In theory, insurance
is an efficient risk sharing mechanism,but the same is not always true in case
of agriculture crop insurance, because of a costly risk shifting mechanism .
Agricultural crop insurance market may or may not lead to Pareto preferred states. Let
us first consider the case of identical
farmers with perfect information.
J. Kurian,Ali and Ahsan have asserted that
in case of identical farmers, a competitive equibrium is
Agricultural
insurance market does not turn out to be like the ‘commodities’ market since it
is very difficult to assess the
information of the land type, weather , risk attitude
Why a competitive market
does not develop?
Imperfect
Information
·
Adverse
Selection
This happens if the
insurer cannot distinguish the inherent riskiness of different farmers. The
individual farmers may have fair knowledge about their own risk position , but
the insurance agencies may not be able
to distinguish among such customers. This will eventually lead to only high
risk farmers buying insurance and hence the insurance companies will run into
losses.
·
Moral
Hazard
It is an alteration
in input use which deviates from social optimality and which occurs because of
incompatible incentives and asymmetric information.Moral hazard problems occur
because the insured can take action which affect the probability of losses and
cannot be observed by the insurer. It is because the insured choices can affect
the distribution of the losses. In crop insurance individuals have no control
over the state of nature , but through dependency in the contract , the
individual can affect the amount of
indemnity.
Absence of adequate information and high cost of collecting
generates imperfect information in agriculture. Given there are two categories
of farmers that is high risk farmers with ph and low risk farmers
with probability pl. where H> L
. Thus in the case of imperfect markets there will be either a pooling
equilibrium or a separating equibrium.The farmers knows and can ascertain his/her risk while the
insurance company cannot find this out.
There would be a separating and pooling equlibria
because of imperfect information in the market. This was given by Micheal Rothschild & Joseph Stiligtiz
Pooling Equilibrium
A pooling equilibrium is an equilibrium in
which a single insurance contract is offered to all customers. Let p’ be the
average accident (loss) probability p’=λph+( 1-λ )pl where λ is the proportion of high risk farmers. If α is the pooling equilibrium and consider profit of insurance firms to be Π(p’,α). Now if Π(p’,α) <0 implies firms are losing money contradicting the
condition of a equilibrium, Similarly if
Π(p’,α) >0
, means there exists a contract which would offer more in both states of
nature and this not the equilibrium then. Therefore we get Π(p’,α) = 0 and α lies on
the line EF ( slope (1-p’/p’).
Competition among insurance firms implies
that any equilibrium contract must break even so any pooling equilibrium must
lie on the ‘pooling line’
There is a contract β near α such that the low risk individual
prefer to α, but the high risk individuals would prefer α to β.
Since β is near α, it
makes profit when the less risky buy it. The existence of β contradicts the
definition of equilibrium
A separating equilibrium is the one where two separate
contracts coexist. This means that the premium rate for the high risk farmers is
greater than that for the low risk farmers. If the insurance companies could
costlessly separate the high risk and
low risk farmers, farmers would demand
full coverage policies under the separating equlibrium.However practically
insurers cannot distinguish perfectly between the risk classes. Hence there
would be imperfect information in the market. Therefore the high risk farmers
would realize that they can increase their utility taking the low insurance
contracts. Given the opportunity to purchase the low insurance contracts they would
do so.
The problem is that high-risk farmers impose an
externality on low-risk people. The low-risk people should have cheap
insurance, if only they could separate the two. But if an insurance company
offers a contract which perfectly
insures low-risks, then the zero-profit condition of competitive equilibrium
means that these contracts make no profit when losses occur with the low
probability p. If such a contract exists, then all high-risk farmers would want
to buy the low-risk contract. This
would drive the insurance companies into losses as the high risk farmers would
be buying the low premium rate insurance contracts and the insurance companies
would be paying a higher benefit for the loss against a lower premium payment.
If you consider the
above diagram EH denotes the high risk farmer’s contract with the slope (1-ph/
ph).Similarly EL denotes the low risk farmers
contract with a slope (1-pl/pl). The contract on EH most preferred by
the high risk farmers gives complete insurance (
). Low
risk farmers would of all contracts on EL preferhigh contract β which also provides full insurance. However β offers more consumption
than
, and high risk farmers would prefer it to
. The nature of imperfect information in that insurance companies are
unable to distinguish between among the farmers. Profits will be negative (
,β)will not be an equilibrium.
An equilibrium contract for low risk farmers
must not be more attractive to the high risk types,. This establishes that (
,
) may be
an equilibrium . But consider the contract γ, if it is offered both low and high
risk farmers would want to purchase it in preference to
or
. If it
makes profit/losses it will upset the potential equilibrium. EF and EF’line
represents the market odds (average probably ) showing the composition of the
market. EF’ is for few high risk farmers , in this case the contact γ will earn
profits and EF represents for
sufficiently high risk farmers, in this case the contract γ will lose
money. Since (
,
) was the only possible equilibrium, therefore no
completive equibriulm exists.
The
above shows that absence of competitive markets can be largely explained by
market failures due to imperfect information.
The following explains the public crop insurance model which is cited by S.M Ahsan, AG Ali, Nj
Kurian as an effective way of managing risks in agriculture.
