Index-Based Insurance in Developing Countries : Rational Neglect?

Microinsurance adoption in developing countries is low, despite its potential to foster economic growth. Recent research is not able to explain the low take-up rates within the neoclassical framework. I contribute to this stream of research by proposing rational as well as boundedly rational explanations for the low attractiveness of microinsurance within a stochastic framework. More precisely, I analyse weather index insurance that guarantees farmers an indemnity payment contingent on the realized rainfall at the nearest weather station. My model makes separate predictions for close farmers, whose location is near a weather station, and distant farmers. Results show that the latter ask for less than 50% insurance coverage even under perfect rationality. I extend the model by integrating two possible cognitive biases that reflect a lack of trust and a lack of knowledge about the insurance. I can show that a lack of trust reduces insurance demand most for close farmers, while a lack of understanding negatively affects the demand of distant farmers. Moreover, subsidies are more effective for close than for distant farmers