The tradeoff between basis risk and transaction costs

Among the most significant issues for any insurance product is the question of how much monitoring and administration is needed to keep moral hazard and adverse selection to a minimum. To accomplish this goal, coinsurance and deductibles are used so that the insured shares the risk and any mistakes in offering too generous coverage are mitigated. Considerable information is needed to tailor insurance products and to minimize the basis risk even for individual insurance contracts. Increased information gathering and monitoring involve higher transaction costs, which convert directly into the higher premiums needed to cover them. Index insurance significantly reduces these transaction costs and can be written with lower deductibles and without introducing coinsurance. When farm yields are highly correlated with the index being used to provide insurance, offering higher levels of protection can result in risk transfer superior even to individual multiple-peril crop insurance (Barnett et al. 2005). tte direct trade-off between basis risk and transaction costs has implications for achieving sustainable product designs and for outlining the role of governments and markets. Section 21.5 will introduce the idea oflayering risk - an approach that also greatly depends on understanding the trade-off between basis risk and transaction costs. Under the risk-layering exercise, at least one party is assumed to accept a certain degree of basis risk at each layer of the risk transfer if the product is to be both sustainable and affordable. Otherwise, extremely high, and most likely, unaffordable transaction costs must be paid for products specifically designed to minimize or nullify basis risk. In effect, the social cost of having products with some basis risk may be significantly lower than the social cost ofhaving products with no basis risk but high transaction costs.

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