Index-based insurance: Lottery ticket or insurance?

Abstract

Environmental shocks are drivers of poverty as well as a fact of life in many rural areas of the developing world. In the developed world, agricultural insurance provides some protection from such calamities. But conventional insurance products have not reached many rural households in developing countries due to the high costs of gathering information relative to the size of policies demanded and well-known moral hazard, and adverse selection issues that complicate product design and pricing. Recently, there has been much excitement around the use of index-based insurance, as an alternative to conventional insurance products, to extend the rural poor’s access to formal insurance coverage in developing countries (Alderman & Haque 2007; Barnett, Barrett & Skees 2008; Mahul & Stutley 2010). Index insurance provides indemnity payments based on a signal that 2 ILRI Research Brief—July 2015 is related to covariate losses rather than actual and observed individual losses. When signals are chosen properly—those that are easy to observe in near-realtime, exogenous to the behaviours and characteristics of both the insurer and insurees, and highly correlated with the insured risk—suppliers of index insurance face much lower costs associated with adverse section, moral hazard monitoring, and validation of claims than they would if they were offering conventional policies.