Learning from Lemons: The Role of Government in Index Insurance for Individuals

Abstract

This paper considers the potential role of government in aiding the scale-up of high quality index insurance products in developing countries. In particular, we analyse optimal public policy in light of the fact that index insurance policies are typically credence goods - that is, the basis risk of a given policy cannot be distinguished by consumers before purchase and only to a limited extent after purchase. We discuss two potential market failures that stem from this property that governments may seek to correct: low takeup and low investment in reducing basis risk. In each case, we consider the costs and benefits of various alternative government policies. We show that policies aimed to improve take-up may improve or worsen incentives for investment, and that the precise nature of these effects will depend on the government’s ability to commit, the marginal cost of funds, and their potential to identify the inputs necessary for constructing a high quality index.