Public
Crop Insurance Model
According to Kurian, Ahsan
and Ali ,public subsidization is cited
as an effective method to overcome the market failures associated with
‘imperfect information’.The insurance policy is such that it guarantees a
minimum income M. The farmers is taxed at the rate for the income before
applying for indemnity. The reason for including ‘s’ is that otherwise the
premium rates would have been very high without such revenues given the value
of M. The value of M is exogenously
determined.
In this approach the
farmer chooses the optimal amount of the resource devoted to risky cultivation,
so as to maximize his utility ,treating the insurance contract as given.The
insurance company ,in turn, selects the optimal insurance contract so as to
maximize social welfare. The insurance treats the factor utilization under
risky farming as determined by the farmer in advance.
This model asserts that the insurance agency chooses an
optimal insurance program to maximize social welfare .Social welfare is
assumed to be the total output of the farmer.
The results of this
model show that the optimal level of s (tax rate) would be such that the
expected marginal product of the resource equals the social value of the
marginal revenue of the agency.In the long
rum the farmer receives what he
has put in the form of premium and tax rates ,but the basic purpose is that high
premium rates inhibit risk taking. This shows that the farmers will not take
high risks and at the same time are given a minimum income guarantee,.This will
ensure a better farming output as the farmers can undertake ‘farming’ optimally
under risky production at the same time have an income guarantee.
In a paper,
Mark V Pauly argued that fears of market failure may be lessened by inducing
farmers to signal their risk situations. He has suggested that the government could
collect and make public the total insurance purchased by individual farmers.
Public
provision generates a specific information and if this information is made
available to firms, optimal market outcome can occur. Another argument that he
raised was to charge premium
with quantity. Firms can increase the marginal rate of premium with
respect to the quantity purchased by individuals. They will recognize, adjust
to the increasing price and thus be inhibited to over insure to some extent.
Private insurance
companies then could use this information to classify farmers. One difficulty
is that unless all farmers have identical tastes, the above procedure would not
yield useful information. Two individuals facing identical risk prospects may
purchase different amounts of insurance if one is more risk averse than the
other. This means that the definition of risk is different for different people
,therefore this solution will not always work.
Carl
H Nelson and Edna T. Lehman argue that the cost of public subsidies may not
justify the benefits and thus offer, ‘Other ‘Second Best Solution’. Information collection and application of contract design principles are
possible ways of achieving the benefits of insurance at less cost than public subsidies. The social returns from government expenditure
on information collection to improve the structure of insurance contracts is likely
to be significantly larger than the social returns from government subsidization
of insurance.
The following give various ‘second best’ solutions to
the problem of agricultural crop insurance
·
Self
selection Mechanism
The mechanism offers a set of contracts
which satisfy the break-even constraint and would cause farmers to voluntarily reveal
their class to the insurer. The basic motive is that the high-risk farmer would
voluntarily chooses the contract designed for him and the low-risk farmer would
choose the other contract. To implement this concept, the insurer would need to
determine the various "types" of farmers. The costs of determining
types of farmers and designing contracts and premia accordingly would be lower
than the costs of obtaining information and designing contracts for individual
farmers. Types of farmers could be defined by the distribution , risk
attitudes, and production possibilities. This solutions seems more practical
but it depends on the magnitude of the costs required to find ‘classes/types’
of farmers. Thus, private market provision of agricultural insurance is not
necessarily impossible. This implies that, without increasing subsidies, it should be possible
to increase participation by offering contracts that are more specialized to an
individual's risk characteristics
·
Repeated
contracts
The insurance contract covers a series
of years under this arrangement. With repeated contracts, a time dimension is
added to the insurance problem; both Pareto-optimal resource use and zero
profits for the insurer will occur in the limit over time even though the
insurer may have positive or negative profits during some particular time
periods. The farmer is charged a premium based on initial expectations about
the expected value of losses. If the farmer's losses are higher than expected,
the premium is revised based on the new loss information and higher premiums
are charged for the next year. Rubinstein and Yaari have proven that repeated
insurance contracts converge to the Pareto-optimal full information
equilibrium.
·
Principles
of Contract Design
In applying the
economic concepts the following principles are suggested
for the design of
an agricultural insurance program or for a revision of the
Inputs and
outputs, risk attitudes, and risk distribution functions. The self-selection
type should be designed according to types of farmers. Information about
realizations of stochastic events, observable input use and imperfect monitors,
or inferences concerning un- observable inputs should be used to determine
insurance payments. Premium rates should be readjusted over time according to
the information obtained about a farmer's actions.The design or revision of an
agricultural insurance program should be based on a systematic application of
these principles in order to achieve the best possible risk sharing at the
lowest cost in terms of resource misallocation and information collection.
According to Nelson
and Loehman, the social returns from government expenditure on information
collection to improve the structure of insurance contracts is likely to be
significantly larger than the social returns from the government subsidization
of insurance. However,the above statement is country specific.
The two equlbria that
arise when there is a imperfect information in the market were discussed and
found that it may not always exist ,therefore according to Rothschild and
Stiglitz model that ‘imperfect information’ may not lead to a competitive
equilibrium in case of agricultural crop insurance. The public insurance model showed the government
provided subsidies in agriculture can ensure a
better outcome. Other solutions
and ways to combat the inefficiency
of the market to deliver agricultural
crop insurance. were also discussed to combat the problem of imperfect information
in agriculture market
No comments:
Post a Comment