Over the last few years, index insurance has been receiving an increasing amount of attention from researchers and policy makers.
Whereas regular insurance pays out when a verifiable loss is incurred (e.g., flood insurance pays out when there has been a flood), whether an index insurance pays out depends on whether some index crosses a certain threshold. So for example, a rainfall index insurance for the agricultural producers in a given region would pay out when growing conditions in that region are too dry, i.e., when rainfall falls below a specific, predetermined threshold.
The beauty of index insurance is that it greatly reduces the scope for moral hazard. Indeed, if I insure your crop, you might well decide to neglect your field, do nothing for the entire season, and wait for me to give you a payout. Not so with index insurance, since the index (e.g., rainfall, temperature, etc.) is typically very difficult to manipulate.
Insurance, which is one of the three components of finance (the other two being loans and savings; this has caused Jonathan Morduch to ask whether microinsurance was going to be the next revolution in development), is especially important in developing countries given that the presence of considerable risk prevents individuals and households from doing a number of things, such as adopting new technologies or expanding their productive activities.
The latest issue of Applied Economic Perspectives and Policy has a new paper on index insurance in developing countries, a survey by Miranda and Farrin summarizing what we have learned from index insurance research conducted in developing countries:
Unlike conventional insurance, which indemnifies policyholders for verifiable production losses arising from multiple perils, index insurance indemnifies policyholders based on the observed value of a specified “index” or some other closely related variable that is highly correlated with losses. Index insurance exhibits lower transaction costs than conventional insurance, potentially making it more affordable to the poor in the developing world. However, it also offers less effective individual risk protection. This article provides a review of recent theoretical and empirical research on index insurance for developing countries and summarizes lessons learned from index insurance projects implemented in the developing world since 2000.
I have an ongoing research project in West Africa looking at index insurance for cotton producers. We started by studying cotton producers in Mali, but the coup d’état which took place there last spring has forced us to relocate the project to neighboring Burkina Faso.
The silver lining is that this provides some sort of external validity check, since we can test whether we get similar results in Mali and in Burkina Faso.