A model of agricultural insurance in evaluating moral hazard and adverse selection

The main motivation for this study is the recognition of the fact that asymmetric information in the form of moral hazard and adverse selection results in sizeable efficiency losses. These costs are passed back to producers in the form of excessively high premium rates and also passed back to the government via the crop insurance subsidy program. A secondary motivation stems from a recent debate in the literature regarding the specific effects of moral hazard on agricultural input use. Conventional wisdom suggests that moral hazard will induce producers to reduce input usage. A competing hypothesis has emerged which suggests that moral hazard may induce producers to increase their usage of risk increasing inputs.;This study has developed a framework to evaluate the problems of asymmetric information such as moral hazard and adverse selection in agricultural insurance. Specifically, three objective were set: first, to develop a model of agricultural insurance to understand why asymmetric information problems might exist; second, to compute and evaluate the relative program costs of agricultural insurance attributed to moral hazard and adverse selection; and third, to identify the ways in which agricultural insurance can be delivered to farmers more efficiently and equitably.;These objectives were achieved by developing a theoretical model of agricultural insurance, and by conducting numerical simulations of the model. Simulation results indicated that insured farmers use less agricultural inputs than uninsured farmers in an attempt to maximize expected indemnities. Moral hazard was found to be a significant problem only at higher coverage levels. Expected returns (in terms of expected indemnities) to agricultural insurance were found to vary substantially between productivity (i.e., risk) types, and farmers were shown to recognize and respond to these differences. These results suggest that crop insurance is confronted with an adverse selection problem.;Program costs to a myopic insurer attributed to moral hazard and adverse selection could be substantial. It is recommended that insurers manage asymmetric information through the imposition of ex ante regulations (with monitoring) on input use or adjusting premiums in anticipation of ex post outcomes. Simulation results show that such actions (mechanisms) alter insureds' optimizing behaviour, and minimize perverse program costs.