Crop insurance: indemnity and index-based
How crop insurance works, indemnity and area-yield insurance, weather and satellite index insurance, basis risk, moral hazard, subsidies, and claim sums.
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A single drought, flood, hailstorm or pest outbreak can wipe out a season's income and push a farming family into debt or force it to sell land or livestock. Crop insurance spreads these risks: many farmers pay premiums, and those hit by disaster receive payouts. Designing insurance that farmers can afford, that pays quickly and fairly, and that insurers can run without huge losses or fraud has proved difficult, and governments in most countries subsidise it heavily.
Crop insurance types, their problems and their calculations are standard topics in agricultural economics, finance and risk management exams.
Why insurance is hard in agriculture
- Covariate (systemic) risk: a drought affects whole regions at once, so losses come together, unlike car accidents or house fires. Insurers need reinsurance and large reserves.
- Asymmetric information:
- Adverse selection: farmers know their own risk better than insurers, so high-risk farmers are more likely to buy.
- Moral hazard: insured farmers may take less care of a crop that is going to be compensated anyway.
- High costs of assessing losses on millions of small, scattered farms.
- Data gaps: insurers need long, reliable records of yields or weather to set premiums.
Types of crop insurance
Indemnity-based insurance
Payouts are based on the actual loss on the insured farm.
- Named-peril insurance covers specific events, such as hail or fire; losses are assessed in the field. Hail insurance has been sold privately in Europe and North America for over a century.
- Multi-peril crop insurance (MPCI) covers yield losses from many causes, compared with the farm's historical average yield. The United States' federal crop insurance programme, begun in 1938, is the largest example; revenue insurance adds protection against price falls.
Indemnity insurance matches payouts to actual losses but is costly to administer and vulnerable to moral hazard and fraud.
Area-yield insurance
Payouts depend on the average yield of an area, such as a district or block, measured by crop-cutting experiments, rather than the individual farm's yield. Because one farmer cannot influence the area average, moral hazard and adverse selection are much reduced, and administration is cheaper. India's Pradhan Mantri Fasal Bima Yojana, launched in 2016, is largely area-yield based and covers tens of millions of farmers.
Index-based insurance
Payouts are triggered by an index strongly correlated with losses:
- Weather indices: rainfall, temperature or wind measured at weather stations or by satellites.
- Satellite vegetation indices, such as NDVI, especially for pasture and livestock (index-based livestock insurance in Kenya and Ethiopia).
- Area-yield indices, as above.
Index insurance is cheap to run, pays quickly and objectively, and is free of moral hazard. Its main weakness is basis risk: the index may not match the farmer's actual loss.
Making insurance work
- Use better data: satellites, drones, automatic weather stations and smartphone crop-cutting to assess losses faster and more accurately.
- Reduce basis risk with denser station networks, smaller insurance units and combined indices.
- Pay claims quickly; delays of many months undermine trust.
- Educate farmers: index insurance in particular is often misunderstood.
- Combine insurance with other risk tools: diversification, savings, drought-tolerant varieties, irrigation and social protection.
Key points
- Crop insurance spreads production risk, but faces covariate risk, adverse selection, moral hazard and high costs.
- Indemnity insurance (named-peril, multi-peril) pays actual farm losses; area-yield insurance pays on area averages; index insurance pays on weather or satellite indices.
- Area-yield and index designs reduce moral hazard and costs but add basis risk.
- Claim (area-yield) = (threshold − actual) ÷ threshold × sum insured; threshold = average yield × indemnity level.
- The fair premium equals expected payouts; most governments subsidise premiums.
What the exams ask
- School-leaving and entrance papers: why crop insurance is needed and the main types.
- Degree and research-fellowship entrances: adverse selection and moral hazard, indemnity versus index insurance, basis risk, claim calculations and premium setting.
- Professional and policy examinations: design and performance of national schemes, reinsurance, technology for loss assessment, and linking insurance with credit.
Described in general terms: the kind of examination, not a past paper. Laisha never reproduces exam questions.
Questions people ask
Why did I lose my crop but get no index payout?
That is basis risk: the weather station or satellite index did not register the conditions on your farm, perhaps because rain fell unevenly, or the loss was caused by a peril the index does not measure.
Why is crop insurance subsidised?
Without subsidies, premiums high enough to cover covariate losses and administration are unaffordable for many farmers, and too few would buy. Governments also see insurance as cheaper than ad hoc disaster relief.
Does insurance replace good farming practice?
No. It protects against shocks beyond a farmer's control. Good practices reduce losses and keep premiums lower over time.
Sources
- Hazell, P., Pomareda, C. and Valdés, A. (eds) Crop Insurance for Agricultural Development. Johns Hopkins University Press, 1986.
- Mahul, O. and Stutley, C. J. Government Support to Agricultural Insurance: Challenges and Options for Developing Countries. World Bank, 2010.
- Carter, M., de Janvry, A., Sadoulet, E. and Sarris, A. "Index insurance for developing country agriculture: a reassessment." Annual Review of Resource Economics 9, 421–438 (2017).
- Glauber, J. W. "Crop insurance reconsidered." American Journal of Agricultural Economics 86, 1179–1195 (2004).
- Hardaker, J. B., Lien, G., Anderson, J. R. and Huirne, R. B. M. Coping with Risk in Agriculture, 3rd edition. CABI, 2015.
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