Clarke Rational Basis Risk Rejection
Expert TheoryReview
Under index insurance with basis risk, highly risk-averse farmers face the hazard of incurring a total crop loss without receiving an insurance payout while still paying the insurance premium. This creates a scenario where risk-averse individuals rationally demand less index insurance than risk-neutral individuals.
Picture this
Imagine a cautious homeowner who buys storm insurance. If a tornado destroys their house but a distant airport weather gauge registers normal wind speeds, the insurance company refuses to pay, leaving the homeowner poorer by the cost of the unpaid claim plus the insurance fee.
What the evidence says
Risk aversion is negatively correlated with stated willingness to pay (p < 0.05) and shows no positive effect on actual uptake (marginal effect = -0.00285, p > 0.10), confirming theoretical models where basis risk reverses standard expected utility predictions.
- Who was studied
- N = 2,399 rural smallholder households in Amhara, Ethiopia (baseline contingent valuation) and N = 418 households (behavioral game experiments).
- How
- Probit regression analyzing stated willingness to pay and actual purchase behavior against experimental risk aversion measures and distance-based basis risk metrics.
What to do
Incorporate downside basis risk protections or supplemental loss-verification mechanisms to prevent risk-averse farmers from rejecting index insurance contracts.
From the source
"Clarke (2011) ... suggests that in the presence of basis risk it is possible that households end up without payouts in the worst state of the world and yet still must pay premiums; hence highly risk-averse agents may dislike the product."
Productivity, credit, risk, and the demand for weather index insurance in smallholder agriculture in Ethiopia