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Rationality of Choices in Subsidized Crop Insurance Markets

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  • Xiaodong Du
  • Hongli Feng
  • David A. Hennessy

Abstract

The U.S. crop insurance market has several features that set it apart from other insurance markets. These include explicit government subsidies with an average premium subsidy rate of about 60% in recent years, and the legislative requirement that premium rates be set at actuarially fair levels, where the federal government sets rates and pays all costs related to insurance policy sales and services. Bearing these features in mind, we examine the extent to which farmers’ crop insurance choices conform to economic theory. A standard expected utility maximization framework is constructed to analyze trade-offs between higher risk protection and larger subsidy payments. We decompose the effect of coverage level on expected utility into insurance, premium loading, and subsidy transfer effects where the loading effect vanishes if rates are actuarially fair. Given an actuarially fair premium, we infer that a rational farmer should choose either the coverage level with the highest premium subsidy or a higher coverage level. Evidence from a large insurance unit-level dataset contradicts this theoretical inference, and so suggests anomalous insurance decisions. In a novel application of the mixed logit framework, we show that the probability an insurance product is chosen declines as out-of-pocket premium expenditures increase, even though higher values of these expenditures should reflect improved grower welfare. Premium expenditures appear to be more salient than the uncertain future benefits they support. We apply our regression to the recent trend yield adjustment innovation in crop insurance.

Suggested Citation

  • Xiaodong Du & Hongli Feng & David A. Hennessy, 2017. "Rationality of Choices in Subsidized Crop Insurance Markets," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 99(3), pages 732-756.
  • Handle: RePEc:oup:ajagec:v:99:y:2017:i:3:p:732-756.
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    File URL: http://hdl.handle.net/10.1093/ajae/aaw035
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    Cited by:

    1. repec:oup:apecpp:v:38:y:2016:i:4:p:712-730. is not listed on IDEAS
    2. Jacobs, Keri & Li, Ziran & Hayes, Dermot, 2016. "Price responses in forward contracting: do we limit the upside and expose the downside?," 2016 Annual Meeting, July 31-August 2, 2016, Boston, Massachusetts 235539, Agricultural and Applied Economics Association.
    3. Babcock, Bruce, 2015. "Using Prospect Theory to Explain Anomalous Crop Insurance Coverage Choice," 2015 Allied Social Science Association (ASSA) Annual Meeting, January 3-5, 2015, Boston, Massachusetts 189682, Agricultural and Applied Economics Association.

    More about this item

    Keywords

    Actuarial fairness; behavioral anomalies; premium subsidy; regret; underinsurance;

    JEL classification:

    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • H2 - Public Economics - - Taxation, Subsidies, and Revenue
    • Q18 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Agriculture - - - Agricultural Policy; Food Policy

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