Dynamics of informal risk sharing in collective index insurance

Extreme weather events often prevent low-income farmers from accessing high-return technologies that would enhance their productivity. As a result, they often fall into poverty traps, a problem likely to worsen as the frequency of weather disasters increases due to climate change. Insurance offers, in principle, a solution for this conundrum and a means to guarantee households’ wellbeing. Group collective index insurance constitutes an alternative to indemnity or individual index insurance, and has the potential to alleviate basis risk through within-group informal transfers. Here we show that collective index insurance introduces a coordination dilemma of insurance adoption: socially optimal outcomes are obtained when everyone adopts insurance; however, a minimum fraction of contributors is necessary before the effects of basis risk can be averaged out and individuals start taking up insurance. We further show that additional mechanisms—such as local peer monitoring and defector exclusion—are necessary to stabilize informal transfers and collective index insurance adoption. Together, collective index insurance and informal transfers may thus constitute a practical instrument to improve sustainability in developing countries.