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

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  • Jensen, Nathaniel D.
  • Barrett, Christopher B.
  • Mude, Andrew G.

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.

Suggested Citation

  • 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.
  • Handle: RePEc:pra:mprapa:59153
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Chantarat, Sommarat & Mude, Andrew G. & Barrett, Christopher B. & Turvey, Calum G., 2017. "Welfare Impacts of Index Insurance in the Presence of a Poverty Trap," World Development, Elsevier, vol. 94(C), pages 119-138.
    2. Mohamed Keinan Hassan & Jane Gathenya & Mike Iravo, 2017. "Moderating Effect of Index Based Livestock Insurance on Socio-Cultural Factors Affecting Performance of Livestock Projects in North Eastern Kenya," International Journal of Academic Research in Business and Social Sciences, Human Resource Management Academic Research Society, International Journal of Academic Research in Business and Social Sciences, vol. 7(3), pages 99-116, March.
    3. Jensen, Nathaniel & Mude, Andrew & Barrett, Christopher, 2014. "How Basis Risk and Spatiotemporal Adverse Selection Influence Demand for Index Insurance: Evidence from Northern Kenya," MPRA Paper 60452, University Library of Munich, Germany.
    4. Morsink,Karlijn & Clarke,Daniel Jonathan & Mapfumo,Shadreck, 2016. "How to measure whether index insurance provides reliable protection," Policy Research Working Paper Series 7744, The World Bank.
    5. Huo, Ran & Octavio, Ramirez, 2017. "Basis risk and welfare effect of weather index insurance for smallholders in China," 2017 Annual Meeting, February 4-7, 2017, Mobile, Alabama 252816, Southern Agricultural Economics Association.
    6. Takahashi, Kazushi & Ikegami, Munenobu & Sheahan, Megan & Barrett, Christopher B., 2016. "Experimental Evidence on the Drivers of Index-Based Livestock Insurance Demand in Southern Ethiopia," World Development, Elsevier, vol. 78(C), pages 324-340.
    7. Jensen, Nathaniel & Barrett, Christopher B. & Mude, Andrew, 2014. "Index Insurance and Cash Transfers: A Comparative Analysis from Northern Kenya," MPRA Paper 61372, University Library of Munich, Germany.
    8. 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.
    9. Platteau, Jean-Philippe & De Bock, Ombeline & Gelade, Wouter, 2017. "The Demand for Microinsurance: A Literature Review," World Development, Elsevier, vol. 94(C), pages 139-156.

    More about this item

    Keywords

    index insurance; basis risk; pastoralists; Kenya;

    JEL classification:

    • O1 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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