Crop insurance is currently the hottest topic being debated in farm policy circles. Reform of crop insurance has been highlighted as a major priority by both the Clinton Administration and congressional leaders. In an effort to assist people in understanding the crop insurance program better, we offer the following background information which describes the basic elements of the program.
Crop insurance is an insurance product. Farmers choose how much insurance they want and how they want the policy structured. Like most insurance policies, there are many options and the choices can be confusing. Unlike other insurance products, however, the basic policy provisions for the crop insurance program are set by the Federal Government.
Crop losses tend to be correlated. When drought strikes it will generally impact a large geographic area. Car accidents or health problems, on the other hand, generally are independent, random events. If person A dies of a heart attack, this does not necessarily mean that his or her neighbor will suffer the same fate. The correlation of crop losses increases premiums for farmers and for many years prevented the commercial development of multi-peril policies as the policy must account for this systemic risk. For companies, the correlation of losses means that capital requirements are higher in order to maintain adequate reserves to cover wide-spread losses. Generally, when a single event occurs that results in multiple losses, insurers refer to the event as a catastrophe. In crop insurance, catastrophic losses are the norm rather than the exception.
On the other hand, a private market without Federal involvement has existed for crop hail and fire insurance for over a century. Losses from hail generally are not correlated across wide geographic areas. More recently, the correlation of loss phenomena has generated calls for Federal assistance in other lines of property and casualty insurance, namely for hurricane (after Hurricane Andrew) and earthquake (after Northridge) insurance. As those parts of the U.S. more prone to these events have become ever more populated, the cost of insurance has risen dramatically for these types of risk.
Finally, production risk varies significantly across the country. Without federal involvement in the crop insurance program, high risk production areas would have significantly fewer affordable risk management options. Federal policy makers have decided over the years that these areas should be afforded the same types of insurance coverage, with even greater subsidies, as low risk production areas. As a result, policy makers have determined that a federally subsidized risk management program is a proper role for the Federal Government.
Multiple Peril Crop insurance, or MPCI, is the crop insurance plan developed and rated by the USDA. MPCI is sometimes also called "yield insurance" or APH (Actual Production History) insurance. MPCI is delivered by private insurance companies and agents. MPCI protects against yield losses. Indemnity payments are made if actual production is below the yield guaranteed in the insurance policy.
As the name implies, multiple-peril crop insurance (MPCI) protects against losses from multiple perils. The specific perils vary by commodity but generally include: (a) adverse weather conditions; (b) fire; (c) insects, but not damage due to insufficient or improper application of pest control measures; (d) plant disease, but not damage due to insufficient or improper application of disease control measures; (e) wildlife; (f) earthquake; (g) volcanic eruption; or (h) failure of the irrigation water supply if due to an unavoidable cause of loss occurring within the insurance period. Hail and fire coverage may be excluded from the covered causes of loss for a crop policy only if private hail and fire coverage is selected. Losses resulting from the inability to plant (prevented planting) are also covered if due to adverse weather. MPCI stands in contrast to a single or named peril policy that would cover only those perils named in the policy such as hail.
Actual production history or APH is the farmer's yield history for the unit to be insured. It forms the backbone of the MPCI program. The APH is used to determine the grower's premium rate as well as the grower's yield guarantee. Farmers prove their yields. The APH is a simple average of 4 – 10 years of historical yields for the unit that is insured.
If farmers do not have 4 years of yield records, a yield is assigned to the farmer. This yield is commonly called the "t-yield" or transition yield. The "t-yield" is generally the county average yield for the crop (generally this is based on the last ten years of data from the National Agricultural Statistics Service). If growers have no records but have grown the crop in the past two years, they are assigned a yield equal to 65 percent of the t-yield. With one year of records, growers are assigned a yield equal to 80 percent of the t-yield. Two years of records brings 90 percent of the t-yield and three years of records result in an assignment of the t-yield for the fourth year. In these cases, the one to three actual yields are averaged with the t yields.
Changes in the APH (a rolling simple average) are "cupped" and "capped" from one year to the next. The "cup" or downward limit on the APH is 10% of the previous APH . This means that a grower's APH cannot drop by more than 10% from one year to the next. In addition, if farmers have four or more yield records, their APH is not allowed to fall below 80% of the t yield. The "cap" or upward limit on the APH is 20% of the previous APH. This means that a grower's APH cannot increase by more than 20% from one year to the next.
