How Is Crop Insurance Price Determined?

Oct 28, 2020 | Business Insurance

How is crop insurance price determined?

Americans tend to follow practical strategies with the change in goods and services. They think that the very best experiment of a consumer’s valuation of a product is what the consumer is willing to buy and consume. Furthermore, they also believe in placing service to the market experiment which is the usual case for a change. It does not sell at an amount that pays what it costs to make it, not put it on the market and do something else. They are for private sector provision of goods and services where it is more effective than public provision.

However, American politicians act differently when discussing and considering federal crop insurance programs. In 2013 when the federal government did not have enough funds for spending, there was a rise in the debt ceiling. Federal politicians then chose to focus on the farm bill. However, they did not cut the budget on bad programs. They encouraged farmers to get risk protection and this is much more expensive for taxpayers. They scratched the program of direct payments and separated it from farmers’ production decisions that were more effective per dollar of the transfer.

This led to the federal government expanding an insurance program that would not be durable in a free market because of expensive administration and reinsurance. In 2011, the program was marketed at $11 billion compared to less than $5 billion in direct payment. This was introduced in 1996 as the main program for transfers to farmers. 

What is crop insurance?

Crop insurance first started in America in 1880. This is when private insurance companies began selling insurance policies to farmers against the harmful effects of hail storms. This kind of insurance, crop-hail insurance policies, is still being sold today and is controlled by individual state insurance companies. Farmers bought more than $1 billion in crop-hail insurance to protect their $35 billion worth of crops in 2001.

Aside from crop-hail insurance, farmers were also encouraged to purchase federal crop insurance which gives the insurers various risk management tools that protect them against the loss of their crops due to natural disasters like drought, extremely cold weather, flood, fire, insect, disease, wildlife or loss of income due to lower prices in the market. Federal crop insurance is being sold by the private sector crop insurance companies while being monitored by the federal government.

The participation of farmers in the federal crop insurance continues to increase as time passes. There were about 45 million acres and $6 billion worth of crops that were insured and this began in 1981. When 2019 came, about 1.1 million policies were sold which protected more than 130 various crops. That’s almost 380 million acres with an insured value of more than $109 billion.

In the long run, the federal crop insurance program changed and improved to give better financial assistance to farmers when they need it while reducing the use of taxpayers’ money. Currently, federal crop insurance is the very significant core of the U.S. farm policy and the safety net for American farmers.

The Federal Crop Insurance Program

The current federal crop insurance program lets you choose from three guaranteed yield levels (50%, 65%, or 75% of their insurable yield) and from a variety of guaranteed price levels. Meanwhile, price election levels are decided from the forecasts of the expected prices of the federal crop insurance program. The highest level is from 90% to 100% of the expected market price. Three price levels were being chosen for most crops before 1994. The recent program has changed and now has allowed price elections between 30% to 100% of the highest price election level. The insurer will receive an indemnity payment equal to the product of the elected price coverage and the yield shortfall if the insurer’s yield decreases below the elected coverage level. The yield shortfall is decided when the amount of the actual yields decrease or is less than the farm’s insured yield.

For the per-acre premium, the total is decided by the product of the price guarantee, the yield guarantee, the Federal Crop Insurance Corporation’s estimate of the farm’s yield, and the premium rate. The subsidies given by the federal government to farmers were started in order to encourage more participation in the program. Under the 1980 Act, there is a 30% subsidy on the 50% and 65% yield guarantees. The subsidy for the 75% yield guarantee is equal to the dollar amount of the 65% guarantee level. Currently, federal crop insurance is available for about 40 various crops.

Federal Crop Insurance Corporation’s Actuarial Determination of Insurance Premium Rates

It is said that unfavorable selection is the main problem affecting the sensibility of the federal crop insurance program. The transparency or absence of unfavorable choices is directly related to how insurance premiums reflect the possibility of losses. The Federal Crop Insurance Corporation has a variety of ways to decide and determine insurance premium rates that may bring about the unfortunate selection in the insurance pool. The most prevalent problem related to rate-setting practices is that rates are decided for a huge geographic area which for instance is a county in which the farm is situated. In conclusion, all producers with the same average yield in a county pay the same premium rate which is dollars per hundred dollars of liability for the same crop and type of practice.

Before 1985, insurance levels in which for instance the liability levels computed from insurable yields were decided using average yields in the location of the farm. This is for both insurance purchasers and non-purchasers. This resulted in poor selection since farms with loss risks are higher than the area averages which also led to a continuously increased proportion of the insured pool. So as to fix this problem, the Federal Crop Insurance Corporation renewed its determination of insurable yields in 1985. They decided to examine the actual production history of the farm when deciding on the insurable yield levels.

