Welfare Consequences of the Compound Risks of Index Insurance

Index insurance is an attractive variant on the standard insurance contract that allows the determination of a loss event to be defined by one or more thresholds on an index that is positively correlated with actual losses. Index insurance also comes with a compound risk, basis risk. We examine how these compound risks for index insurance affect behavior towards the decision to purchase the product or not. Using incentivized experiments, we control the actuarial specifics of contracts offered, the information provided to decision makers, and our knowledge of the risk preferences of decision makers. We demonstrate that individuals that fail to process compound risks, end up purchasing the contract more than other individuals, as well as more than they should, generating significant welfare losses. We also develop a natural information treatment that mitigates these welfare losses.