Crop Insurance Subsidies: Efficiency, Risk, and Policy

Introduction to Crop Insurance Subsidies

Crop insurance has become highly subsidized due to the private sector's inability to successfully provide crop insurance products to the agricultural industry. While concerns exist about the efficiency of crop insurance subsidies given their high costs, crop insurance remains the most important risk management tool available to producers.

Rationale for Government Intervention

The rationale for public crop insurance subsidies includes the private sector's inability to successfully provide all-risk crop insurance products (Smith, 2012). There are high loading costs associated with crop insurance, and producers use a variety of other risk management strategies, such as futures and options, contracting, and cultural practices including irrigation, pesticide use, and herbicides. Producers also rely on 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, tends to be positively correlated across farmers, and insurers cannot easily diversify their risks through reinsurance. Farmers with crop insurance are more likely to report incidences of infectious plants, animal diseases, and pest infestations without delay, which reduces the impact of rapid-spreading 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 on willingness to pay (WTP) shows that a substantial subsidy covering administrative costs plus 40% of the actuarially fair premium is needed to achieve a 50% participation rate. 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, higher participation rates and higher expected outcomes result.

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. Creating pools within government programs would result in participants paying different premiums in the same areas, which creates substantial political costs for policymakers and program administrators.

Adverse Selection and Moral Hazard

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 where crop insurance programs were available in the county, subsidized premiums, provided an additional subsidy of up to 30% of premium costs, and placed the delivery of crop insurance in the hands of private insurance companies. Today, subsidies are issued in higher amounts and cover a large share of the costs of premiums and indemnities.

To mitigate moral hazard risks, producers can be required to share in losses through insurance deductibles and co-payments, where the insurance company pays only part of each dollar of loss. Subsidization can also establish crop insurance as a prerequisite for eligibility for 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, thereby increasing incentives for crop production. Shallow loss programs also affect the budgetary costs of crop insurance programs. Research shows that farms participating in crop insurance reduce the use of agricultural chemicals through moral hazard effects, with associated reductions in water pollution.

Conclusion

Government subsidies have stemmed from the private sector's inability to provide all-risk crop insurance products, high loading costs, high moral hazard monitoring costs, systematic risk, and the likelihood of early reporting of pest infestations, infectious plants, and animal diseases. Inefficiencies in the market have been created because welfare costs and deadweight costs are not always fully considered. The shift from yield insurance to revenue insurance has further contributed to inefficiency.