How Does Risk Management Influence Production Decisions? Evidence from a Field Experiment

Abstract

Weather is a key source of income risk for many firms and households, particularly in emerging market economies. This paper studies how an innovative risk management instrument for hedging rainfall risk affects production decisions among a sample of Indian agricultural firms, using a randomized controlled trial approach. We find that the provision of insurance induces farmers to shift production towards higher-return but higher-risk cash crops, particularly amongst more-educated farmers. Our results support the view that financial innovation may help mitigate the real effects of uninsured production risk. In a second experiment we elicit willingness to pay for insurance policies that differ in their contract terms, using the Becker-DeGroot-Marshak mechanism. Willingness-to-pay is increasing in the actuarial value of the insurance, but substantially less than one-for-one, suggesting that farmers’ valuations are inconsistent with a fully rational benchmark.