Basis Risk and the Welfare Gains from Index Insurance: Evidence from Northern Kenya

Jensen, Nathaniel D. and Barrett, Christopher B. and Mude, Andrew G. (2014): Basis Risk and the Welfare Gains from Index Insurance: Evidence from Northern Kenya.

Abstract

Index insurance products circumvent many of the transaction costs and asymmetric information problems that obstruct provision of low value conventional insurance policies in developing countries. Recent years have seen tremendous growth in index insurance pilots in developing countries, but there has been little progress in our understanding of the quality of those products. Basis risk, or remaining uninsured risk, is a widely recognized, but rarely measured drawback of index insurance that carries significant implications for the quality of any such product. This research uses a rich longitudinal household dataset to examine basis risk associated with an index based livestock insurance (IBLI) product available to pastoralists in northern Kenya since 2010. We find that IBLI coverage reduces downside risk for most households when purchased at actuarially fair premium rates and has net utility benefits for most even at commercial rates. Examining the components of basis risk, we find that IBLI reduces exposure to covariate risk due to high loss events by an average of 62.8%. The benefits of reduced covariate risk exposure are relatively small, however, due to high exposure to seemingly mostly random idiosyncratic risk, even in this population often thought to suffer largely from covariate shocks. Depending on covariate region, IBLI policy holders are left with an average of between 62.3% and 76.7% of their original risk due to high loss events. This research underscores the need for caution when promoting index insurance as a tool for reducing exposure to risk and the importance of ex post product evaluation.

• Item Type: MPRA Paper
• Language: English
• Keywords: index insurance, basis risk, pastoralists, Kenya
• Subjects: O - Economic Development, Innovation, Technological Change, and Growth > O1 - Economic Development; O - Economic Development, Innovation, Technological Change, and Growth > O1 - Economic Development > O16 - Financial Markets ; Saving and Capital Investment ; Corporate Finance and Governance

References

Barrett, C. B., Belle mare, M. F., & Osterloh, S. M. (2006). Household-level livestock marketing behavior among northern Kenyan and southern Ethiopian pastoralists. In McPeak, J., & Little, P. (Eds.), Pastoral Livestock Marketing in Eastern Africa: Research and Policy Challenges, (15-38). London: Intermediate Technology Development Group Publishing.

Barrett, C. B., Marenya, P. P., McPeak, J., Minten, B., Murithi, F., Oluoch-Kosura, W., Place, F., Randrianarisoa, J., Rasambainarivo, J., & Wangila, J. (2006). Welfare dynamics in rural Kenya and Madagascar. Journal of Development Studies, 42(2), 248-277.

Barrett, C.B., & Santos, P. (2014). The Impact of Changing Rainfall Variability on Resource-Dependent Wealth Dynamics, Ecological Economics, 105(1), 48-54.

Breustedt, G., Bokusheva, R., & Heidelbach, O. (2008). Evaluating the potential of index insurance schemes to reduce crop yield risk in an arid region. Journal of Agricultural Economics, 59(2), 312-328.

Chantarat, S., Mude, A. G., Barrett, C. B. and Carter, M. R. (2013). Designing Index-Based Livestock Insurance for Managing Asset Risk in Northern Kenya. Journal of Risk and Insurance, 80, 205–237.

Clarke, D. J. (2011). A theory of rational demand for index insurance. Department of Economics D. Phil. dissertation, University of Oxford.

Dercon, S., Hill, R. V., Clarke, D., Outes-Leon, I., & Seyoum Taffesse, A. (2014). Offering rainfall insurance to informal insurance groups: evidence from a field experiment in Ethiopia. Journal of Development Economics, 106, 132-143.

Elabed, G., Bellemare, M. F., Carter, M. R., & Guirkinger, C. (2013). Managing basis risk with multiscale index insurance. Agricultural Economics, 44(4-5), 419-431.

Giné, X., Townsend, R., & Vickery, J. (2008). Patterns of rainfall insurance participation in rural India. World Bank Economic Review, 22(3), 539-566.

Global Index Insurance Facility. (2013). Global Index Insurance Facility Factsheet. Updated April 2013.

Hazell, P. B., & Hess, U. (2010). Drought insurance for agricultural development and food security in dryland areas. Food Security, 2(4), 395-405.

Hill, R. V., Robles, M., & Ceballos, F. (2013). Demand for Weather Hedges in India: An Empirical Exploration of Theoretical Predictions. Food Policy Research Institute (IFPRI) Discussion Paper 1280.

