Quantifying basis risk associated with supplemental area-based crop insurance

Purpose: Area-based insurance plans trigger payments based on losses which may not match actual loss experience at the farm level, an issue often referred to as basis risk. The purpose of this paper is to quantify the basis risk associated with the Supplemental and Enhanced Coverage Option (SCO and ECO) crop insurance programs, and the risk reduction that can be achieved when these area-based plans are added to farmers’ risk management portfolios. Design/methodology/approach: This study utilizes simulation techniques to build a stylized model for representative farms at the county-level for non-irrigated corn and soybean production. We model farms for each county in the 17 states included in USDA’s Crop Progress Reports for corn and soybeans, which comprise more than 90% of planted acreage for those crops. Yield and price data from the USDA’s National Agricultural Statistics Service (NASS), futures price data and insurance premiums from the Risk Management Agency are used to calibrate the simulation model. Findings: Area-based plans may provide (1) insufficient coverage for actual losses, which is a risk management concern or (2) payments exceeding actual losses, which is a program efficiency concern given federal support for the insurance program. The risk of insufficient coverage (under-compensation) can be reduced by increasing the coverage level of the area plans, but that also increases the likelihood of support exceeding actual loss experience (over-compensation). The scale of basis risk associated with the area plans differs by region and crop due to differences in yield risk. Area plans do have the potential to provide additional risk reduction; however, risk reduction is inversely related to the level of basis risk. Originality/value: To the best of the authors’ knowledge, this study is the first to focus on quantifying the basis risk associated with the relatively new supplemental area options (SCO, ECO) currently available in the US federal crop insurance program. It provides important insights which could inform current and future Farm Bill debates as policymakers consider modifications and enhancements to commodity and crop insurance programs. It also provides useful information to help educate farmers and other stakeholders about the use of SCO and ECO in their risk management plans.