Prospect Theory, Basis Risk, and Crop Insurance Demand: A Field Experimental Evidence from India Ref.No.SSTCRC2650
1. Introduction
Agriculture remains the backbone of many developing economies worldwide, serving as a crucial livelihood option and a key contributor to food security. Even in India, more than half of the population still relies on agriculture for their livelihood. However, agriculture in India is a highly uncertain economic activity characterized by many risks and uncertainties. Besides production risk, agriculture also faces various other kinds of risks, including market, credit, health, and financial risks. Within the purview of production risk in agriculture, weather-related risks become particularly significant, surpassing other risk factors, with localised uneven rainfall emerging as a noteworthy risk in India. Farmers adopt various formal and informal strategies to mitigate production risks arising from adverse weather conditions. However, crop insurance is one of the most effective formal mechanisms for compensating farmers for their losses, even though it is often deemed financially burdensome and unsustainable. It is considered a proactive risk management measure because it transfers risk from insured farmers to insurers.
However, despite implementing various restructured and innovative insurance schemes over time and offering them at highly subsidised premium rates to mitigate production losses, the adoption rate of crop insurance remains low in developing countries like India. In a developing country like India, only 12.8% of farmers insure their crops, even though highly subsidised crop insurance is available. Furthermore, voluntary participation in crop insurance, such as PMFBY (Pradhan Mantri Fasal Bima Yojana), is substantially lower among non-loanee farmers. One of the crucial explanations of farmers' mistrust of the crop insurance scheme is the prevalence of basis risk, where crop insurance indemnity mismatches the actual individual loss. The prevalence of basis risk not only reduces trust in crop insurance but also weakens its perceived value. Most studies on basis risk assume rational agents and stable preferences within the expected utility framework. However, expected utility theory fails to explain farmers' demand for crop insurance, as it suggests that all risk-averse farmers should take full insurance as long as the premium is actuarially fair. Further, growing literature on decision-making under risk and uncertainty has highlighted the role of prospect theory parameters, such as loss aversion, reference points, and asymmetric evaluation of gains and losses. However, there is a dearth of literature in the Indian context on how its prospect theory parameters influence crop insurance participation. In developing countries like India, where a lion's share of small-holding farmers don't evaluate the outcome of crop insurance in isolation, instead, they evaluate it relative to past yields, indebtedness, past experiences, neighbouring farmers' experiences, and the perceived value of crop insurance. These behavioural factors become crucial in shaping farmers' decisions on crop insurance participation. Moreover, basis risk fundamentally undermines the effectiveness of crop insurance by weakening the perceived link between premiums paid and the expected level of protection. When farmers experience or anticipate situations in which losses are not compensated, they evaluate these outcomes relative to a salient reference point, often the expectation of protection after paying the premium. Such "uncompensated losses" are likely to be perceived as severe, disproportionately weighted by loss aversion and the overweighting of low-probability adverse events. Consequently, frequent basis risk events can generate persistent negative beliefs and further reduce future insurance participation. Therefore, basis risk interacts strongly with prospect theory parameters, such as loss aversion, probability weighting, and reference dependence, and influences crop insurance purchasing decisions significantly, from a behavioural economics standpoint.
2. Objectives
-Examine how the parameters of prospect theory influence farmers' participation in crop insurance.
-Analyze how perceived and actual basis risk interact with prospect theory parameters, such as loss aversion and reference dependence, and how they influence crop insurance participation.
-Compare insurance demand across different experimental farmings of risk, payouts, basis risk types, and basis risk degrees.
3. Research Progress
The project is currently at the conceptual and design stage. The following aspects of the research project have been completed successfully:
-Review of existing empirical and experimental literature on crop insurance and behavioural decision-making
-Development of the core research framework based on Prospect Theory and behavioural economics
-Identification of key behavioural parameters (loss aversion, probability weighting, reference dependence)
-The design of the primary survey questionnaire has been completed for the baseline survey
-A preliminary design for a field experiment and treatments incorporating different levels of basis risk has been prepared
4. Cooperation Required
For this research project, we seek the full financial support for fieldwork, experiments, and dissemination activities. Further, financial support is required to publish the research papers from this project.
5. Benefits
This research project will provide a field-experimental estimate of prospect theory parameters among Indian farmers and examine their impact on crop insurance. Further, this study contributes to the behavioural economics and agricultural insurance literature regarding how basis risk moderates the relationship between the prospect theory parameters and crop insurance demand among Indian farmers.
This project is also helpful for policymakers and crop insurance providers to understand behavioural insights to improve the product design, messaging, and communication of crop insurance schemes (PMFBY) among farmers. Additionally, it helps policymakers and insurance companies to understand that providing subsidies alone would not be sufficient to increase participation rates. It offers some explanations for the lower participation in highly subsidised crop insurance.
Further, it helps farmers make behaviourally informed decisions and allows policymakers to design a behaviourally informed crop insurance product that encourages farmer participation and mitigates production risk in agriculture. Furthermore, it helps to understand the role of basis risk in shaping farmers' behavioural insights, which allows policymakers to design policies to combat the negative consequences of basis risk in farmers' crop insurance purchasing decisions.