Units determine the size of the acreage to be insured. Generally, the larger the size of a unit, the lower the premium. There are four unit structures: (1) basic, (2) optional, (3) enterprise county crop, and (4) whole farm which combines multiple crops in the county.
The basic unit is determined by ownership of the commodity produced on the land to be insured in a county. Cash rent and owned land are generally considered one basic unit, while share cropped arrangements result in multiple basic units within the county. For example, if a farmer owns 500 acres, cash rents another 500 acres, and share crops another 400 acres, the farmer has two basic units (one basic unit of 1000 acres and one of 400).
Optional units are subdivided basic units. Generally, optional units must be in separate sections or section equivalents. Farmers must keep separate records for each optional unit. Smaller units are advantageous for farmers if their land's production capacity is variable. Poorer producing land can be separated from better producing land for example. Optional units are popular. In 1998, there are 1.2 million policies and 2.7 million units. Optional units include a rate surcharge above the basic unit and are available only on coverage levels that exceed the catastrophic coverage.
In some cases, farmers are able to choose a unit structure that aggregates land further than a basic unit. An "enterprise" unit includes all shares of a crop in the county. This would aggregate share-cropped land with land owned and/or cash rented. Enterprise units are available on revenue insurance plans and were pilot tested on MPCI in 1998. A "whole farm" unit, available only on certain revenue insurance policies aggregates all shares of insured crops farmed in the county. The advantage of these larger unit structures are significantly reduced premiums.
Farmers are able to insure their expected production. The MPCI guarantees a certain production amount for each acre planted. The guarantee is the product of the farmer's APH and the coverage level that the farmer selects. Coverage levels are available in increments of 5% at levels between 50% and 85% of APH. The coverage level sets the farmers' deductible. If 65% coverage is elected, for example, the deductible is 35%. This means that any loss greater than 35% will result in an indemnity payment. The first 35% of loss, however, is not covered by the insurance policy. Farmers can elect coverage by crop and county. Coverage levels cannot vary at the unit level for the crop insured. In 1998, over 90% of the crop insurance policies carried a deductible of 35 percent or greater.
USDA sets a pre-determined maximum price for each commodity each year. Farmers can select a price level between 55 percent and 100 percent of the USDA established price. Most farmers elect the maximum price. USDA sets the price early (before planting) so that farmers and lenders know what the policy guarantees. In addition, insurance companies need to know their total exposure, which drives their capital requirements. Because the price is set well in advance of harvest, it almost always is not equal to market price.
The shorthand expression of the yield and price guarantee is stated as the percent of yield, for example 65 percent, and price, for example 100 percent. This would commonly be expressed as 65/100. A 50/60 policy is a 50 percent yield combined with a 60 percent price guarantee.
The per acre liability is equal to: APH multiplied by Coverage level and Price. The liability determines the maximum guarantee. For example, assume a soybean farmer who elects a 65 percent coverage level, has an APH of 50 bu/ acre, and elects 100% of the pre-established USDA price for soybeans ($5.25 in 1999). The liability is 50*0.65*$5.25 or $171 per acre. This is the most the farmer can expect to be paid per acre, assuming a total loss.
The premium is the amount the producer pays for the insurance protection. The premium is a proportion of the liability and is determined by multiplying the liability by a premium rate.
The MPCI rates are set by USDA. The average rate is based on the historical loss experience of crop insurance participants growing the crop in the county. This average rate becomes the basis for determining an individual farmer's premium rate. Around the average rate, USDA has calculated several different risk levels, call R-spans. The R-spans reflect different ranges of yields and growing practices (irrigated versus non-irrigated). Lower than average yields are assumed to be more risky and receive a higher rate. Higher than average yields are assumed to be less risky and receive a lower rate. An individual farmer's APH determines which R-span the farmer is in and the corresponding rate. The premium is adjusted for unit size.
For example, in 1998, soybean rates in Robeson County, North Carolina at the 65 percent coverage level ranged from 45.7 percent at the R-1 span (APH of 11 bu. or less) to 10.5 percent at the R-9 span (APH of 35 and above). These rates are for optional units and would be multiplied by the farmer's liability to determine the premium amount. The R-5 span is the county average.
