| Abstract: |
Moral hazard and adverse selection impede the development of formal crop
insurance markets in developing countries. Besides, the risk mitigation
provided by informal risk-sharing arrangements is restricted by their
inability to protect against covariate shocks. In this context, index-based
insurance is seen as a promising scheme as it is immune to moral hazard and
adverse selection and may offer effective protection against covariate shocks.
It would thus seem that the two institutions are ideal complements.
Unfortunately, this intuition ignores the potential effects on incentives and
behavior generated by the interaction between both schemes. This paper
explores this interaction in a model with moral hazard and shows that the
formal contract may crowd out informal risk-sharing if it is offered to
individuals. Second, we find that both risk-taking and welfare may be reduced
by the introduction of index insurance if the premium is set too high. If the
formal insurance is offered to the group instead of the individual, the impact
on moral hazard is internalized and welfare increases. |