Premium Payments Why Crop Insurance Costs Too Much

by Vincent H. Smith

Premium Payments Why Crop Insurance Costs Too Much

by Vincent H. Smith

Introduction

Agricultural insurance has become an increasingly important component of the farm program over the past decade. Since 2007, government subsidies for crop insurance have averaged about

$5.6 billion per year, representing over one-third of total expenditures on income transfers and other government payments for programs targeted directly to farmers. However, about 58 per- cent of those expenditures have ended up in the hands of agricultural insurance companies and agricultural insurance agents. In fact, since 2005, on average, the agricultural insurance indus- try has received $1.44 for every dollar farmers have received in crop insurance subsidies.

Vincent H. Smith ([email protected]) is a professor of agricultural economics in the Department of Agricultural Economics and Economics at Montana State University.

1 Thus, the US federal crop insurance program has offer multiple-peril crop insurance (MPCI), one in become one of the most expensive ways of trans- 1919 and the other in 1922, collapsed almost ferring income to farmers while, at the same time, immediately. In the 1920s, several congressmen and supplying products that most farmers would Henry Wallace, a future secretary of agriculture, never buy absent subsidies. Further, the program expressed support for the concept of a federally involves many products that generate moral- managed program. However, no federal action was hazard behavior by farmers and waste resources. taken until, in the aftermath of the Dust Bowl drought Nevertheless, the program is likely to continue for years of 1934 and 1935, and in the maelstrom of a the foreseeable future, and to expand even further vigorous presidential campaign, Franklin Roosevelt as livestock operations seek to benefit from a sub- promised farmers in the Midwest and southern sidy pool that until recently has been the domain plains that his administration would establish a of crop producers. Aside from substantial support commission to create such a program; the commis- for the program from agricultural organizations sion delivered on Roosevelt’s promise in 1938.1 and insurance industry lobbies, it has broader The initial program, managed by the newly estab- political appeal as a Good Samaritan program that lished Federal Crop Insurance Corporation (FCIC),2 helps people when they appear to be in trouble. was offered for a limited number of crops (wheat and In this context, this paper begins by examining corn) in a limited number of counties, and farmer- the origins and evolution of the US crop insurance paid premiums were intended to cover indemnity program and provides an overview of its complexity payments. However, several management follies and diversity with respect to individual insurance (including allowing local farmer-based committees to products. The program’s growth in terms of subsidies determine expected yields) and an inherent adverse- and overall actuarial performance is then described. selection problem resulted in what were then viewed Next, the economic issues surrounding the program as substantial losses and the discontinuation of the are examined, including concerns about delivery program in 1941. The program’s apparent demise was costs and the supply side. The paper ends with con- relatively, and perhaps regrettably, brief, and by 1944 clusions and recommendations for policy change. the FCIC was back in the business of offering MPCI The major recommendations are as follows. Ideally, yield contracts to some farmers in some counties for the entire crop insurance program should be aban- wheat, corn, and cotton. The program remained a doned. However, given that subsidized crop insur- relatively modest exercise in government support ance is here to stay—at least for a while—first, the until the early 1980s. At that point, tired of providing subsidized insurance products should be designed to what was described as free insurance through a minimize incentives for moral-hazard behavior, standing disaster aid program that operated during which almost always results in wasted resources. the 1970s, President Jimmy Carter proposed and Second, the program should be structured to mini- Congress passed the 1980 Crop Insurance Act.3 The mize delivery costs. Third, insurance subsidies should 1980 act mandated the rapid expansion of MPCI to as be capped on a per-farmer basis to minimize adverse many counties and crops as possible, but only income redistribution (taking from the relatively poor envisioned offering yield insurance. to disproportionately benefit the relatively rich). Between 1980 and 2010, the federal crop insur- ance program grew like a weed, both in scope (num- bers of crops and geographic regions covered) and A Brief History of Crop Insurance complexity (array of different products), mainly because of substantial increases in subsidies and con- Multiple-peril agricultural insurance did not exist gressional mandates. In 1994, the Crop Insurance until the late 1930s. Two commercial attempts to Reform Act increased subsidies and expanded the

2 American Boondoggle: Fixing the 2012 Farm Bill Table 1: A Taxonomy of Multiple-Peril and Index-Based Agricultural Insurance Products

MPCI: Individual Farm Plans Index Insurance: Area Plans

Yield and Revenue Insurance Offered for single crops, multiple crops, Offered for area yield and revenue crop quality, and whole-farm revenues, (typically on a county basis for yields sometimes with riders covering quality using national prices) losses (for example, malt barley and tobacco)

