Index Basis Risk Sensitivity
RCTReview
Index insurance payouts rely on measurements from central reference stations rather than individual plot damage, creating spatial basis risk where a farmer suffers localized crop failure without receiving compensation. This potential mismatch significantly diminishes consumer valuation and adoption of index contracts.
Picture this
Imagine buying a home fire insurance policy whose payout is triggered only if a smoke detector located in a neighboring town 10 miles away goes off. If a fire destroys a house but the smoke fails to reach the distant detector, no payout occurs, making the homeowner view the insurance policy as nearly worthless despite its official coverage terms.
What the evidence says
Assigning an insurance policy to a distant weather station (introducing substantial basis risk) reduced farmer willingness-to-pay by Rs. 29.45 (p < 0.01), effectively halving consumer valuation from the baseline average bid of Rs. 68.40 despite identical actuarial expected payouts.
- Who was studied
- N = 1,978 smallholder farmers (1,464 existing participants and 514 new subjects) in Andhra Pradesh, India.
- How
- Incentive-compatible Becker-DeGroot-Marschak (BDM) mechanism comparing willingness-to-pay for local weather station policies against policies tied to distant reference stations.
What to do
Construct dense networks of automated weather stations or integrate remote-sensing satellite data to minimize reference station distance and reduce basis risk in agricultural microinsurance.
From the source
"Finally, the coefficient on the indicator for the policy that induces substantial basis risk is negative and very large, roughly halving farmers' willingness to pay for policies."
751_How_Does_Risk_Management_Influence_Production_Decisions.pdf