Bridging the Disaster Protection Gap with Index Insurance, (with Peng Shi). Under Review. SSRN.
Abstract: Natural disasters have become increasingly frequent and severe, leading to sharply rising financial costs in recent decades. Yet, the insurance protection gap remains substantial, with over 60% of global economic losses left uninsured between 2012 and 2021. Index insurance, a relatively new approach, offers a potential solution by providing payouts based on pre-specified indices, which can be quickly calculated and made available post event. Unlike traditional indemnity insurance, which involves high adjustment costs and lengthy delays in claims settlement, index-based contracts can significantly reduce both costs and settlement times while offering critical protection against catastrophic events. This raises the question: can index insurance complement indemnity insurance in bridging the disaster protection gap? While promising, index insurance faces the challenge of basis risk -- the discrepancy between the index used and the actual losses experienced. This paper introduces a conceptual framework that theoretically demonstrates how proper index design can reduce basis risk and increase insurance take-up. Our empirical analysis focuses on flood insurance. By leveraging rich, yet complex, weather data and advanced deep learning techniques, we develop a modeled index designed to forecast ultimate flood losses while reducing basis risk. Specifically, to capture the intricate effects of compound weather events, we propose a neural-network based predictive model. This model features a recurrent neural network with an attention mechanism to capture the temporal dynamics of weather data, complemented by a feedforward network to handle nonlinear dependencies and complex interactions between weather variables and static information. We show that the proposed index achieves a 20.0% reduction in basis risk compared to the benchmark neural network model-based index without weather inputs. Furthermore, reducing the loading on the index boosts insurance take-up by an additional 3.4%, generating a welfare gain of $16.6 per consumer. These findings offer valuable insights for policymakers, insurers, and policyholders on how risk management innovations can enhance disaster resilience.
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