The Welfare Effects of Index-Based Livestock Insurance: Livestock Herding on Communal Lands

Agricultural (index) insurance for smallholders in developing countries has gained traction in academic and policy circles. The expectation is that the uptake of insurance will protect smallholders from production shocks and incentivize them to modernize production. We develop a simple theoretical model to demonstrate that the welfare effects of insurance are fundamentally ambiguous—even in the absence of transaction costs or basis risk. The second-best nature of the institutional context within which smallholders operate implies that the uptake of insurance may accentuate pre-existing inefficiencies. This idea is worked out in detail for the case of livestock herding on common grazing lands. Our theoretical model predicts that insurance invites overstocking of communal lands, and lowers the profitability of herding when common pastures are degraded.