Paper: Fail-safe Index Insurance Without the Cost: a Satellite Based Conditional Audit Approach

While index insurance offers a compelling solution to the problem of covariant risk among smallholder farmers in developing countries, most weather based contracts suffer from poor quality due to a low correlation between the index and farmer losses. Moreover, area yield contracts are generally infeasible due to high data collection costs. This paper proposes and analyzes an alternative index insurance contract, which combines a satellite based index with the potential for a second-stage audit. The satellite index is created using a model which takes publicly available high-resolution satellite data and converts them into an index. Using plot level panel data from a retrospective yield survey among smallholder rice farmers in Tanzania, the research team estimate a response function mapping actual yields to this index. If the index fails to predict losses, an audit, in the form of a crop-cutting exercise, can be invoked at farmers’ request. The team's results suggest that the index explains approximately 60% of the variation in zone level yields across years. Moreover, when combining this index with a possibility of an audit, this contract closely mimics the payouts of an area yield contract, but at a fraction of the cost, as audits are estimated to occur only 17% of the time. Based on expected utility analysis, the Principal Investigator also shows that demand for this contract would exceed that of an area yield contract and a pure satellite contract under reasonable loading cost assumptions.