Pilot Projects on Index-Based Insurance in Africa: Insights and Lessons Learned

“…8 However, the use of this information has brought new and as yet unresolved challenges. For instance in the case of IBLI, the performance of the first index was found to perform poorly in estimating drought-related mortality (Jensen et al 2014b). The low quality of livestock mortality data led to study a new algorithm for 6 The accuracy of these information, used to estimate the parameters of the probability distribution for the underlying weather risk, clearly determinates the pure risk of the insurance contract (Makaudze 2012 Regarding the NDVI, for instance, retrieving long-term consistent time series from various sources based on different sensor characteristics and algorithms could be time and resource consuming (Miura et al 2006).…”