Behavioral Economics & the Design of Agricultural Index Insurance in Developing Countries

Research has shown that people do not approach risk in accordance with economics' workhorse theory of "expected utility." For example, a simple contract reformulation in Peru led to a tripling of demand, which is seemingly consistent with insights from behavioral economics, such as cumulative prospect theory. One area of focus in behavioral economics is the concept of compound risk aversion. Basis risk is a significant concern in index insurance, but compound risk aversion makes it even bigger. In Mali, a study measured ambiguity aversion and its impact on insurance demand. The results showed that certain premium and uncertain payouts have a greater impact on insurance demand than previously thought. Another area of focus is the concept of discontinuous preferences, specifically a strong preference for certainty. In Burkina Faso, a study examined the impact of contract formulation on contract demand. The results showed that people are more likely to purchase insurance contracts that offer certainty, rather than those with uncertain payouts. Index insurance can be viewed as a compound lottery, where the contract failure probability (q2) is greater than zero. Expected utility theory explanations predict that people will dislike partial insurance, but empirical evidence shows that people demand more than a 20% reduction in the premium to compensate for q2 = 1%. This aversion to basis risk is even more pronounced when insurance is a compound lottery. Aversion to ambiguity and compound lotteries is a long-standing phenomenon in behavioral economics. People tend to act more conservatively in the presence of ambiguity, and this aversion is linked to compound risk attitudes. A study in Mali used a framed field experiment to measure the coefficient of risk aversion and compound-risk aversion among cotton farmers. The results showed that people are willing to pay a premium to eliminate basis risk, even if they are compound-risk neutral. The study used a smooth model of ambiguity aversion to model compound risk aversion. The results showed that compound-risk aversion has a significant impact on index insurance demand. The predicted impact of compound risk aversion on index insurance demand is shown in a graph, where the fraction of the population that would purchase the contract decreases as the probability of false negative increases. Overall, behavioral economics provides valuable insights into the design of and demand for agricultural index insurance. By understanding the concepts of compound risk aversion and discontinuous preferences, policymakers and insurance providers can design more effective insurance products that meet the needs of farmers in developing countries.