Risk sharing and the demand for insurance: Theory and experimental evidence from Ethiopia

Households in developing countries commonly engage in risk sharing to cope with shocks. Despite this, the residual risk they remain exposed to — often due to aggregate events such as droughts and floods — is considerable. To mitigate these risks, governments, NGOs and multilateral organizations have introduced index insurance. To appreciate its welfare implications, however, it is necessary to assess how insurance interacts with pre-existing risk sharing. We ask to what extent the demand for index insurance — as compared to standard indemnity insurance — depends on the level of pre-existing risk sharing. We contribute by developing a simple theoretical framework which shows that, relative to a state of autarky, risk sharing between agents increases demand for index insurance and decreases demand for indemnity insurance. In an artefactual field experiment with Ethiopian farmers who share risk in real life, we test and confirm these predictions.