Addressing climate change through risk mitigation: Welfare implications of index insurance in Northeastern Tanzania

Abstract

While index insurance offers a compelling solution to the problem of covariant risk among smallholder farmers in developing countries, most rainfall-based contracts suffer from poor quality due to a low correlation between the index and farmer losses. Moreover, a lack of historical household-level yield data has made it difficult to quantify the level of basis risk and the impact on farmer welfare. This paper utilizes a unique dataset of plot-level historical rice yields in Northeastern Tanzania to estimate the level of basis risk and the welfare implications of two hypothetical index insurance contracts. One is a standard area-yield contract, while the other uses an index based on publicly available high-resolution satellite data that are mapped to actual yields to minimize basis risk. Our results suggest that the satellite index explains approximately 55 % of the variation in zone-level yields across years. Moreover, despite the presence of large basis risk under both contracts, they are each found to improve the welfare of the average farmer in the sample. Finally, we show that the demand for satellite contracts may be as high as 30 % under reasonable assumptions about loading costs and risk preferences.