With the actual production history approach, insurable yields and premium rates are computed by examining the yield of the farm’s next 10 years of production data. Just the start of the 1994 crop year, producers are now able for actual production history yields with only four years of production data. This can be done up to 10 years of data. If there are only less than four years of actual data available, weighted Agricultural Stabilization and Conservation Service program yields will replace the missing yields. Farmers buy coverage to insure a specific proportion such as 50%, 65%, or 75% of their average yields. However, the direct use of average yields without taking notice of the yield variation would not let you collect indemnity payments.

The Federal Crop Insurance Corporation studies different factors in determining the county-level rates. The very first step to take in determining the rates is examining the 20-year loss history of a given county. Also, loss cost rations for the next years are also studied. The four biggest loss cost ratios are round off at the fifth largest ratio. The round-off values are grouped into a pool which represents a catastrophic loading factor and lays out over the whole state. In order to obtain a loss cost ratio, you need to get the average of the round-off loss cost ratio plus the 16 lowest loss cost ratios. This is then used to make an actuarially sound rate for each county. The loss cost ratios are also made to flatten across county lines. This leveling is needed to soften large differences in the cost of insurance for nearby farms. The catastrophic loading factor is then rolled out in the whole state and rates are modified. The lending rates are given for a certain crop practice such as irrigated versus dryland production. These are offered at the county level. These certain practices may include an unfavorable selection in rates since high loss-risk counties will have lower rates while low loss-risk counties will have higher rates.

Also, prices are calculated according to county average yields as shown by yield data computed by the National Agricultural Statistics Service. Prices are regulated oppositely with county average yields. This results in counties with low average yields without actual losses or yield variation.

County rates are determined according to a variety of average yields using a proportional spanning procedure. Under the proportional spanning, nine risk categories are given and rates in each category are oppositely adjusted according to the farm’s yield. Through this, farms with larger average yields have smaller premium rates. Furthermore, the premium falls at an increasing rate due to the proportional nature of the discounting as the average yields get higher.

One more challenge faced by the Federal Crop Insurance Corporation in determining the premiums is the restriction laid by the legislation which limits the amount that a rate can increase from year to year. Most times, premium rates cannot increase by more than 20% from one year to the next. This one difficulty may result in a reduction in the flexibility of the Federal Crop Insurance Corporation in hopes to eliminate unfavorable selection through premium rate adjustments.

More Information on the Costs of Federal Crop Insurance Subsidies

Only a few farmers will purchase insurance of their crop yields against multiple perils at full cost to the insurer. In reality, there are no private multiple peril insurance programs that have been maintained by the voluntary participation of farmers. A significant problem is that the price of administration, adjustment and reinsurance is expensive between 30% and 40% of indemnities. Prices reach at least 25% of expected indemnities even though payouts are tied to a weather index leading to eliminating expensive adjustment of claims.

Due to the development of insurance markets, economists give attention to another issue called “adverse selection”. “Adverse section” means unfavorable selection. Early insurers tend to have private knowledge that they have large expected losses per dollar of premium. Premiums that are bought to cover expected payouts will be too high to encourage less risky farmers. A subsidy is an answer to this problem by encouraging a large part of the population of possible customers leading to less risk of loss and improving performance.

This kind of strategy or way to solve a problem has been trialed in a large number of crop insurance programs worldwide. Many empirical studies have been made and have verified that the consumption of crop yield or income insurance expands positively when the price of an expected dollar of indemnities falls below one dollar. From 1999 to 2005, the average U.S. subsidy per acre was $7.76 excluding administrative costs. When 2011 came, over 70% of enrolled acres were insured for up to 70% of expected revenue or yield. This was only 9% in 1988. With this kind of participation, adverse selection will not be a major problem. In addition, the federal government is still giving subsidies for about 60% of the expected indemnities that are part of total premiums together with the burden of the costs of administration, adjustment, and reinsurance.

Crop Insurance Decisions for 2020

The 2020 price discovery period used to decide projected prices and unstable factors for federally-sponsored corn and soybean crops is done for places with a March 15 sales closing date. The approved projected price for corn is $3.88 and the unstable factor is .15. For soybeans, the projected price is $9.17 with an unstable factor of .12.