Jensen, N., Mude, A., & Barrett, C.B. (2014). How Basis Risk and Spatiotemporal Adverse Selection Influence Demand for Index Insurance: Evidence from Northern Kenya. Working paper, Cornell University.

Kenya National Bureau of Statistics. (2013). Consumer Price Indices. Retrieved May 28, 2014, from http://www.knbs.or.ke/

Leblois, A., Quirion, P., & Sultan, B. (2014). Price vs. weather shock hedging for cash crops: Ex ante evaluation for cotton producers in Cameroon. Ecological Economics, 101, 67-80

Lybbert, T. J., Barrett, C. B., Desta, S., & Layne Coppock, D. (2004). Stochastic wealth dynamics and risk management among a poor population. Economic Journal, 114(498), 750-777.

Mahul, O. (1999). Optimum area yield crop insurance. American Journal of Agricultural Economics, 81(1), 75-82.

McPeak, J. G., Little, P. D., & Doss, C. R. (2012). Risk and social change in an African rural economy: livelihoods in pastoralist communities. New York: Rutledge. Miranda, M. J. (1991). Area-yield crop insurance reconsidered. American Journal of Agricultural Economics, 73(2), 233-242.

Miranda, M. J., & Farrin, K. (2012). Index insurance for developing countries. Applied Economic Perspectives and Policy, 34(3), 391-427.

Mobarak, A., & Rosenzweig, M. (2012). Selling formal insurance to the informally insured. Yale University Economic Growth Center Discussion Paper 1007.

Norton, M. T., Turvey, C., & Osgood, D. (2012). Quantifying spatial basis risk for weather index insurance. Journal of Risk Finance, 14(1), 20-34.

OCHA. 2011. Eastern Africa: Drought - Humanitarian Snapshot. http://www.fews.net/docs/Publications/Horn_of_africa_drought_2011_06.pdf.

Santos, P. & Barrett, C. (2006). Heterogeneous Wealth Dynamics: On the Roles of Risk and Ability, Working paper, Cornell University.

Smith, V. H., Chouinard, H. H., & Baquet, A. E. (1994). Almost ideal area yield crop insurance contracts. Agricultural and Resource Economics Review, 23(1).

Smith, V., & Watts, M. (2009). Index based agricultural insurance in developing countries: Feasibility, scalability and sustainability. Report to the Gates Foundation.

Turvey, C. G. (2001). Weather derivatives for specific event risks in agriculture. Review of Agricultural Economics, 23 (2), 333-351.

USAID/OFDA. 2011. Horn of Africa-Drought, Fact Sheet #1, Fiscal Year 2011.

Vedenov, D. V., & Barnett, B. J. (2004). Efficiency of weather derivatives as primary crop insurance instruments. Journal of Agricultural and Resource Economics, 387-403.

Vrieling A, Meroni M, Shee A, Mude A, Woodard J, & de Bie Rambold, F. (2014). Historical Extension of Aggregated NDVI from Operational Products for Livestock Insurance in Kenya. International Journal of Applied Earth Observation and Geoinformation, 28 (238-251).

Williams, J. R., Carriker, G. L., Barnaby, G. A., & Harper, J. K. (1993). Crop insurance and disaster assistance designs for wheat and grain sorghum. American Journal of Agricultural Economics, 75(2), 435-447.

Woodard, J. D., & Garcia, P. (2008). Basis risk and weather hedging effectiveness. Agricultural Finance Review, 68 (1), 99-117.

Woodard, J. D., Pavlista, A. D., Schnitkey, G. D., Burgener, P. A., & Ward, K. A. (2012). Government Insurance Program Design, Incentive Effects, and Technology Adoption: The Case of Skip-Row Crop Insurance. American Journal of Agricultural Economics, 94(4), 823-837.

Woodard J, Shee A, & Mude A. (2014). A Spatial Econometric Approach to Scalable Index Insurance against Drought Related Livestock Mortality in Kenya. Under review, Journal of Risk and Insurance.

Zwaagstra, L., Sharif, Z., Wambile, A., Leeuw, J. D., Said, M. Y., Johnson, N., Njuki, J., Said, M., Ericksen, P., & Herrero, M. (2010). An assessment of the response to the 2008 2009 drought in Kenya. International Livestock Research Institute (ILRI).