Question

4. The Dairy Margin Protection Program is a form of protection that requires farmers to choose a level of coverage with an associated premium. Crop Insurance follows a similar model where farmers choose a level of coverage with an associated premium. Explain why policymakers prefer this type of system. Be sure to appropriately reference "riskin your answer. (4 points)

Answer 1

The model of crop insurance mentioned involves farmers choosing a level of coverage with associated premiums. Due to obvious reasons, the level of premium to be paid by the farmer will increase with the level of coverage provided in the insurance cover. Similarly, a farmer who is "risk averse" will be willing to get maximum coverage, even if it involves paying higher premium. The policy makers or insurance companies prefer this type of system to avoid the problem of adverse selection, that is, presence of higher number of insurance seekers who are highly likely to default/ claim it. For instance, adverse selection here would mean when the farmers whose crops are likely to get damaged purchase insurance, while the farmers whose crops are not likely to damage stay out of the insurance market. This would lead to bankruptcy of the insurance company. This problem arises due to presence of asymmetric information where buyers or sellers have incomplete information about the other side. When the insurance premium associated with more coverage is greater than an otherwise level of insurance premium for moderate coverage, only those farmers will opt for it whose crops have a greater probability of being damaged. This neutralizes the risk of paying out for the insurance company itself since the defaulter group pays premium higher than other groups.

Alternately, risk adverse farmers will agree to opt for maximum coverage and higher premiums while risk lover farmers will opt for lower coverage and consequently lower level of premium.