Evaluating the long-term effectiveness of crop insurance products to provide cost effective and constant cover for maize producers under stochastic yields and prices

ABSTRACT

The long-term effectiveness of crop insurance products to provide cost effective and constant cover for maize producers against a production risk under stochastic yields and prices was evaluated. Hail occurrence in low and high risk areas was considered as the production risk, with Short-term Crop Hail Insurance (SCHI) and a Contingency Policy (Self-insurance) in the Alternative Risk Transfer (ART) market as insurance options. A financial simulation model was built to simulate the cash flow of a maize enterprise and to calculate the producer’s annual margin after interest and tax. Stochastic Efficiency with Respect to a Function (SERF) was used to rank Net Present Value (NPV) of the margin after interest and tax for different scenarios of Certainty Equivalents (CE’s) and to calculate the Utility Weighted Risk Premium (UWRP) of each scenario. The model could evaluate the effectiveness of crop insurance products. The SCHI was the preferred option in Mpumalanga (high hail risk area) and ART in North West (low hail risk area) based on the cost effectiveness of the options. The ART, however, was not able to provide constant cover at all times and the long term efficiency thereof should be carefully considered before it is applied as the sole hail risk mitigation strategy.

KEYWORDS:

• insurance
• alternative risk transfer
• SERF
• risk aversion
• certainty equivalent

JEL CLASSIFICATION:

• D81
• C15
• Q12

Notes

1. All the data are available from the authors on request.

2. All calculations are available from the authors on request.

3. For the purpose of this study the term “decision maker” refers to the producer.

4. The margin distributions of the two areas with and without SCHI (Insurance and Base) are presented in the Appendix.