Crop insurance issues and concerns

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Crop Insurance – Issues and Concerns

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Table of Contents 1. Introduction ................................................................................................................................3 2. Crop Insurance Profitability ..........................................................................................................4 3. Farm Bill 2013 ..............................................................................................................................9 4. Conclusion ................................................................................................................................. 10 5. References................................................................................................................................. 11

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1. Introduction Crop insurance is the primary risk management tool farmers use to financially recover from natural disasters and volatile market fluctuations; pay their banks, fertilizer suppliers, equipment providers and landlords; and purchase their production inputs for the next season. Without an effective and affordable crop insurance program, catastrophic production losses would sap the rural economy by setting in motion a series of harmful events: farm failures and consolidation, job losses, farm-related small business failures and financial stress on rural banks. A financially healthy rural economy requires a financially healthy farm production sector. The Federal Crop Insurance program, commonly known as MPCI, has been offered to U.S. farmers since the 1930s. Originally available only through the Federal government, the program has operated since 1981 as a public-private partnership between members of NCIS, as direct insurers or their managing general agents, and the Federal Crop Insurance Corporation (“FCIC”), as their principal reinsurer. The basic terms of this relationship are set forth in a Standard Reinsurance Agreement (“SRA”) signed by FCIC and each individual direct insurer. FCIC, a federally owned corporation, delegates the responsibility of managing the program to the Risk Management Agency (“RMA”) of the U.S. Department of Agriculture (“USDA”). In crop year 2012, the MPCI program: provided coverage on 282.5 million acres of eligible acreage of major U.S. crops, insured liability of around $117 billion, estimated total premiums of $11.08 billion (of which $6.9 billion were premium subsidies), and distributed $17.3 in indemnity payments. As a Congressionally authorized insurance program subsidized by the U.S. Treasury, FCIC and RMA have the responsibility for ensuring that the profitability of the MPCI program is reasonable in relation to the financial risk retained by the participating insurers. In addition, the government has a duty to taxpayers to ensure that the program is delivered to insured farmers in a cost effective manner. Multi-peril crop insurance represents a very modest portion of U.S. property/casualty insurance industry revenues. Crop insurance represents approximately 1% of property/casualty industry annual net written premium volume. However, this segment has garnered considerable attention as scorching summer heat and extensive drought conditions in 2012 wrought large crop losses across multiple agricultural regions. The world’s two most costly natural disasters in 2012 were in the United States, with Hurricane Sandy and the summer drought generating an estimated $100 billion in economic losses. Crop losses have subsequently led to insurers reporting underwriting losses on crop insurance business. Insured losses from Sandy net of reinsurance (high-end estimates at $25 billion) are considerably more substantial than private crop insurer underwriting losses that could fall between $1-2 billion. Losses from both events have significantly affected near-term earnings, but have not adversely impacted capital levels.

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2. Crop Insurance Profitability In recent months, a variety of claims have been aired in the press regarding the cost of delivery of the Federal crop insurance program and the profitability of the private sector companies that deliver the program to farmers. These claims place the crop insurance industry in an unfavorable light, arguing that the industry is too profitable, that profits are guaranteed, and that Administrative and Operating (A&O) expense payments are excessive. Naturally, the companies participating in the program disagree. They argue that if profits were generous or excessive, new insurance companies would be entering the program on a regular basis. This is simply not taking place. At one time, 49 companies participated in the Federal program, but in recent years the number of insurers has not exceeded 16.

Crop Insurance Loss Ratio

While crop insurance experienced past cycles of extended underwriting losses, the business was consistently profitable for nearly a decade. However, this streak ended in 2012. For crop year 2012, FCIC reports that indemnity losses are $14.2 billion or 129 percent of total premiums, which is the worst result since the 140 loss ratio posted in the more severe drought year of 2002. Pricing in any P&C insurance lines is all about estimating future losses and understanding the potential variability around the expected loss, but MPCI operates in a different way. Risk Management Agency (RMA) establishes the rates that every farmer will pay. These represent expected indemnities only, without taking into account expenses or profit for the insurance company.

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Since no insurance company can operate without the ability to recoup its expenses or earn a profit, the government created a separate contractual arrangement by which it can enlist the services of the private sector in delivering the program to all eligible farmers while simultaneously providing participating insurers the ability to recoup their program delivery costs and the opportunity to earn a reasonable return. SRA which provides financial terms for A&O compensation and for risk-sharing establishes the amount of A&O the government pays to compensate insurers for their cost of delivering the program. Delivery costs would be included as part of the premium in any other line of insurance, but the government has chosen to reimburse these costs by making A&O payments on behalf of insured farmers. What should be kept in mind is that the underwriting gain or loss a company earns in a year depends primarily on the weather. When weather conditions are good and farmers have high yields, fewer claims are reported and companies are able to earn underwriting gains. However, in a year with poor weather conditions and low yields, farmers report more claims and insurers absorb Underwriting losses. If poor weather affects a large number of states, the underwriting losses in those states could swamp the gains earned throughout the rest of the country. Due to the potential for widespread losses, crop insurance is much riskier than most other P&C lines of insurance. This point can be illustrated by considering how often an industry loses money. Industry sources report that the P&C industry as a whole has lost money only once, in 2001, due to the unprecedented attack on the World Trade Center in New York City. In comparison, the crop insurance industry has lost money in two years over just the past two decades, in 1993 and 2002. If the current SRA had been in effect during 1983 and 1988, two years with widespread crop failures, the industry would have lost money in those years as well.

