Concepedia

A Theory of Rational Demand for Index Insurance

American Economic Journal Microeconomics · 2016 · 289 citations · 25 references

TL;DR

Index insurance demand differs fundamentally from indemnity insurance because of basis risk. The paper introduces a simple ratio to monitor basis risk and uses it to explain the low demand for consumer hedging instruments. The authors derive upper bounds on optimal demand for risk‑averse and decreasing absolute risk‑averse agents given a belief. Optimal demand is zero for infinitely risk‑averse individuals and varies nonmonotonically with risk aversion, wealth, and price, explaining the low demand for consumer hedging. JEL codes: D14, D81, G13, G22, Q14.

Abstract

Rational demand for index insurance products is shown to be fundamentally different to that for indemnity insurance products due to the presence of basis risk. In particular, optimal demand is zero for infinitely risk-averse individuals, and is nonmonotonic in risk aversion, wealth, and price. For a given belief, upper bounds are derived for the optimal demand from risk-averse and decreasing absolute risk-averse decision makers. A simple ratio for monitoring basis risk is presented and applied to explain the low level of demand for consumer hedging instruments as a rational response to deadweight costs and basis risk. (JEL D14, D81, G13, G22, Q14)