Table 1 below contains projected prices, unstable factors, and harvest prices for the previous 10 years.  The projected price and harvest price are both used to decide the guaranteed revenue based on future prices and are not the same on a cash basis. The projected price for corn is decided by averaging the upcoming closing December prices during the trading days of February. For soybeans, you will be able to get the value by averaging the upcoming November 

Closing prices during February. The unstable factors are decided by an average of the recent five trading days’ that showed unstable estimates and estimates for the interval of time from now until the middle of October. October is the month when average prices are used to decide the harvest prices.

Table 1. Projected Prices, Harvest Prices, and Volatiles, Corn, SCD 3/15 (RMA)

Proj Price6.015.685.654.624.153.863.963.964.003.88
Harvest Price6.327.504.393.493.833.493.493.683.90?
Proj Price13.4912.5512.8711.369.738.8510.1910.169.549.17
Harvest Price12.1415.3912.879.658.919.759.758.609.25?
Source of the table:

The projected price for corn is $.12 below last year’s projected price. For soybeans, it’s 0.37 lower than for the previous year. The end result is that the coverage will be less in 2020 as compared to the previous year. However, this will still depend if the same coverage level has been selected and the actual production history yield has not changed rapidly. The unstable factor sums up the market’s estimates of the possibility for price movements of various magnitudes and has correlating impacts on the premium paid for revenue and harvest price-related products. Furthermore, lower unstable factors will result in lower premiums and the other way around. Other ratings might change from year to year and would sometimes be heavier than the direct effects. This year’s unstable factors estimates are the same as the previous year. This means that the market’s estimates of possible price changes have not changed drastically from the previous year until today.

Corn harvest prices have not surpassed projected prices since the drought in 2012 due to the corresponding high yield years since 2013 and also due to unforeseen trade impacts. Soybeans have the same case except for 2016 which is due to production patterns, basic supply, and demand conditions. Both unstable factors are the same but at small levels before 2018. What makes the cost of insurance lower are the lower projected prices and unstable factors.

The upcoming November 2020 soybean price is about 9.085 or $.085 below the projected price and the upcoming corn price is $3.765 which is more than 10 cents below the projected price. When actual upcoming prices are below the projected prices, there is a high possibility to experience an insured revenue shortfall since the insured price is higher than the market’s estimate of actual value. However, the harvest price decreases incomparable value since it is impossible that prices will end the insurance period above the projected price.  When actual upcoming prices are higher than the projected price, there is a possibility that products with harvest prices will ensure a higher guarantee value. However, a portion of the market’s view of actual value is not included in the insured part. Furthermore, the premiums for crop insurance do not vary in response to differences in prices during the announcement of the product price although the values of coverage of different products are affected. The value of revenue protection insurance is higher if the average price during February is also higher than the upcoming price during the sales period and also the value of revenue protection insurance is lower if the average price during February is also lower than the upcoming price during the sales period. However, the cost of insurance is not affected by both cases. This can significantly influence the net cost of insurance from year to year and can have effects on the corresponding desirability of various products and coverage levels.

The next table depicts information grouped according to the type of policy across coverage levels. There are three groups of results with the left side showing revenue protection policies which are the most common bought. The center column is the revenue protection harvest price exclusion and the right side is for yield protection or yield policies. The table shows information for each kind of policy with each row representing various coverage levels from 50% to 85%. The county-level products that are shown in the following table are computed assuming maximum protection levels in all cases and a maximum protection factor of 1.2 for area products. For each insurance policy option, there are five columns that show the following:

  1. Farmer-Paid Premium per Acre (Est Premium) offers the costs of the product for a representative case. For instance, an 85% revenue protection policy has a $12.60 per acre premium.
  2. Average Payment per acre (Avg Payment) – offers the average expected payment from the insurance product. The average payment you will get for 85% revenue protection is $46.08 per acre. As time passes by, payment from the product will be the same value. After a few years, payments will result in $0, and in some more years, the payments will be positive. The average of all those payments will result in $46.08 for an 85% revenue protection policy.
  3. The frequency that the policy makes a payment (Payment Frequency) – offers the percent of the time that the policy will make a payment. For 85% revenue protection policies, the frequency of payments is at 37.9% which means that this policy will be more than one-third of the time.
  4. Net Cost of insurance – offers estimated premium excluding average payments. This certain value is the cost of the insurance policy. Negative costs mean that the policy will receive payments exceeding the farmer-paid premium. All costs as stated in the table are negative. The 85% revenue protection policy has a -$33.48 net cost. Negative values showed since there is federal assistance provided for crop insurance premiums.
Source of the table:

