incentives to appropriately monitor the policies they underwrite. Also, the current
structure of the SRA is restrictive in terms of how insurers may price the policies they
underwrite. All of these factors contribute to excess costs, whether implicit or explicit,
generated by the absence of competitive and independent agricultural insurance markets.
MG suggest that area yield reinsurance contracts may permit crop insurers to
cover most of their systemic crop loss risk, reducing their risk exposure to levels typically
experienced by conventional property liability insurers.2 Given the ability to hedge their
systemic risk, crop insurers may be less averse to insuring crop production independently,
lessening the need for government intervention and increasing the efficient functioning of
agricultural insurance markets.
Hayes, Lence and Mason (2004), 3 as well as MG (1997), investigate the
effectiveness of area yield derivatives in hedging crop insurance risk. Although area
yield contracts did trade for a short time in an exchange setting, they eventually failed
due to insufficient trading volume. A major problem was that market-makers were
largely uninterested in taking the other side of such specialized contracts because they
were unable to offset the resulting risk. This does not appear to be the case for weather
derivatives. The potential for liquidity in WD markets is greater due to the number of
market agents with naturally opposing hedge preferences (e.g., electrical utilities).
Hayes, Lence and Mason (2004) also investigate the hedging effectiveness of
price derivatives. The primary risk factor in crop insurance, however, is not price but
rather widespread adverse weather events such as drought and extreme temperatures
during critical growing periods. In addition, plant disease and infection can be intensified
by adverse weather.