Catastrophic coverage is the lowest level of coverage available. Beginning in 1999 catastrophic coverage is 50/55 coverage. It was 50/60 coverage in from 1995 - 1998. Buy-up coverage is considered coverage equal to or greater than 50/100 coverage.
Generally, the policy provisions are the same for catastrophic and buy-up coverage. Optional units are not available for catastrophic coverage and the Federal subsidies vary significantly between the two. Farmers pay no premium for catastrophic coverage. They pay a $60 per policy administrative fee instead. Farmers do pay a portion of the premium for buy-up policies.
If the USDA sets the rates and determines the policy parameters, what does the private sector do? Private industry has been involved in the crop insurance program since 1981. It has been the exclusive delivery mechanism for the program since 1997. There are over 14,000 agents and 17 companies involved in the program today.
Insurance agents are the sales force for the program. Agents interact with farmers, helping the farmer choose the insurance instrument and coverage level that is most appropriate. They calculate the farmer's APH, provide the premium quotes for the policy, answer questions, and notify the company in an event of loss. Insurance companies do not directly market policies to farmers. All policies are sold through an agent. In addition, most agents sell other types of insurance and financial products (annuities for example) other than crop insurance.
The insurance companies deliver the program. Their functions include, but are not limited to: hiring and training agents, paying for marketing and advertising, hiring and training loss adjusters and carrying-out loss adjustment activity, billing and collecting premiums, processing and verifying applications, conducting APH reviews, processing and verifying acreage reports, paying claims, auditing and verifying claims data, processing and sending 1099 forms to farmers and the IRS, paying uncollected premiums, and maintaining the necessary automated data processing infrastructure to communicate data with USDA on a routine basis.
The policy a farmer buys is a contract between the insured and the insurance company, not the Federal Government. The policy (commonly referred to as "paper") is private paper, not Federal. In order for the farmer to receive the Federal subsidy attached to the program, the private insurance policy must follow the Federal standards and rates. But the policy itself is a private policy. For this reason, all premiums are owed to and guaranteed by the insurance companies. The Federal Government is not involved in the collection of delinquent debt (premiums owed). In addition, the private insurance companies bear the risk associated with the policies, even though they do not set the rates. Like many insurance companies, crop insurance companies have reinsurance agreements to transfer risk to other private companies known as reinsurers. Unlike most other insurance lines, the private insurance companies also transfer some of the risk associated with the crop insurance program directly to the Federal Government.
Reinsurance provided by the Federal Government and private reinsurance companies is a critical component of the Federal crop insurance program. Reinsurance is risk transfer. Insurance companies transfer risk to other companies who are willing to bear risk, but are not necessarily interested in administering an insurance policy. Insurance companies may seek to transfer risk for a variety of reasons. In the Federal crop insurance program, there are three primary reasons. First, an insurance company may be writing policies in a high risk area where it would normally choose not to operate but must according to the agreement it has with the Federal Government. For example, USDA requires a crop insurance company to write all policies in all geographic areas of a State once it chooses to operate in that State. Second, companies may not have sufficient capital to cover all potential losses. The correlated nature of losses associated with farming requires insurance companies to seek reinsurance for catastrophic losses. Third, an insurance company may not agree with USDA that the premium rates set by USDA accurately reflect the risk in the area. It may therefore choose to transfer the risk of inaccurate rating back to USDA.
An insurance company analyzes its book of business, determines where its exposure is higher than it is capable or willing to underwrite and seeks reinsurance for that part of its business. In effect, the insurance company is buying insurance. Generally, the reinsurer will pay a commission or ceding commission to the insurer. The commission is designed to reimburse the insurer for the reinsurer's share of the acquisition costs (brokerage fees for example), as well as covering the insurer's other costs, such as administrative expenses.
USDA offers reinsurance through the Standard Reinsurance Agreement (SRA). In 1998 there are 17 SRA holders, that is, insurance companies that have signed the SRA with the USDA. USDA offers two basic kinds of reinsurance: pro-rata (proportional) and excess of loss or stop loss reinsurance. The terms and conditions of both are found in the SRA.