Enterprise unit policies as presented in the table above cost less than basic unit policies since the slightly lower risk and lower higher rates are shown. Enterprise units have the largest subsidy. Consider 85% policies when looking at the table below and take note that the estimated premiums for this farm in McLean county would be $12.60 per acre with a guaranteed income of $656 per acre = 199bu x 3.88PP x .85coverage. Under the revenue protection insurance, the guaranteed revenue will be at a higher price if the harvest prices at the end of the insurance period are higher than $3.88. The guarantee is fixed and will not be higher if the harvest prices will increase under the revenue protection harvest price exclusion policies. A similar basic unit policy would cost $16.89 per acre. The revenue protection harvest price exclusion policy in the center column will have a premium cost of $5.56 per acre and the yield protection policy would be $5.91 per acre.

Other rows in the table have similar information for various coverage levels. As shown, scaling back coverages can lead to lower premiums since the lower implied revenue or covered yield and the low possibility of insurance. The subsidy rate for lower coverage policies is greater than higher coverage policies with tendencies to be the same dollar value of the subsidy per acre.

The table below shows similar results but for county-level or area products for McLean county. These are computed assuming maximum elected coverage factors.

Source of the table:

The county-level policies start with 70% coverage choices and can reach up to 90%. Meanwhile, farm-level policies only have a maximum of 85%. The highest coverage area risk protection policies also have the greatest expected average premiums and payments since the protection factor is 1.2 scaling of payments to help counterbalance the farm to county basis risk that still exists due to imperfect connection between farm and county yields. The payments may be made when they are not needed and may not happen in many years where they are more needed to counterbalance low on-farm incomes. Area risk protection policies have the highest payments but can result in low-risk protection. As shown in the table on the right side, the area yield protection policy is prompted by the county’s shortfall from its assured fraction of the county’s expected yield. However, it is paid as a limited fraction of the shortfall. It also shows high payments. However, this can result in limited risk protection due to the probability of localized yield disruptions. In the end, a farm could have low yields and even not receive any payments since the county yields were unaffected.

The data given provides information about the expected performance of different insurance policies and coverage levels. They center mainly on the average through time in each case. However, it is significant to understand the power of insurance on the possibility of experiencing low incomes. For instance, an insurer might ask which insurance allows them to most consistently cover cash rent and all variable costs or do the best job of balancing low revenue outcomes under closed production and other concerns. One way to understand this type of concern is to check the revenue risk, revenue levels, and probabilities. These are so-called “values at risk” as stated in different insurance contracts. 

To deeply know the impact on risk reduction by various insurance policies, the graph shows the possibility of achieving different gross revenue levels (bottom axis) against the probability of occurrence (vertical axis). Distributions with a higher possibility of higher income are preferred so lines at the bottom and right are preferred to those above and to the left in this graph. The blue line is the possible income outcomes with no insurance. The entries above the graph show specific percentile and income pairs at 1%, 5%, 10%, and 25% revenue levels. For instance, there is a 25% chance of income with no insurance being below $563 without insurance and a 5% or 1 in 20 year chance of revenue below $414 per acre with no insurance.

Source of the table:

Buying insurance has two kinds of consequences on revenue distribution. First, it transfers the whole schedule left by the price of the premium. Then, it adds payments to outcomes that are covered by insurance leading to moving specific parts of the income distribution back to the right. In reality, insurance should make payments when income is lowest and not make payments when income is highest leading to a full shift in the income distribution to the right at lower income levels and leading to lower incomes when only premiums are paid and no insurance are paid. The data at the top part of the curves are not shown in the graph but would be shifted to the left of the no insurance case. As shown in the graph, area risk protection at a 90% coverage level shifts the distribution to the right by its large average payments. However, it only results in serious low-income outcomes. Yield protection (green) has only a slight effect as compared to no insurance moving the income distribution to the right. However, this is still not cutting off the low-income tail risk. Revenue protection of 85% and revenue protection harvest price exclusion of 85% (hidden behind the revenue protection line) cuts off the tail of the income distribution with minimum revenues of about $570 or more that is guaranteed in most cases. Group products are tempting to get and they pay back more than premiums over a large range of incomes. However, they do not protect against serious income shortfalls. What’s more, in many years with high crop income, they are expensive when it comes to total income due to their higher initial premiums.

Crop insurance is mainly viewed as a foundation for active risk management programs and it is significant in places with higher input costs and greater margin risk. The differences in rates starting prices and unstable conditions can have an effect on the performance of the alternatives from year to year and with their various operations within a given year.

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