Optimal Index Insurance and Basis Risk Decomposition: An Application to Kenya
New research released in AJAE
New research develops a theory of maximum insurable risk in index insurance, and showcases how satellite data can be used to estimate the maximum risk reduction for maize in Kenya. Results indicate that the maximum insurable risk is rather low in Kenya, highlighting a strong local heterogeneity in yields.
In the new article “Optimal index insurance and basis risk decomposition: an application to Kenya,” Matthieu Stigler from ETH Zurich and David Lobell from Stanford University, find out how well can index-based insurance products theoretically reduce risk in smallholder agriculture.
The authors say, “Our new theory shows that the optimal zone-level index is given by a Principal Component Analysis (PCA). This leads to a new interpretation of a standard statistic -the first eigenvalue of a PCA- as indicating the theoretical maximum insurable risk of a given insurance zone. Practically, this result allows now practitioners to quickly compare the performance of their proposed index relative to the theoretical optimal index, helping them to distinguish a ‘good index in a bad zone’ from a ‘bad index in a good zone.’ Empirically, our finding of a low homogeneity of yields in Kenya underscores the challenge of implementing index insurance in smallholder systems and the potential benefits of low-cost yield measurement approaches that can enable more local definitions of insurance zones.”
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