ENDOGENOUS ADVERSE SELECTION: EVIDENCE FROM U.S. CROP INSURANCE

Adverse selection tests in the tradition of Chiappori and Salanie (2000) examine correlation between contract choice and risk, given variables observed by the insurer. Positive correlation is evidence that inefficiency is due to unobservable variables (which includes the hidden information about buyer heterogeneity). If the goal is to eliminate the inefficiency, such a conclusion falls short. I argue that the analytical framework must endogenize the adverse selection and postulate a possible source. The empirical analysis requires hypothesis tests that are motivated by predictions from a model of Endogenous Adverse Selection (EAS). Such analysis requires the analyst to posit the presently unobserved, but potentially observable source of adverse selection. The analysis requires a data set that includes more variables than observed by insurers. I use the Agricultural Resources Management Survey cross-sectional sample for 1996 to test if the U.S. crop yield insurance market is characterized by a zero-subsidy EAS equilibrium, caused by a producer's commitment to forward price contracts. Using data for corn and soybean producers, I estimate that use of forward contracts is associated with a 6% increase in risk in one state: Indiana. This is substantial when compared to the benchmark increase in risk of 1% to 2% for differentially rated producers who use higher risk crop production practices. The policy recommendation is to design a new policy at a higher coverage level, at the current or lower premium, for the low-risk insured Indiana producers that do not have forward contracts. Low-risk insured producers' welfare increases above the second-best level, while the high risk insured producers are already at their first-best level of welfare.