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A Theory of Rational Demand for Index Insurance

  • Daniel J. Clarke

Rational demand for hedging products, where there is a risk of contractual nonperformance, is fundamentally different to that for indemnity insurance.� In particular, optimal demand is zero for infinitely risk averse individuals, and is nonmonotonic in risk aversion, wealth and price.� For commonly used families of utility functions, demand is hump-shaped in the degree of risk aversion when the price is actuarially unfair, first increasing then decreasing, and either decreasing or decreasing-increasing-decreasing in risk aversion when the price is actuarially favourable.� For a given belief, upper bound are derived for the optimal demand from risk averse and decreasing absolute risk averse decision makers.� The apparently low level of demand for consumer hedging instruments, particularly from the most risk averse, is explained as a rational response to deadweight costs and the risk of countractual nonperformance.� A numerical example is presented for maize in a developing county which suggests that some unsubsidised weather derivatives, currently being designed for and marketed to poor farmers, may in fact be poor products, in that objective financial advice would recommend�low or zero purchase from all risk averse expected utility maximisers.

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File URL: http://www.economics.ox.ac.uk/materials/working_papers/paper572.pdf
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Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 572.

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Date of creation: 01 Oct 2011
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Handle: RePEc:oxf:wpaper:572
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  1. 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.
  2. Shawn Cole & Xavier Gine & Jeremy Tobacman & Petia Topalova & Robert Townsend & James Vickery, 2013. "Barriers to Household Risk Management: Evidence from India," American Economic Journal: Applied Economics, American Economic Association, vol. 5(1), pages 104-35, January.
  3. 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.
  4. Gine, Xavier & Townsend, Robert & Vickery, James, 2007. "Statistical analysis of rainfall insurance payouts in southern India," Policy Research Working Paper Series 4426, The World Bank.
  5. 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.
  6. Mahul, Olivier & Verma, Niraj & Clarke, Daniel J., 2012. "Improving farmers'access to agricultural insurance in India," Policy Research Working Paper Series 5987, The World Bank.
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