Crop insurance has become highly subsidized due to the private sector being unsuccessful in providing crop insurance products to the industry. There are concerns as to the efficiency of crop insurance subsidies due to the costs being high. But, crop insurance is the greatest risk management tool used by producers.
The rationale for public crop insurance subsidies includes the inability of the private sector to successfully provide all risk crop insurance products (Smith, 2012). There are high loading costs of associated crop insurance and producers use other strategies of risk management, such as futures and options, contracting, cultural practices, such as irrigation, pesticide use, herbicides, crop and livestock diversification, non-farm income, saving and borrowing, leasing, government price and support programs, and government disaster assistance payments. Moral hazard monitoring can be costly and raise premiums too high. Systematic risk or yield losses tend to be positively correlated across farmers. Insurers cannot easily diversify their risks through reinsurance. Farmers with crop insurance are more likely to report incidence of infectious plants, animal diseases, and pest infections without delay. Early reporting reduces impacts of rapid spreading of infections and diseases.
Monitoring costs are large and both moral hazard and adverse selection are substantial problems. The private insurance sector has not successfully offered multiple peril products on a purely commercial basis. Evidence shows on willingness to pay (WTP) that substantial subsidy cover administrative costs plus 40% actuarially fair premium and is needed to achieve a 50% participation rate. The index products for crops and livestock have been unsuccessful because of basis risk where the indexes have been imperfectly correlated with farm yield and fail to provide indemnities for losses. With heavy subsidization and no competition, it creates higher participation with higher expected outcomes.
The private sector addresses adverse selection by creating pools of more homogenous clients that contain a better mix of similar risks. All members receive the same contract and the premium reflects the expected indemnity of the overall group. The government, on the other hand, increases subsidized rates to achieve participation rate goals. By creating pools in the government, the participants would have different premiums in the same areas, which create substantial political costs to policy makers and program administrators.
Adverse selection has become less of a problem today compared to the 1980s due to increased subsidy payments and policy changes. The Crop Insurance Act of 1980 eliminated disaster programs if crop insurance programs were available in the county and premiums were subsidized. It provided additional subsidy up to 30% of the premium costs and put delivery of crop insurance in the private insurance companies. Today, subsidies are issued in higher amounts and cover a huge amount of the costs of premiums and indemnities.
Crop insurance loss and transfer efficiency are variable and tied to actuarial performance in a given year. Comparing net producer gains to total crop insurance costs, it does not provide benefits at lower delivery costs. The economic welfare costs and other implications of delivery are not always considered. There is little conventional theoretical or empirical welfare analysis applied to analysis of agricultural markets. This can create inefficiency in the market with higher costs compared to other countries who offer the same products for lower costs.
Inefficiency is also brought about by revenue crop insurance. "In 2011, only 17% of farmed acres were covered by yield insurance while 83% carried revenue insurance" (Babcock). Revenue insurance premiums are subsidized on a percentage basis that caused higher costs in premiums. Revenue insurance increased higher costs in premium subsidies and subsidies to the industry. Revenue insurance compared to yield insurance in 2011 showed revenue insurance premiums costs taxpayers twice as much as yield insurance premiums that produced higher delivery costs.
Private insurance companies offer insurance products when the premium covers all costs, including administrative and operating costs as well as indemnities paid to cover losses. Subsidized market private companies require premiums from insurers and government subsidies to cover all costs. The government subsidized programs allow the private sector incentives to capture regulatory authority and lobby for increased subsidies to enhance revenues and returns. For this reason, the private insurance companies cannot survive without government subsidies.
The provision of subsidized crop insurance can influence farmers' use of other risk management tools. Reductions in the level of protection provided by farm programs and requirements to have insurance for eligibility to receive disaster payments increased participation and higher coverage levels (Collins, 2013). Even though producers can design farm specific risks, they must consciously choose to manage risks and must share in program costs. This reduces public costs and aids in accountability. The crop insurance also helps producers gain credit and aids forward marketing.
To mitigate moral hazard risks, producers can be required to share the losses by insurance deductibles and co-payments where the insurance company only pays part of each dollar of loss. The subsidization can establish crop insurance as a prerequisite for eligibility of government programs. Shallow loss proposals link payments directly to farm yields, effectively buying down a farmer's deductible and providing incentives for moral hazard behaviors that could potentially affect indemnities increasing incentives for crop production. Shallow loss programs affect budgetary costs of crop insurance programs. Research shows farms participating in crop insurance reduce use of agricultural chemicals through moral hazard effects, with reductions in water pollution.
An essential risk management tool for farmers who face unique and unmanageable risks is a lump sum transfer to promote crop diversity. Crop diversity acts as a 'natural insurance' and is less affected from moral hazard (Capitanio, 2011). Financial instruments can affect the environment negatively with the use of pesticides, herbicides, and industrialized fertilizers. Welfare implications of challenging weather can be managed by both conservation strategies and financial insurance. Crop diversification may act as a complement for financial insurance. It also helps to keep the land in agriculture instead of going to wasteland.
Subsidies lower prices because farmers increase subsidies by planting more acres that drives the prices down (Riedl, 2007). Crops planted depend on what the subsidies pay for. If the government promotes crop diversification in the subsidies, the prices of crops can remain relatively stable over time and subsidies would not be driven up.
Disaster aid programs impact crop insurance, particularly participation rates. Ad hoc disaster programs are viewed as free insurance. "To the extent farmers believe they can obtain a substantial amount of aid through such programs on a fairly regular basis, and especially when losses from drought or other natural catastrophes, such as hurricanes, are relatively large, they may be less likely to obtain crop insurance to cover the same risks" (Smith, 2012).
In the absence of government intervention, the farm level demand curve Do and private insurance supply curve So do not intersect, so not insurance is offered without government intervention. The choke price (quantity demands fall to zero Pc) is lower than the minimum supply price where insurance companies are willing to offer coverage Pmin. Per unit rate subsidies that exceed the difference between the supply price and the choke price must be provided. The farmers receive E1F, which shifts demand to D1. The post-subsidy equilibrium is E1, crop insurance purchased Ao, insurance company rate Pi, farmers pay Pf, and taxpayers pay E1F, equal to PiE1FPf. Excluded dead weight costs include raising taxes, external effects of the crop insurance program, and the program environmental impacts.
If the per unit subsidy remained Pi-Pfd, the farmers would insure more than Ao because the additional dead weight costs are transferred to the taxpayer. The dead weight costs of excessive welfare effects are higher than the welfare effects of subsidies because the welfare costs increase by the amount of the subsidies. Pure transfers resulting from rent-seeking activities raise the welfare costs with additional expenditure.