The Impact of Interlinked Index Insurance and Credit Contracts on Financial Market Deepening and Small Farm Productivity

This paper explores the relationship between credit and index insurance market development using a theoretical model in which small farm households have the option to either (i) adopt a capital-intensive technology that is risky but high-yielding, or (ii) self-insure by adopting a traditional low-input and low-yielding technology. We show that neither market is likely to develop in isolation from the other, and that uptake of improved technology will be low absent efforts to link credit and insurance. The failure of index insurance markets to independently develop is not per se due to the existence of basis risk or to its expense, as self-insurance strategies are similarly characterized by basis risk and are costly to the household as they reduce mean incomes. However, we show that the interlinkage of credit and index insurance contracts can allow both markets to develop because the interlinked contract is more likely to stochastically dominate self-insurance. The analysis also shows that the way interlinkage will work depends fundamentally on the nature of the credit market and the degree to which lenders are able to demand and seize collateral in the event of loan default. This interplay between collateral and the nature of credit-insurance interlinkage has direct and important implications for the design of programs to simultaneously boost small farm productivity and deepen rural financial markets.