Costly Yield Verification, Moral Hazard, And Crop Insurance Contract Form

The theories of hidden‐action, both moral hazard and costly state verification, are drawn on to analyse crop insurance contract structure. The hidden‐action moral hazard model allows few clear predictions regarding optimal contract form. In particular, the conditions under which actual contracts are optimal are not clear. Posing crop insurance as a problem of costly yield verification, however, results in optimal contracts with familiar properties ‐ a deductible indemnification if and only if yield is verified, and indemnification only when yield is low. However, these contracts require full insurance across low yield states, while actual contracts typically involve co‐insurance. This model is then generalised to incorporate hidden‐action moral hazard, and it is shown that optimal contracts then require co‐insurance. Thus, this model reflects the essential features of actual contracts, suggesting that recognising the incentives for misreporting and for insurers to economise on yield verification costs will potentially result in a better understanding of crop insurance.