Marketing Rainfall Insurance to the Informally Insured in India

Project Summary
Agricultural activity is inherently risky, and smoothing consumption across years or seasons is a significant challenge for agrarian households in developing countries. Farmers and entrepreneurs in rural agrarian economies therefore should have high demand for credit and insurance services, but the option to purchase such services often does not exist.  Institutional innovations that lower the cost of loans have led to thriving microcredit enterprises in certain areas, but farmers still largely resort to informal alternatives – insuring each other through gifts and loans, forward-selling labor to landowners at high implicit interest rates – to cope with risks associated with pest or drought-induced harvest failure or price volatility in commodities markets.  Surprisingly, rainfall insurance markets do not function well even in areas where farmers face large weather risks.  Recent studies show that take-up rates are extremely low even when actuarially-fair rainfall insurance contracts are offered.

There are several possible explanations for the observed low demand for formal insurance products: (a) liquidity constrained households cannot afford premiums, (b) insurance products are too complex for uneducated farmers, (c) farmers do not trust the insurance seller to make the promised pay-outs, or (d) farmers are already implicitly insured through informal networks or through limited liability credit contracts, which in turn limits their demand for a formal insurance product.

This IGC-funded research project seeks to understand why Indian farmers exposed to rainfall risk are reluctant to purchase formal insurance products that mitigate those risks. Our approach combines exogenous natural variation in informal insurance among Indian farmers (based on their membership in a sub-caste-based risk-sharing network), with designed (randomized) variation in the insurance contract offered. The randomized design component of the project will help identify the causal effects of liquidity (or credit or savings) constraints in explaining low take-up rates. On the other hand, marketing to farmers from different sub-castes or jatis who are differentially indemnified through their informal risk-sharing networks will help identify whether farmers are reluctant to purchase formal insurance contracts simply because they are already informally insured.

The Interaction Between Informal Risk Sharing & Index Insurance
We show in a simple model incorporating cooperative informal risk sharing and index insurance subject to basis risk (i.e. mismatches between the rainfall-index-based payouts and the actual losses incurred by the policy holders) that formal insurance products and informal risk sharing networks interact in the market in ways that depend upon the type of informal indemnification and the extent of basis risk afflicting the index-based insurance product.  When the formal insurance product is imperfect due to basis risk, informal risk sharing, by covering household losses that are the consequence of basis risk, may enhance the benefits from formal index insurance contracts.  Thus, the index contract increases risk-taking in constant to informal risk-sharing networks, which may reduce risk-taking if the network primarily indemnifies against idiosyncratic risk.

Using a combination of non-experimental and experimental survey data from rural India, we find that sub-castes both compensate for individual losses and pay out on the basis of village-level rainfall shocks.  We also find empricially that basis risk, as measured by the perceived distance of the respondent to the nearest rainfall station, is a significant impediment to the take-up of the index insurance product.  However, the negative effect of basis risk is attenuated for households in sub-castes that more successfully indemnify individual losses.  Households in sub-castes that already informally provide insurance coverage based on aggregate shocks on the other hand are less likely to purchase the index product. Thus, our findings indicate that informal insurance is both a complement to formal index insurance and a substitute, depending on basis risk and the nature of the informal insurance arrangement.

Marketing Insurance
In the course of marketing insurance products for the randomized experiment component of this project, we found that agricultural laborers, whose livelihoods are weather dependent, demonstrate as strong a demand for weather index insurance as cultivating landowners. Strikingly, landless laborers currently do not have access to index insurance markets because regulatory restrictions in India prevent the sale of such contracts to non-cultivators. Laborers are less susceptible to basis risk, and the relative demand for index insurance is particularly strong among this group compared with cultivator households in villages that are farther away from rainfall stations.

General Equilibrium Effects
Consistent with the theoretical predictions of a general-equilibrium model of wage setting with weather risk, we find that both labor demand and equilibrium wages become more rainfall sensitive when cultivators are offered rainfall insurance, because insurance induces cultivators to switch to riskier, higher-yield production methods. The same insurance contract offered to agricultural laborers smoothes wages across rainfall states by reducing labor supply during droughts (when insurance payouts occur). Policy simulations based on our estimates suggest that selling insurance only to land-owning cultivators (which is the current regulatory practice in India and other developing countries) makes wage laborers worse off in some states of the world due to the increase in wage volatility, relative to a situation where insurance does not exist at all. Marketing insurance to both cultivators and the landless eliminates this adverse effect on the landless, and mildly increases average wages compared to a regime of no insurance.

These findings also yield a clear policy message – the current practice of designing insurance contracts on the basis of owned acreage, and marketing products only to landed cultivators likely reduces the welfare of the landless. These unintended spillovers create a more risky economic environment for those who have to rely exclusively on their own labor for their livelihoods. The problem is compounded because this same population is also denied the possibility of insurance coverage. Our general-equilibrium analysis highlights this adverse spillover effect on a non-treated population, but our experimental design and simulations also allows us to show that the problem can be addressed by expanding insurance coverage for this population.

Research Partners:
Mark Rosenzweig (Yale University); Center for Microfinance, IFMR (Chennai, India); National Center for Applied Economic Research (Delhi, India)

Papers Submitted
A. M. Mobarak and M. Rosenzweig. “Informal Risk Sharing, Index Insurance, and Risk-Taking in Developing Countries,” American Economic Review: Papers & Proceedings, 103(3): 375-380, May 2013
A. M. Mobarak and M. Rosenzweig. “Risk, Insurance and Wages in General Equilibrium” Working Paper
A. M. Mobarak and M. Rosenzweig. “Selling Formal Insurance to the Informally Insured” Working Paper

Press & Blog Coverage
Ideas for India, November 16, 2012. “Formally insuring the informally insured

175th public meeting of Board for International Food and Agricultural Development for USAID

IGC Bangladesh Presentation by Dr. Mobarak, “Formally insuring the informally insured

NCAER Questionnaires (Link)
Insurance Sales Scripts (Link)
Follow-up Survey (Link)