Informal Risk Sharing and Demand for Index Insurance: Experimental Evidence from Rural Uganda

Index insurance holds promise for smallholder farmers in developing countries, but its value is limited by basis risk: the imperfect correlation between the index and actual losses. If basis risk can be informally shared among farmers, the value of index insurance may increase, potentially raising demand. Conversely, the availability of formal insurance may reduce informal risk sharing; if farmers anticipate this, their demand for insurance may decline. The net effect is therefore ambiguous.
We designed a lab experiment to study how informal risk sharing affects demand for index insurance and implemented it among farmers in Uganda. We find that demand for index insurance responds negatively to the presence of risk sharing, suggesting that informal arrangements crowd out formal insurance. We also find that absolute informal transfers are larger under index insurance than under indemnity insurance, but this reflects larger losses rather than a higher proportion of losses being shared. At the same time, the availability of risk sharing paradoxically reduces demand for index insurance, primarily by lowering high coverage choices. We discuss how strong local sharing norms and behavioral motives may help explain this finding.