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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:(a) explicit government subsidies with an average premium subsidy rate of about 60% in recent years; and (b) 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 to what extent farmers' crop insurance choices conform to economic theory. A standard expected utility maximization framework is set up to analyze tradeoffs between higher risk protection and larger subsidy payments. Given an actuarially fair premium, 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. Mixed logit estimation reveals that larger out-of-pocket premium reduces the probability that an insurance product is chosen.

Suggested Citation

  • Xiaodong Du & Hongli Feng & David A. Hennessy, 2014. "Rationality of Choices in Subsidized Crop Insurance Markets," Center for Agricultural and Rural Development (CARD) Publications 14-wp545, Center for Agricultural and Rural Development (CARD) at Iowa State University.
  • Handle: RePEc:ias:cpaper:14-wp545
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    References listed on IDEAS

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    Cited by:

    1. 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.
    2. 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; under-insurance. JEL Classification: D03; H25; Q18. Highlights: • Under standard economic theory; farmers should choose subsidized crop insurance contracts at high coverage levels. • Scrutiny of contract choice data shows that farmers underinsure their crops. • A mixed logit model suggests that behavior is motivated by aversion to incurring out-of-pocket premiums.;

    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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