Why Index-Based Insurance Could Work

By Shardul Oza

A post by NYU researcher Jonathan Bauchet on the CGAP Microfinance Blog discusses some of the reasons behind the low takeup of microinsurance products.  Bauchet mentions results from CMF’s randomized controlled trial study of an index-based weather insurance product in rural Gujarat which show that price is a major barrier to adoption. (The studies, conducted in Andhra Pradesh and Gujarat, also find that trust and household liquidity constraints significantly impact takeup.)
He goes on to cite the promise of index-based insurance, new products which may help minimize the administrative and incentive problems associated with standard insurance programs. He writes:

New innovative insurance products carry high hopes for expanding insurance offerings and take up. “Index” insurance products rely on public events to trigger payouts rather than clients reporting a loss and starting a costly and typically lengthy claims verification process.
Read the Bauchet’s original post here.
How do index-based products solve incentive problems?
Since index-based products calculate payouts based on publicly observable events, insurance, purchasers cannot change their behavior to increase the chance that they will receive a payout (moral hazard). For example, a farmer who purchases crop insurance which insures him based on yield, may have an incentive to underinvest in his plots, since underinvesting will increase the probability that he will receive a payout. However, if he is insured based on a factor that impacts yield but that he cannot control (rainfall), he has less incentive to underinvest (in terms of time, labor or farm inputs).
While rainfall insurance is promising, researchers and practitioners must be able to a) design products that truly protect against crop losses and; b) market rainfall insurance effectively.
CMF, in partnership with several researchers based in the US, in is currently conducting two studies to assess the impact of weather insurance on low-income households and to better understand what factors impact takeup:
1) An long-term impact evaluation of index-based weather insurance in Gujarat
2) A study examining whether being informally insured through caste networks dampens the demand for formal insurance
To read about these studies and for more information on index-based products, please see our weather insurance web portal.