Basis Risk Valuation Sensitivity

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In Simple Words

Imagine buying a fire insurance policy where the heat sensor is installed in the next town over; if a fire destroys your house but fails to trip the distant sensor, you receive zero compensation despite paying your premiums.

Farmers valuing rainfall insurance

Local-station policy
Mean bid Rs.68.4
Distant-station policy
Mean bid Rs.39.0

The same farmers valued both contracts in 2010. Selected policies; lower bids reflect the contract comparison, not production outcomes.

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Research question

Index insurance products eliminate moral hazard and administrative claims verification, but introduce spatial basis risk when reference weather stations are situated far from insured agricultural plots.

Participants

N = 1,978 smallholder farmers across Mahbubnagar and Anantapur districts, Andhra Pradesh, India.

Study Design

Incentive-compatible Becker-DeGroot-Marschak (BDM) mechanism eliciting willingness to pay for index policies linked to local versus distant rainfall stations.

Results

Assigning an insurance contract to a distant rainfall station reduced mean willingness to pay by 29.45 Rupees (p < 0.01), cutting baseline policy valuation (68.4 Rupees) roughly in half.

Takeaway

Deploy dense networks of automated weather stations or satellite-derived rainfall indices to reduce distance-induced basis risk before marketing index insurance to smallholder producers.

Source and citation

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