Insure or Unsure? The Role of Negative and Positive Basis Risk in Weather Index Insurance Uptake in Kenya

Weather index insurance may help smallholder farmers in the developing world cope with environmental risks and shock-induced poverty traps. Despite this, adoption rates remain low. Basis risk—or the disconnect between observed outcomes and the index itself—is cited as a core contributor, unique to index insurance among other factors usually ascribed to low technology adoption. We examine a rainfall-based index insurance in Kenya and explore how its uptake relates to a measure of basis risk constructed from simple rainfall thresholds. This is the first attempt to estimate the elasticity of adoption not only to negative (type I error: no pay-out under low rain conditions) but also positive basis risk (type II error: pay-out under favourable conditions). We find notable levels of negative basis risk, with around 7% of farmers receiving no pay-out following ‘drought-like’ conditions in the insured period. We gauge the elasticity of georeferenced insurance demand to prior adoptions in the same area under various outcomes of pay-out and basis risk. Uptake is found to be positively related to localised prior outcomes when the product performs as ‘expected’, and negatively related to likely basis risk outcomes. Importantly, this result holds irrespective of the basis risk being negative or positive. The latter finding is the main contribution of this paper: it suggests that the effect is driven by updated reliability expectations, rather than income effects. We take this as evidence to support the theoretical notion that smallholders consider weather insurance products as risk protection mechanisms, rather than risky bets. In the eyes of those seeking to insure, positive and negative basis risk do not cancel each other out, rather compounding a distaste for the (non-performing) insurance product