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A Theory of Rational Demand for Index Insurance

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  • Daniel J. Clarke

Abstract

Rational demand for index insurance products is shown to be fundamentally different to that for indemnity insurance products due to the presence of basis risk. In particular, optimal demand is zero for infinitely risk-averse individuals, and is nonmonotonic in risk aversion, wealth, and price. For a given belief, upper bounds are derived for the optimal demand from risk-averse and decreasing absolute risk-averse decision makers. A simple ratio for monitoring basis risk is presented and applied to explain the low level of demand for consumer hedging instruments as a rational response to deadweight costs and basis risk. (JEL D14, D81, G13, G22, Q14)

Suggested Citation

  • Daniel J. Clarke, 2016. "A Theory of Rational Demand for Index Insurance," American Economic Journal: Microeconomics, American Economic Association, vol. 8(1), pages 283-306, February.
  • Handle: RePEc:aea:aejmic:v:8:y:2016:i:1:p:283-306
    Note: DOI: 10.1257/mic.20140103
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    References listed on IDEAS

    as
    1. Dean Karlan & Robert Osei & Isaac Osei-Akoto & Christopher Udry, 2014. "Agricultural Decisions after Relaxing Credit and Risk Constraints," The Quarterly Journal of Economics, Oxford University Press, vol. 129(2), pages 597-652.
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    4. Gin, Xavier & Yang, Dean, 2009. "Insurance, credit, and technology adoption: Field experimental evidencefrom Malawi," Journal of Development Economics, Elsevier, vol. 89(1), pages 1-11, May.
    5. Daniel J. Clarke, 2011. "Reinsuring the Poor: Group Microinsurance Design and Costly State Verification," Economics Series Working Papers 573, University of Oxford, Department of Economics.
    6. Ross, Stephen A, 1981. "Some Stronger Measures of Risk Aversion in the Small and the Large with Applications," Econometrica, Econometric Society, vol. 49(3), pages 621-638, May.
    7. Xavier Giné & Robert Townsend & James Vickery, 2007. "Statistical Analysis of Rainfall Insurance Payouts in Southern India," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 89(5), pages 1248-1254.
    8. Hongbin Cai & Yuyu Chen & Hanming Fang & Li-An Zhou, 2009. "Microinsurance, Trust and Economic Development: Evidence from a Randomized Natural Field Experiment," NBER Working Papers 15396, National Bureau of Economic Research, Inc.
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    10. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
    11. Clarke,Daniel Jonathan & Mahul,Olivier & Verma,Niraj, 2012. "Improving farmers'access to agricultural insurance in India," Policy Research Working Paper Series 5987, The World Bank.
    12. Jensen, Nathaniel D. & Barrett, Christopher B. & Mude, Andrew G., 2014. "Basis Risk and the Welfare Gains from Index Insurance: Evidence from Northern Kenya," MPRA Paper 59153, University Library of Munich, Germany.
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    15. Carter, Michael R. & Galarza, Francisco & Boucher, Stephen, 2007. "Underwriting area-based yield insurance to crowd-in credit supply and demand," MPRA Paper 24326, University Library of Munich, Germany.
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    More about this item

    JEL classification:

    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • Q14 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Agriculture - - - Agricultural Finance

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