Impact of Index Insurance on Moral Hazard in the Agricultural Credit Market: Theory and Evidence from Ghana

Abstract

Recent research suggests that coupling microfinance loans with an index insurance policy may be a cost-effective way to expand credit market access to smallholder farmers in developing countries. Index insurance can increase demand for credit and encourage increased supply of credit by protecting borrowers and lenders from covariate production shocks that discourage credit market expansion. In this paper, we propose that index insurance, when bundled with credit, may also reduce a different barrier to credit market access: high transaction costs caused by moral hazard in the credit market. We develop a theoretical model of a competitive credit market with moral hazard. In this market, lenders use either dynamic incentives or collateral to mitigate the moral hazard problem. The model shows that index insurance bundled with loan contracts can reduce moral hazard and increase borrower welfare. We then test the model and find some empirical support using a subset of data from a randomised control trial in northern Ghana.