Weather Insurance Not offered on a farm-by-farm basis Offered using single and multiple indicators for forage and hay (weather and temperature)

Vegetation Insurance Offered (at least in the United States) Offered for forage and hay (using for hay satellite-based vegetation indexes)

Commodity Price Insurance Not offered on the basis of individual Offered using national and futures price farm prices information (for example, Livestock Risk Protection and Livestock Gross Margin products for cattle, dairy, and hogs)

allowable scope of insurance products; in 2000, the federal agricultural insurance is now available for over Agricultural Risk Protection Act (ARPA) further 130 different crops and livestock nationwide, and increased subsidies, further expanded the potential over 80 percent of the planted area eligible for federal array of products, and required that the Risk crop insurance is currently insured. Management Agency (RMA) introduce a crop cost-of- The evolution of the federal crop insurance pro- production product and products that cover live- gram since 1980 is reflected in figure 1 with the stock.4 In addition, the 2008 Farm Bill required number of crop acres insured and participation rates farmers who wanted to be eligible for the new (measured as the ratio of insured acres to total Supplemental Revenue (SURE) standing disaster planted crop acres) and in figure 2 with total liabil- aid program for crops to purchase subsidized federal ity and total premiums (the sum of farmer-paid pre- crop insurance. The 2008 Farm Bill also expanded miums and government-premium rate subsidies). a “508h” process (introduced in the 2002 Farm Bill) Between 1981 and 1988, participation fluctuated that, through private initiatives, now allows farm between 9 and 17 percent but jumped to 31 percent groups and insurance companies to seek funding for in 1989 and 1990, years when recipients of disaster developing other new agricultural insurance policies payments in 1988 were required to purchase cover- for which premium subsidies may be provided. age to remain eligible for other federal commodity Currently, farmers pay about 46 percent of the esti- program benefits. Subsequently, between 1991 and mated actuarially fair premium for the most widely 1993, participation rates fell to about 25 percent used federally subsidized insurance instruments (rev- but increased substantially after passage of the enue and yield products based on a farm’s actual pro- 1994 act as direct premium subsidies to farmers duction histories), and about one-third of the total increased to between 40 and 50 percent of estimated cost of the products. The federal government picks actuarially fair premiums. The introduction of even up the other two-thirds of the outlays.5 As a result, larger subsidies in 2001, as a result of the 2000

Premium Payments: Why Crop Insurance Costs Too Much Vincent H. Smith 3 Figure 1: Total Insured Acres, 1981–2010

) 300 s products, covering over 130 crops and n 120% o Total Acres Insured Percentage of Planted Acres Insured i l

l forages as well as beef cattle, dairy cattle, P i 250 e M r (

100% c and hogs. Table 1 provides a taxonomic e d n e t r 200 overview of the products that the RMA a u g

s 80% e

n currently manages. The most widely used I o s

150 f

e products are based on a farm’s actual P

r 60% c l a A

n production yield history (APH) and its l 100 t e a 40% t d current yields. The APH products come in o T A

c two general forms. The first is pure yield 50 20% r e s insurance, under which farmers receive a I n

0% s 0 u payment when their actual yield is less

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 r e

Year d than the yield that triggers losses. The

SOURCE: Data on insured acres were obtained from the US Department of Agriculture (USDA) Risk Management Agency (RMA); trigger yield is established by multiplying data on annual acres planted to crops were obtained from the USDA National Agricultural Statistical Service. the average of the farm’s APH yield7 by a coverage level selected by the farmer. Losses are valued at a predetermined Figure 2: Total Liability and Total Premiums, 1981–2009 price also selected by the farmer. Revenue

$100,000 $12,000 insurance uses futures-market contracts

Total Liability Total Premiums ) $90,000 to establish expected harvest-time prices s

n $10,000

o when the insurance is obtained (at plant-

i $80,000 l l T i o ing and program sign-up time). A farmer’s t

M $70,000 a ( $8,000 l y

P APH is multiplied by the expected t $60,000 i r l i e m b harvest-time price to establish the farm’s $50,000 $6,000 a i i u L

m expected per-acre revenue, which is l $40,000 a s t $4,000 (

o used in conjunction with the farmer’s M

T $30,000 i l

l insurance-coverage decision to establish

$20,000 i $2,000 o n the liability for the crop (the indemnity $10,000 s ) the farmer would receive in the event $0 $0 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 of a complete crop loss). The farmer Year effectively selects a coverage level to SOURCE: USDA RMA. establish the trigger revenue for the crop and receives a payment when the ARPA, engendered some additional increases in farm’s realized yield multiplied by the harvest-time participation. The total area of insured crops realized price (the harvest-time price established for increased from around 206 million acres in 2000 to the futures contract on which the expected harvest over 265 million acres in 2009, and participation price was based) is less than the trigger revenue. rates rose from about 63 percent to over 80 percent.6 Area-yield products also come in two forms: pure yield insurance and revenue insurance. In basic The Current US Agricultural structure, they are similar to APH products, Insurance Product Portfolio although generally based on how county yields per- form relative to their historical averages and how far expected harvest-time prices deviate from actual The US federal agricultural insurance product port- harvest-time prices (again, as reflected in futures folio is complex, consisting of more than twenty contracts). In each case, an expected per-acre county

