Conclusion and recommendations
Index-based insurance products are primarily used to mitigate the negative impacts of agriculture and livestock mortality risks and are especially attractive for developing countries because of its lower costs than traditional claim based insurance. Providing index-based insurance often depends on a risk sharing partnership between an insurance company and insurance customers, like farmers, sometimes supported by a governments or NGOs with start-up capital. Despite their advantages, the demand for index insurance products is lower than expected and there is limited empirical evidence to suggest that index insurance products are indeed risk reducing. Our literature review demonstrates that basis risk hampers the functioning of index insurance products and lowers insurance demand. However, while there are empirical studies that try to quantify the impact of basis risk on risk reduction and insurance demand, there are few systematic and complete analyses of these impacts. This can be attributed to a number of gaps in the current literature such as a lack of a clear definition of basis risk. To ameliorate this challenge, the review proposed that basis risk is defined as the weak correlation between the selected insurance index and the individual loss outcomes. The other gap in the current literature is that most studies only analyze a portion of basis risk, but basis risk is a multi-faceted problem with a variety of causes and the impacts of basis risk can be quite large if all these aspects are considered. To further complicate the analysis, there are many ways to design the index insurance contracts – area-yield index insurance, weather based index insurance, satellite based index insurance – and each approach has its advantage and disadvantage as discussed above. However, to the authors’ knowledge, there is not yet one study that provides an empirical comparison on the variation of basis risk across the different types of contracts.
