Price basis risk and demand for crop insurance: fostering crop sector resiliency in peripheral production regions

Purpose Spatially heterogeneous participation patterns in US Federal Crop Insurance Programs (FCIP) exist across the US Great Plains and Corn Belt, participation being generally higher in the core production regions. We ask whether price basis risk (PBR) arising from how futures contract prices enter crop insurance indemnities is related to this phenomenon. Basis risk can alternatively be framed as background risk or payoff distribution ambiguity. Design/methodology/approach In the expected utility model, basis risk acting as background risk may increase risk aversion and so demand for insurance. In the ambiguity aversion model, the same basis risk increases insurance outcome ambiguity and so decreases demand for insurance. By addressing how PBR affects demand for revenue and yield insurance contracts with basis risk metrics derived from elevator-level price data in a fractional probit regression, we provide evidence on which behavioural model best fits market data. Findings We find suggestive evidence that PBR reduces crop insurance participation rates at the extensive margin for both maize/corn and soybean growers but has little effect at the intensive margin. The extensive margin finding is consistent with the perspective that farmers view basis risk as distribution ambiguity to which they are averse. An implication is that incorporating more localized price indices into indemnity calculations will increase resiliency in food supply by increasing participation rates in regions with high PBR and reducing the need for subsidies to attain a given participation level. We also provide evidence that yield risk increases extensive margin demand and decreases intensive margin demand for crop insurance. As comprehensively controlling for all factors that co-determine basis risk and participation rates is challenging given the data available, the above relationship between basis risk and crop insurance participation should not be viewed as causal. Originality/value Our paper’s contributions are threefold. We propose PBR as one determinant of low crop insurance demand, spatial variation in demand and the need for high subsidy rates to obtain participation goals. We construct price basis measures, empirically analyse how basis risks affect crop insurance demand and show how PBR can explain spatial disparities in demand. We shed further light on related core and periphery theories and impediments to production system resiliency in the periphery. Using futures prices rather than more location-specific price indices strengthens crop production resiliency in core regions at the expense of the periphery.