4 American Boondoggle: Fixing the 2012 Farm Bill yield or county revenue is established, and the the plant growth index for the grid falls below the producer selects a coverage level. Producers have trigger level selected by the farmer. The second, generally shunned area-yield and revenue products based on rainfall indexes for grids that are approxi- when equivalent APH products are available because mately twelve square miles, provide indemnities for of “basis risk.”8 That is, county-based insurance forage loss when the rainfall index falls below the often does not provide coverage when a farmer trigger level selected by the farmer. These products’ suffers an “on the ground” loss because yields at the premiums are also subsidized at approximately farm level are imperfectly correlated with county- 60 percent. The two products highlight the rel- wide yields. Nevertheless, these products are used evance of the income-enhancing role of the federal by some producers and also receive substantial crop insurance program. Regardless of location premium subsidies (56 percent of the actuarially fair and the actual agronomic conditions that pertain premium for 90 percent coverage levels). for plant growth, producers can select any three- Whole-farm crop insurance products (Adjusted month period in the insurance year in which to Gross Revenue [AGR] and AGR Lite) have also been insure their rangeland and hayland. Producers available since the mid-2000s with subsidized pre- therefore can maximize their expected subsidies by miums, but they have encountered severe market picking the three-month periods that maximize total resistance because farmers widely view them as premiums (also the months when the indexes most overly complex and likely to generate relatively frequently generate losses), regardless of any link infrequent and small indemnities.9 between precipitation in those months and plant Price insurance is also available through the Live- growth, because subsidies are proportional to total stock Risk Protection product for lamb, beef cattle, premiums. These two products have been relatively and hogs and effectively amounts to a subsidized popular,10 perhaps in part because they most obvi- put. Livestock Gross Margin products are also avail- ously embody the “inverse Las Vegas world” that the able for dairy cattle, beef cattle, and hogs. Under the federal crop insurance program has created. Livestock Gross Margin products, an estimated gross margin based on futures prices for feed (corn) and Agricultural Insurance Subsidies for the animal is established. The producer selects a and the Federal Program’s coverage level for the margin and receives a payment if the margin shrinks below the coverage level at the Actuarial Performance estimated time of sale because of adverse shifts in feed and animal prices. The Livestock Risk Protec- The federal government provides explicit and tion products receive premium subsidies that are implicit subsidies to support agricultural insurance much smaller than the premium subsidies available in the United States. The subsidies take three for crops, and farmers are prohibited from taking forms. First, as discussed above, producers receive a offsetting positions in futures markets simply to premium-rate subsidy, which varies by class of prod- obtain the premium subsidies. With the exception uct and by level of coverage within products. Sec- of the dairy Livestock Gross Margin product, which ond, insurance companies are given a subsidy for is also subsidized at a relatively low rate, Livestock administration and operations (A&O) expenses, Gross Margin products are unsubsidized. which varies by product, but which, for any given In addition, to serve the livestock industry, the insurance product, is defined as a fixed proportion RMA introduced two area-based forage insurance of the total premium associated with each policy.11 products in 2007. The first, based on satellite Third, the federal government acts as a reinsurer in imagery of plant growth in grids that are approxi- two ways: by providing overall stop-loss coverage mately five square miles, provides indemnities when and, to some extent, copayments for losses on each

Premium Payments: Why Crop Insurance Costs Too Much Vincent H. Smith 5 Table 2: Premiums and Premium-Rate Subsidies, 1981–2009

Total Premiums Producer-Paid Government-Paid Average Premium Period (Billions) Premiums (Billions) Premiums (Billions) Subsidy Rate*

1981–84 $0.373 $0.298 $0.075 20.11% 1985–88 $0.405 $0.309 $0.096 23.68% 1989–92 $0.788 $0.586 $0.202 25.65% 1993–96 $1.274 $0.691 $0.583 45.76% 1997–2000 $2.127 $0.978 $1.149 54.03% 2001–2004 $3.378 $1.367 $2.011 59.54% 2005–2009 $6.778 $2.785 $3.993 58.91%

*The average premium subsidy rate is the ratio of producer-paid premiums to total premiums. SOURCE: USDA RMA.

