Premium Benefits? A Heterogeneous Agent Model of Credit-Linked Index Insurance and Farm Technology Adoption

Abstract

Lack of protection from downside risk has been posited as one explanation for sluggish technology uptake among subsistence agricultural households in the developing world. Access to credit and insurance is thought to be a stimulant to technology adoption where new methods are riskier but higher yielding on average, or, in the alternative, require sunk costs of investment that can be significant for households that already consume very little when harvests are poor. Despite recent efforts to pilot index-based insurance to smallholder farmers where no formal insurance was previously available, demand for individual-level contracts has been unexceptional at best, even when premiums are highly subsidized. On the flip side, the effect of index insurance on credit supply is ambiguous: if clients are insured against potential losses, theory suggests that credit supply should increase, as banks face lower probabilities of systemic default; however, due in part to the nature of basis risk that is inherent in index-based contracts, there are cases in which mandatory index insurance that indemnifies the policyholder directly can lead to decreased internal rates of return for lending institutions. In this paper, we employ a dynamic, stochastic, heterogeneous agent model where farm households have access to contingent credit or credit-linked insurance, and may also make dichotomous choices regarding technology and loan repayment in each period. The approach we take is novel in that insurance is modeled as a meso-level product, where the bank is first indemnified before any payouts are distributed to its borrowing clients. Thus, the model we put forward takes into account both supply- and demand-side concerns, and shows the possibilities of a trickle-down effect when index insurance contracts are sold not to individual households, but instead to risk aggregators for whom basis risk is lower. Results show that insurance can have a positive effect on technology uptake, while letting the lender lay first claim on indemnities lowers default rates.