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Demand for Weather Index Insurance Among Smallholder Farmers Under Prospect Theory ∗

This study examines the relationship between risk parameters and weather index insurance demand among smallholder producers in Kenya under prospect theory. Using an experimental game and an auction, we elicited three prospect theory relevant risk parameters (risk aversion, loss aversion, and non-linear probability) and insurance demand. We show theoretically that loss averse individuals are less likely to purchase insurance and this effect is more prominent when they face high insurance premiums. We then estimate the effects of risk parameters on insurance demand. Consistent with the theoretical results, we find that loss aversion has a negative effect on insurance demand and this effect is enhanced when farmers understand basis risk and/or are offered insurance at high prices. Combining farmers’ context and theoretical predictions, we suggest that an insurance premium matters to insurance purchases in that farmers consider this upfront payment as an investment or a lottery focusing on outcomes from the insurance contract itself, irrespective of rainfall shocks.