Informal risk sharing and demand for index insurance: Experimental evidence from rural Uganda

Abstract

Index insurance holds promise for smallholder farmers in developing countries, but its value is limited by basis risk. If basis risk can be informally shared, the value of index insurance may increase, potentially raising demand. Conversely, formal insurance may reduce informal risk sharing; if farmers anticipate this, their demand may decline, making the net effect ambiguous. We designed a lab experiment to study how informal risk sharing affects demand for index insurance and implemented it among farmers in Uganda. We find that demand for index insurance decreases in the presence of risk sharing, suggesting that informal arrangements crowd out formal insurance. We also find that absolute informal transfers are larger under index than under indemnity insurance. At the same time, the availability of risk sharing paradoxically reduces demand for index insurance, primarily by lowering high coverage choices. We discuss how strong sharing norms and behavioral motives may explain this finding.