Risk and ambiguity aversion behaviour in index-based insurance uptake decisions: Experimental evidence from Ethiopia 2016-2017

We conducted lab-in-the-field experiments with 1139 smallholders out of whom 596 have adopted IBI in Ethiopia to elicit their risk and ambiguity aversion behaviour, and examine whether risk and/or ambiguity aversion can explain actual IBI uptake decisions. Index-based insurance (IBI) is an innovative pro-poor climate risk management strategy that suffers from low uptake. Evidence on the role of behavioural impediments in adoption of IBI is scant. Our study suggests that an increase in risk- aversion increases uptake, but an increase in ambiguity-aversion lowers uptake of IBI. We also find evidence that an increase in risk aversion speeds-up the uptake of IBI, while an increase in ambiguity aversion delays the adoption of IBI.Farm households in Africa must cope with bad conditions as to soil quality, weather and infrastructure. The variability of rainfall causes yields to vary strongly from one year to the next. With yields already low (due to poor soil condition) these variations can be life threatening. Meanwhile, inadequate infrastructure makes it difficult to help the households with access to financial services, insurance and inputs that could stabilize their access to resources, and enhance yields. Solving a single aspect, say bringing inputs to the farm, will not be sufficient as credit is also needed. But credit can only be provided if sufficient likelihood exists that loans will be repaid. Here, insurance can help. If insurance of the loan makes it attractive enough for the lender, a package can be composed of inputs, with credit and insurance, that solves all these problems with one bundle. Yet, the households will remain exposed to some risks as insuring against all is prohibitively expensive. What is the appropriate degree of insurance in such bundles? That is the core question addressed in this research. It aims at supplying inputs to farmers on credit, with insurance, in such a way that a good balance is found between the benefits and risks to the farmers and the profits and risks to the credit provider. We investigate the possibilities for such a balanced approach in Kenya and Ethiopia in collaboration with a large insurance provider and a farmers organisation. Together with them we collect information on the costs, benefits and risks involved in using the inputs, the alternatives open to them, and the costs and benefits involved in providing credit to finance the purchase of inputs, with and without an insurance against crop failure. With all this information, we go and talk to the stakeholders concerned to find out how they would respond if more or less insurance would be provided. Will credit suppliers lower their prices, if repayment of loan is more likely because the crop is insured? Will households decide to take higher yielding (but more risky) crops if part of the downside risk is insured? We establish this for the parties concerned in Kenya and Ethiopia, but also in other African countries. Having established how these stakeholders respond to changes in insurance, we can proceed to derive what the best degree of insurance might be. And this is then finally tested in a field experiment. With this knowledge we can help other suppliers of insurance and credit, and farm organisations to establish similar packages that are adapted to the local conditions for input supply, and financial services.