Paper: Basis Risk and Compound-risk Aversion: Evidence from a WTP Experiment in Mali

In this paper, we present a novel way to understand the low uptake of index insurance using the interlinked concepts of ambiguity and compound lottery aversion. We begin our analysis by looking at index insurance from the farmer's perspective, noticing that index insurance is a compound lottery. Specifically, we use the smooth model of ambiguity aversion developed by Klibanoff, Marinacci, and Mukerji (2005) to derive an expression of the willingness to pay to reduce basis risk. Empirically, we implement the WTP measure using framed field experiments with cotton farmers in southern Mali. In this sample, 57% of the surveyed farmers reveal themselves to be compound-risk averse to various degrees. Using the distributions of compound-risk aversion and risk aversion in this population, we then simulate the impact of basis risk on the demand for an index insurance contract whose structure mimics the structure of an actual index insurance contract distributed in Mali. Compound-risk aversion decreases the demand for index insurance relative to what it would be if individuals had the same degree of risk aversion but were compound-risk neutral. In addition, demand declines more steeply as basis risk increases under compound-risk aversion. Our results highlight the importance of designing contracts with minimal basis risk if potential buyers are compound-risk averse.

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