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Abstract:
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Index insurance is a financial tool that can help individuals hedge their risk of low income when their annual income is uncertain. Recently, it has been suggested as a way for farmers in developing countries to increase their chance of avoiding a poverty trap. The key mechanisms underlying index insurance are statistical: an index, such as rainfall, is correlated with a farmer's income, and a weather derivative is designed that reduces the variance of the farmer's annual income, at the cost of simultaneously reducing his expected income. We discuss a framework for designing index insurance contracts, and also specific models and weather-based contracts that are fit to data from sites in Africa and Central America. We show that substantial reductions in variance can be achieved with small reductions in expected value, provided that transaction costs aren't prohibitively large.
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