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Crop Insurance Industry Income Statement 2012

Source: NCIS

In order to respond to the public debate regarding the profitability of the program, we first need to clarify the distinction between gross revenue and net income. The net income, or profit, of a business is the difference between its revenue and expense. For a crop insurer, revenues consist of underwriting gains and A&O payments, as well as any income earned from the investment of the insurer’s capital. Program delivery expenses include loss adjustment expense, agent compensation and company overhead. Net income is also net of Federal, state, and local taxes. While net income is important in itself, companies also need to know how well they are performing in comparison to their peers and other industries. The accepted standard for measuring the profitability of a company or an industry is its Return on Equity (ROE), defined as the ratio of net income to the equity (i.e., capital) invested in the business. According to financial theory, unless ROE is competitive with other uses for capital, capital will be withdrawn from an industry and be reinvested in industries with better rates of return. In general, the riskier a business, the greater its rate of return needs to be. Financial theory refers to the required rate of return of a business as its cost of capital. In effect, a company needs to achieve an ROE equal to its cost of capital in order to remain viable over the long term.

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Cost Effectiveness Another issue raised during public discussions has been the A&O payments made to the companies. A&O has often been described as extra profit that companies make in addition to their underwriting gains. The reality is that A&O is used to compensate insurers for their cost of delivery. A&O is paid on behalf of farmers rather than included as part of the premium in order to reduce farmers’ out-of-pocket cost for risk protection. One question critics raise with regard to A&O is whether the government is overpaying for private sector delivery of the program. This question can be addressed by comparing the cost of delivery of the Federal crop insurance program to other P&C lines of insurance. That comparison has been published in a report prepared by Grant Thornton LLP1. The report demonstrates that the crop insurance industry is vastly more cost effective than other sectors of the insurance industry. Total Expense to Premium Ratios (MPCI vs. Property & Casualty)

Total delivery expense in 2011 for the crop insurance industry was around 16% of expected indemnities. For the P&C industry in total, the comparable cost was in around 62%.

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Last 5-Year Average Loss Adjustment Exp % of Direct Written Premium

Average loss adjustment expense for crop insurance industry for the period of 2007-2011 was just 2.3%, whereas it was 19% for the total P&C industry for the same period.

Last 5-Year Average Commission Exp % of Direct Written Premium

Last 5-Year Average Other Exp % of Direct Written Premium

Agent compensation was 13.8% in comparison to 18.4 percent for the P&C industry in total. Company overhead expense for the crop insurance industry was only 4.1 percent versus 24.9 percent for the P&C industry as a whole. Clearly, the industry has very little fat left to trim. As far as A&O payment is concerned, it has been cut drastically over time, from 35 percent of premium in the early years of the program, to an estimated 11 percent in 2011. It needs to be recognized, however, that the current A&O reimbursement is a fraction of the amount that other insurers receive for delivering the Federal Flood insurance program, a program in which insurers share none of the risk, and a fraction of the premium expense loading in other sectors of the P&C industry. The reality is that A&O does not now and has not been adequate to cover program delivery cost for the past 15 years. Companies have been compelled to dig into their own pockets instead to pay the portion of expenses not covered by A&O.

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3. Farm Bill 2013 Senate Agriculture Committee approved a farm bill on Tuesday, costing $500 billion over a decade that would expand the scope of the federally subsidized crop insurance program and modestly trim spending on food stamps for the poor. The House bill is expected to go to the floor next month The 1,000-page bill now goes to the Senate floor, where a vote could be called as soon as this month. Despite an estimated $24 billion in savings in the Senate bill and $40 billion in the House, the new farm bills preserve several Depression-era subsidy programs, like price supports for American sugar growers and limits on sugar imports. The bills also create subsidies for Southern peanut and rice farmers. The most significant change in both the House and Senate bills is the end of direct payments, which cost taxpayers about $5 billion a year. Both the House and Senate bills would use the savings from eliminating direct payments to increase financing for crop insurance, a federally subsidized program that pays 62 percent of the premiums for farmers and covers decreases in crop yields or revenue. About $1.3 billion a year is paid to 15 insurance companies to sell and process the policies. The new farm bills would increase the crop insurance programs by $9 billion and include an additional subsidy called the “shallow loss� program, which would cover farmers for modest crop yields or declines in prices. Expansion of crop insurance in the Senate bill would be part of a broad remodeling of farm subsidies. Most notably the $5 billion a year direct-payment subsidy to farmers, long a target of reformers, would end. Separate insurance programs to guarantee revenue to cotton and peanut growers would be created, as well as an insurance program to compensate growers if revenue from other crops drops by more than 10 percent.

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4. Conclusion The one certainty in the crop insurance industry is that change is continual. Ongoing program changes may bring about further changes. How these may affect the industry is yet to be determined. Additional points to keep in mind with regard to the results shown here are that returns earned by the industry are not guaranteed. Companies are exposed to considerable risk that may cause their results to vary widely from year to year and from region to region. The high degree of risk has not been adequately considered in any analysis provided by the government. Furthermore, an adequate rate of return at the national level may not ensure an adequate return for individual states. Certain states, particularly in the Southern Plains, have extremely low or even negative expected rates of return, which has serious implications for the long term viability of the private delivery system in those regions. Despite the drought-related crop losses and concerns regarding the potential for further extreme weather conditions, private market crop insurers are likely to add exposure to their portfolios going forward and the market has recently added a few new participants.

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5. References •

National Crop Insurance Services, Inc.

Grant Thornton LLC

Federal Crop Insurance Corporation (FCIC)

Agricultural & Applied Economics Association (AAEA)

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