Estimating the Extent of Moral Hazard in Crop Insurance Using Administrative Data

T asymmetric information problems of adverse selection and moral hazard can cause insurance markets to fail. Adverse selection occurs when those seeking insurance know more than insurers do about their risks. Agents facing greater risks are more likely to insure at average prices, causing those facing less risk to be priced out of the market. Moral hazard refers to the effect insurance contracts may have on the insured’s hidden actions. When bad outcomes are indemnified, the insured may have less incentive to prevent these outcomes from happening. Insurers, understanding agents’ incentives, may be less likely to provide insurance, and the private market for insurance can break down. Perhaps as a result of these information problems, little crop insurance was available to the U.S. farmers until the government began providing it in the 1930s. Participation in the program was low until premium subsidies increased, particularly with the 1994 Federal Crop Insurance and Reform Act. Total liability insured under the program has steadily increased from about $5.98 billion in 1981, to $23.73 billion in 1995, to $40.64 billion in 2003 in nominal dollars. Every year since 1995, over 200 million acres have been enrolled in the Federal Crop Insurance program. Previous research shows strong evidence of adverse selection (Just, Calvin, and Quiggin; Makki and Somwaru). Early insurance adopters and those with higher coverage levels appear to benefit from the program, in part because their true risk is greater than the risk reflected by their premiums. In contrast, evidence of moral hazard is mixed. Horowitz and Lichtenberg (hereafter referred to as HL) found that crop insurance caused fertilizer and pesticide use