A Prospect Theory Approach Explaining the Low Demand for Index-Based Insurance

Abstract

In a neoclassical framework risk averse agents ask for full insurance coverage if the premium is actuarially fair. Recent empirical observations of the demand for index-based weather insurance in developing countries reveal the opposite: the more risk averse farmers are, the less they buy insurance. In this work, we investigate if the same holds for loss averse farmers, i.e., if loss aversion might explain low take-up rates of index insurance. Therefore, we set up a stochastic model using prospect theory preferences. We distinguish two different groups of farmers: sophisticated farmers who understand the insurance product and naive farmers. Naive farmers neglect insurance coverage even if the premium is highly subsidized. Further, higher loss aversion implies a lower take-up rate. Sophisticated farmers buy more insurance the more loss averse they are. Finally, insurance demand might increase with a more frequent payout and a deferred premium payment.