When does forecast-based insurance benefit? An economic analysis of drought risk anticipatory insurance

Improvements in forecasting technologies create opportunities for anticipatory actions before disasters occur. However, traditional ex post financing and limited operational capacity often prevent countries from acting early. This paper examines anticipatory index insurance, specifically African Risk Capacity's pilot program in Malawi and Zambia for drought risk, which offers capacity building and forecast-based financing for early actions. However, its benefits are unclear given the trade-off between early actions based on imperfect forecasts and post-disaster relief after certain losses. Since imperfect forecasts increase basis risk, anticipatory index insurance can exacerbate this trade-off. Using a stylized economic model and numerical analysis, we identify conditions under which anticipatory insurance is beneficial. Results show that its primary value lies in building operational capacity for forecast-based actions. However, due to basis risk, the incremental value from insurance payouts may not always justify the premium costs. Our findings can help governments and aid agencies design optimal financing strategies for anticipatory actions.