The impact of index-based insurance on informal risk-sharing arrangement

Moral hazard and adverse selection impede the development of formal crop insurance markets in developing countries. Besides, the risk mitigation provided by informal risk-sharing arrangements is restricted by their inability to protect against covariate shocks. In this context, index-based insurance is seen as a promising scheme as it is immune to moral hazard and adverse selection and may offer effective protection against covariate shocks. It would thus seem that the two institutions are ideal complements. Unfortunately, this intuition ignores the potential effects on incentives and behavior generated by the interaction between both schemes. This paper explores this interaction in a model with moral hazard and shows that the formal contract may crowd out informal risk-sharing if it is offered to individuals. Second, we find that both risk-taking and welfare may be reduced by the introduction of index insurance if the premium is set too high. If the formal insurance is offered to the group instead of the individual, the impact on moral hazard is internalized and welfare increases.