Academic journal article Journal of Risk and Insurance

Evidence of Adverse Selection in Crop Insurance Markets

Academic journal article Journal of Risk and Insurance

Evidence of Adverse Selection in Crop Insurance Markets

Article excerpt

This article analyzes farmers' choices of crop insurance contracts and offers empirical evidence of adverse selection in crop insurance markets. Farmers' risk characteristics, their level of income, and the cost of insurance significantly affect the choice of yield and revenue insurance products as well as the selection of alternative coverage levels. Empirical analysis indicates that high-risk farmers are more likely to select revenue insurance contracts and higher coverage levels. Results show that low-risk farmers are overcharged and high-risk farmers are undercharged for comparable insurance contracts, implying informational asymmetries in the crop insurance market.

INTRODUCTION

Rapid expansion has occurred since 1996 in the number of new federally backed insurance products offered to farmers in the United States. They include several new revenue insurance products that bring new challenges for evaluating the performance of the multiple-product crop insurance market. In some sense, these new products might be very instrumental in increasing efficiency in the U.S. crop insurance market by meeting the needs of different producers. The question arises, however, as to whether the introduction of these new products, viewed as efficiency mechanisms, reduce or eliminate adverse selection. This study is the first attempt to analyze the potential for adverse selection and test for its presence when a portfolio of insurance products is offered to farmers. The authors analyze the crop insurance market in Iowa, where multiple yield and revenue insurance products were offered to corn and soybean farmers starting in 1996.

Theoretical and empirical studies in automobile and health insurance markets have shown that adverse selection reduces the consumption of insurance by low-risk individuals and results in the transfer of income from low-risk to high-risk insureds and eventual market failure. The seminal works of Akerlof (1970) and Rothschild and Stiglitz (1976) set the foundations and established market equilibria conditions under asymmetric information. Akerlof offers theoretical reasons for the failure of insurance markets when the insurer is unable to rate risk accurately, while Rothschild and Stiglitz provide a theoretical model of equilibrium in an insurance market characterized by asymmetric information between the insured and insurer. The Rothschild and Stiglitz model entails a separating equilibrium with low-risk and high-risk agents buying different insurance products, both of which break even individually. Miyazaki (1977) and Wilson (1977) further demonstrate that, when it is impossible or highly expensive to disting uish between high- and low-risk insurance applicants, the insurer prices insurance contracts at an average premium for all individuals. This results in undercharging high-risk customers and overcharging low-risk customers for similar contracts.

Empirical evidence in automobile and health insurance markets generally supports the predictions of these theoretical models (Browne, 1992; Browne and Doerpinghaus, 1993; Puelz and Snow, 1994). Browne (1992) and Browne and Doerpinghaus (1993) found evidence of adverse selection in individual health insurance markets, while Puelz and Snow (1994) found similar results in the market for automobile insurance. However, more recent studies that apply new modeling frameworks have found no evidence of adverse selection in automobile insurance markets (Dionne, Gourieroux, and Vanasse, 1998; Chiappori and Salanie, 2000; Dionne, Gourieroux, and Vanasse, 2001). In an analysis of Canadian automobile insurance markets, Dionne, Gourieroux, and Vanasse (1998) show that the Puelz and Snow model incompletely specified and that the model results are not robust. Furthermore, Dionne, Gourieroux, and Vanasse (2001) show that adverse selection is not present in the Canadian automobile insurance markets when the model incorporates a ppropriate risk classification. …

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