The pro-rata reinsurance terms of the SRA have evolved over the years. Today, the SRA provides three separate "pools" or "funds" of reinsurance that reflect varying degrees of risk sharing to the companies. The three funds are the assigned risk, developmental and commercial fund. A company may cede business directly to USDA, which means that the USDA bears all of the risk for the business ceded or the company may retain the liability (risk). Retention is fixed within pools and states. Companies must retain at least 35 percent of their business nationwide. For example, 88 percent of the premium was retained in Iowa in 1998, while 74 percent of the premium was retained by the companies in Texas in 1998.
The premium that a company retains may be assigned to the three risk sharing funds. The three funds contain different stop loss agreements. Broadly speaking, an assignment to the assigned risk fund means that USDA will bear most of the risk for a policy, whereas an assignment to the commercial fund means that private industry accepts more of the risk. The developmental fund is in-between the assigned risk and commercial funds in terms of the risk sharing arrangement. There are separate funds for catastrophic policies (50/55 coverage beginning in 1999) and for revenue policies.
USDA places various cession limits on how much can be placed in the assigned risk fund. For example, 75 percent of the business in Texas, Alaska, Georgia, Maine, and Montana can be placed to the assigned risk . In Iowa 15 percent of the business can be placed in the assigned risk fund. In Illinois, Indiana, and Kansas 20 percent of the business can be placed in the assigned risk fund. USDA also requires that a company retain at least 35 percent of its nationwide book of business.
In addition, the companies "lay-off" additional risk with private reinsurers. Again, the majority of these reinsurance agreements are pro-rata or quota share and stop loss agreements.
As mentioned above, the Federal Government provides two basic subsidies for farmers. It subsidizes premium costs and it provides reinsurance for high risk production areas (the assigned risk pool). The reinsurance is discussed above. The premium subsidy is separated by statute into two components: 1) subsidy of the premium associated with production risk and 2) an administrative and operating subsidy paid by the government to insurance companies on behalf of the farmer.
The 1999 administrative payment is 24.5 percent of the total premium associated with the production risk. This compares to a payment of 27 percent in 1998, 29 percent in 1997, and 31 percent in 1996. For example, if the total premium without administrative expenses is $100, then the administrative payment is $24.50. Administrative payments are not made for catastrophic insurance policies (50/55 coverage in 1999, 50/60 coverage in 1998). Farmers pay a $60 fee for catastrophic insurance coverage. The fee is remitted to USDA and helps offset the cost of the overall program. USDA does make a loss adjustment payment for catastrophic insurance policies to the companies, equal to 11% of the imputed premium (recall there is no premium paid for CAT, but premium is calculated).
The subsidy structure for the premium associated with the risk portion of the insurance policy varies by coverage level. Catastrophic policies are fully subsidized. For all policies with less than 65/100 coverage, the premium subsidy is equal to catastrophic coverage (50/55 in 1999, 50/60 in 1998). In 1998 this worked out on average to roughly a 60% premium subsidy at the 50/100 level, 50% at the 55/100 level and 41% at the 60/100 level.
For all policies equal to or greater than 65/100 coverage, the premium subsidy is equal to 50/75 coverage. This subsidy is capped at 50/75. This works out on average to roughly a 42 percent premium subsidy at the 65/100 level, 32 percent subsidy at the 70/100 level, and 23 percent subsidy at the 75/100 level in 1998.
Federal program expenses are: total indemnities minus farmer paid premium/fees net of underwriting gains plus administrative payments. In the aggregate, it is really that simple. For example, for crop year 1998 (as of March 1, 1999) total indemnities equaled $1.585 billion, farmer paid premium net of underwriting gains was $681 million and the administrative expenses were $439 million. This sum, $1.344 billion is the total Federal program cost for crop year 1998 (note for budgeting purposes, it must be converted to a fiscal year basis).
Moral hazard is a euphemism for cheating or ripping off any insurance program. Moral hazard can be particularly troublesome for the crop insurance program because many management decisions made between planting and harvest ultimately impact the grower's production.
Adverse selection occurs when an insured selects coverage levels or plans of insurance knowing that an indemnity is highly likely and the premium rates does not reflect that expectation. Often adverse selection occurs when a new crop insurance plan does not fully appreciate all the risks that the plan is intended to cover. Adverse selection can be detrimental to the program as it increases losses, which are then incorporated in the historical rating data base.
