WP 2016-07 Evaluating the Welfare of Index Insurance

AUTHORS: Glenn W. Harrison, Jimmy Martínez-Correa, Karlijn Morsink, Jia Min Ng and J. Todd Swarthout

ABSTRACT: Index insurance is a complex financial product with significant potential as a risk management product for weather, climate, and aggregate health risks. It is difficult to understand by many consumers, and several behavioural characteristics determine its potential welfare contribution. Evaluations of the product, and other complex financial products, therefore need to start from the recognition that individuals make mistakes when purchasing financial products, and are heterogenous in terms of the relevant preferences and beliefs. We apply the principles of behavioural welfare economics and use descriptive models of risk preferences to make normative evaluations of index insurance purchase decisions. We demonstrate that the level and the type of risk preferences, as well as violations of the Reduction of Compound Lotteries Axiom, matter for welfare. Individuals in an experiment only maximize, on average, 50% of the potential welfare gain that can be achieved by purchasing index insurance or not. We show that “bad” decisions in terms of welfare are predominantly generated by excess purchase, and that alternative "framing" of the insurance purchase decision context has potential to improve welfare.