Basis Risk and Low Demand for Weather Index Insurance

Basis risk --an imperfect correlation between an aggregate index and idiosyncratic damage-- is a major impediment to index insurance take-up in developing countries. However, empirical evidence is scarce because of the difficulty in its direct measurement. This study uses household panel data from rural Zambia to estimate the impact of spatial basis risk on demand for a rainfall index insurance contract. First, we develop a simple insurance demand model to motivate our econometric specifications. Then, we quantify the spatial basis risk for each household using past rainfall data at the plot level. Exploiting changes in insurance design across years, we use within-household variations in basis risk to identify its impact. The empirical results show that spatial basis risk suppresses insurance demand. Despite its statistical significance, our results also suggest that minimizing the spatial basis risk would not yield sufficient economic benefits to offset the associated costs. Overall, this study offers a general analysis framework for spatial basis risk, product basis risk, and index insurance demand.