GRP was designed to address some of the traditional problems of adverse selection and moral hazard associated with the crop insurance program in the late 1980s and early 1990s. The GRP program is based only on county yields, not individual farmer's APH records. Farmers can choose coverage levels between 70 and 90 percent in 5 percent increments of the historic county yield. If the actual county yield, as determined by USDA falls below the guaranteed historical county yield, an indemnity results. This program is most attractive to farmers whose production is closely correlated with county performance. GRP was first introduced in 1993.
GRIP is an area-based revenue insurance product that pays an insured in the event the county revenue per acre falls below the insured's guaranteed revenue. The insured's guarantee is determined by multiplying the expected county revenue by the coverage level chosen by the insured. The expected county revenue is the expected county yield multiplied by the expected price. Coverage levels can be selected between 70 and 90 percent in 5 percent increments. It is available in 1999 in Indiana, Illinois and Iowa for corn and soybeans. Like GRP the program is most attractive to farmers whose production is closely correlated with county performance.
CRC was first introduced in 1996. It is a revenue insurance plan. It protects farmers against low prices, low yields or a combination of both. In addition, CRC provides replacement coverage, where revenue coverage can increase during the growing season if prices rise.
Crop Revenue Coverage (CRC) is the most popular revenue insurance product on the market today. It guarantees a minimum income per acre by crop. The minimum income is the product of the traditional yield guaranteed under the existing MPCI insurance program times the higher of a base price (price established before planting) or a harvest price. Both the base and harvest price typically are determined from futures contract prices. Because the revenue guarantee calculation uses the higher of the base or harvest price, CRC provides "upside" and "downside" price protection.
Because CRC covers up- and downside price movements, premiums are generally higher than traditional multi-peril insurance, which has a fixed price. The Federal Government currently does not subsidize the component of the premium associated with the price risk. The premium subsidy is capped at the equivalent MPCI subsidy at the MPCI price. If the CRC price were the same as the Government's price election, the farmer's out-of-pocket cost for CRC is roughly 45% greater than the equivalent MPCI coverage. However, the CRC price is not likely to ever be equal to the MPCI price election due to differences in price setting methodologies. Because CRC provides a guarantee based on the higher of two prices, in general (although not always) CRC will provide a higher price guarantee than traditional MPCI. The price differential combined with the current subsidy formula means that the farmer's relative cost for CRC compared to MPCI is actually greater than 45%.
The ability to aggressively market a crop is the principal advantage of crop revenue insurance product with replacement value at harvest. One of the chief concerns of farmers who forward contract the sale of their crop is a major crop failure and the ensuing inability to meet the terms of the forward sale. Farmers can mitigate this risk by purchasing option contracts or by insuring their crop with a revenue insurance product that provides harvest replacement value protection.
IP is a revenue product developed by USDA. It protects farmers against low yields, low prices, or a combination of both. Unlike CRC it does not provide "up-side" price protection. The planting season price is the guaranteed price. The price for IP is set from the futures market for the crop during the planting season. Indemnity payments are paid if the actual revenue falls below the revenue guarantee. Because the Federal Government does not have authority to offer a revenue insurance product on a nationwide basis, IP has been piloted tested in limited counties in various States.
RA is the third crop revenue product available in the market. Revenue assurance has been available in Iowa since 1997 for corn and soybeans. The program has been significantly changed for crop year 1999. Beginning in 1999, RA will be available in Iowa, Illinois, Minnesota, and South Dakota for corn and soybeans. It is also available in North Dakota for corn, soybeans, and wheat. RA will now use the Chicago Board of Trade prices rather than posted county prices to determine the revenue guarantee. Also, a fall harvest price option is added. The fall harvest price option is identical to CRC coverage. Whole farm coverage is available under RA up to a 80 percent coverage level.
For products without a futures market and those commodities for which insurance is currently not available, a revenue insurance product that protects against revenue decline for the entire revenue of the farm rather than crop-by-crop may be a feasible alternative. USDA will pilot such a product in 1999.
The product, "Adjusted Gross Revenue," will be available in selected counties in four states in 1999. The pilot is intended to test the feasibility of insuring producers who primarily grow crops that are currently not insurable. However, it could be expanded to include crops that are insurable, but for which no futures contract market currently exists. The insurance plan is based on a farmer's previous five years of Schedule F tax information.