WP 2022-02 Welfare Consequences of the Compound Risks of Index Insurance

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

ABSTRACT: Index insurance is an attractive variant on the standard insurance contract that allows the determination of a loss event to be defined by one or more thresholds on an index that is positively correlated with actual losses. Pre-defined payments would then be affected if the index threshold is triggered. One complication of index insurance is that the product poses a compound risk for the agent considering whether to purchase it or not. One risk is that the index pays off, and the other risk is that there is in fact a loss. We examine how these compound risks for index insurance affect behavior towards the decision to purchase the product or not. Using incentivized experiments we control the actuarial specifics of contracts offered, the information provided to decision makers, and our knowledge of the risk preferences of decision makers. We demonstrate the individuals that fail to process compound risks well end up purchasing the contract more than other individuals, as well as more than they should, generating significant welfare losses. We also develop a natural information treatment that mitigates these welfare losses.