Basis risk and welfare effect of weather index insurance for smallholders in China

Recent years have witnessed a proliferation of weather-index insurance (WII) pilot programs in developing countries. However, the uptake of this novel insurance turns to be generally low despite that most WII programs are heavily subsidized by central and local government. Although basis risk is widely referred to as the most serious drawbacks to the effectiveness of index-based insurance, the impact of basis risk on the potential benefits of adopting weather index insurance is rarely documented. This paper designs a weather index contract for cotton in Shandong province and examines impact of two components of basis risk, covariate risk and idiosyncratic risk, separately. The findings of this paper underscores the importance of minimizing covariate risk in designing weather index insurance contracts and sheds lights on the different impacts of basis risk components on potential benefits of WII