A Theory of Rational Demand for Index Insurance

Abstract

Rational demand for index insurance products is shown to be fundamentally different to that for indemnity insurance products due to the presence of basis risk. In particular, optimal demand is zero for infinitely risk-averse individuals, and is nonmonotonic in risk aversion, wealth, and price. For a given belief, upper bounds are derived for the optimal demand from risk-averse and decreasing absolute risk-averse decision makers. A simple ratio for monitoring basis risk is presented and applied to explain the low level of demand for consumer hedging instruments as a rational response to deadweight costs and basis risk. (JEL D14, D81, G13, G22, Q14)