Relative advantages and disadvantages of index insurance

Index insurance can sometimes offer superior risk protection compared to traditional farm-level, multiple- peril crop insurance. Deductibles, co-payments, or other partial payments for loss are commonly used by farm-level, multiple-peril insurance providers to mitigate asymmetric information problems such as adverse selection and moral hazard. Asymmetric information problems are much lower with index insurance because, first, a producer has little more information than the insurer regarding the index value, and second, individual producers are generally unable to influence the index value, ttis characteristic of index insurance means that there is less need for deductibles and co-payments. Similarly, unlike traditional insurance, few restrictions need be placed on the amount of coverage an individual purchases. As long as the individual farmer cannot influence the realized value of the index, liability need not be restricted. An exception occurs when governments offer premium subsidies as a percentage of total premiums. In this case, the government may want to restrict liability (and thus, premium) to limit the amount of subsidy paid to a given policyholder. As more sophisticated systems, such as satellite imagery, are developed to measure events causing widespread losses, indexing major events should become more straightforward and quite acceptable to international capital markets. Under these conditions, traditional reinsurers and primary providers may begin offering insurance in countries they would have never previously considered. New risk management opportunities can develop if relevant, reliable, and trustworthy indexes can be constructed.

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