Index Basis Risk Sensitivity

In Simple Words

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.

Research question

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.

Participants

N = 1,978 smallholder farmers (1,464 existing participants and 514 new subjects) in Andhra Pradesh, India.

Study Design

Incentive-compatible Becker-DeGroot-Marschak (BDM) mechanism comparing willingness-to-pay for local weather station policies against policies tied to distant reference stations.

Results

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.

Takeaway

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.

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