Table 3: Insurance Subsidies, 1981–2009

Annual Average Annual Average Annual Average Annual Average Company Company Income: Government Company A&O Underwriting Sum of Underwriting Average Delivery Payments to Reimbursement Gains or Losses Gains and A&O Costs per Dollar Period Farmers (Billions)1 (Billions) (Billions) (Billions) of Transfer2

1981–84 $0.242 $0.037 $0.0001 $0.037 $0.15

1985–88 $0.375 $0.112 –$0.0048 $0.107 $0.28

1989–92 $0.429 $0.251 –$0.0247 $0.227 $0.53

1993–96 $0.638 $0.100 $0.0996 $0.200 $0.69

1997–2000 $0.949 $0.485 $0.2948 $0.780 $0.82

2001–2004 $2.008 $0.720 $0.3678 $1.087 $0.54

2005–2009 $1.871 $1.338 $1.3594 $2.697 $1.44

NOTES: 1. Average government payments to farmers are computed as the difference between total indemnities paid to farmers and total premium payments paid by farmers. Average total government payments are defined as the sum of average payments to farmers and average A&O subsidy payments to insurance companies, less any underwriting gains that accrue to the government. 2. Costs per dollar of transfer are computed as the ratio of the sum of company underwriting gains and A&O payments to total government payments to farmers.

6 American Boondoggle: Fixing the 2012 Farm Bill Figure 3: Premium Subsidies and Insurance Company Income by Source, 1981–2009

company’s aggregate book of business, $600,000,000 and by accepting most of the risk for policies placed in an assigned risk $500,000,000 12 fund. As a result, the government $400,000,000 increases underwriting gains for the pri- vate insurers and, therefore, provides $300,00 0,000 additional subsidies to the program, in $200,000,000 this case targeted to the agricultural insurance industry. $100,000,000

Subsidies to the federal crop insur- $0 ance program have expanded substan- 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 tially since 1981, as shown in tables –$1,000,000,000 Year 2 and 3 and in figure 3. Between 1981 Premium Subsidy A & O Payments to Companies Company Underwriting Gains and 1984, on average, farmers paid about 80 percent of the total actuarially SOURCE: USDA RMA. fair premiums for their federal insurance coverage, and the government provided

8 9 an annual average of about $75 million in subsidy The increase in5 6 average7 premium subsidy rates 3 4 0 1 2 0 0 0 9 0 0 0 0 6 7 8 0 0 0 0 4 5 0 0 0 0 2 3 9 9 0 0 2 2 0 1 9 9 9 0 0 2 2 8 9 9 9 9 0 2 2 6 7 9 9 9 9 2 2 4 5 8 9 9 9 2 2 1981 2 13 983 1985 8 198 87 1989 199919 91993 19951 11997 1999 2001 2003 2005 2007 20 09 1 8 8 9 9 continued1 1 into the 2000s, when, as a result of the payments. As the program expanded in the 1980s, 1 8 9 8 8 9 9 1 1 1 8 9 9 1 1 9 9 9 1 1 9 1 1 1 1 1 government contributions to estimated1 1 actuarially 2000 ARPA, Congress authorized further subsidy fair premiums increased to about 24 percent, but by increases. Between 2005 and 2009, premium the period 1989–92 total federal outlays on pre- subsidy rates averaged about 59 percent, and the mium subsidies had more than doubled, averaging federal government provided an annual average of $202 million each year, because the program’s crop $3.993 billion in premium subsidy payments. and geographic coverage had increased substantially. Actual government outlays were in fact somewhat By the late 1990s, as a direct result of the 1994 less than that because loss ratios, the ratio of total Crop Insurance Reform Act, average premium subsidy indemnities paid to farmers to total premiums rates had increased even more, exceeding 54 percent paid by farmers and the federal government, were of the actuarially fair premiums. In addition, because relatively low (less than 1.00) over the period of further expansion in the program in terms of crops 2005–2009, so the government received substan- and products, annual total premium subsidies had tial underwriting gains, as did the private insur- increased by over 500 percent to about $1.15 billion. ance companies. The increase in total federal subsidies was nontrivially Three sets of average annual loss ratios for the fed- linked to both the increase in authorized subsidy eral crop insurance program are presented in figure 4 rates and the introduction of a series of farm-level as indicators of the federal program’s actuarial per- revenue products for major commodities like corn, formance. The first is the ratio of total indemnities soybeans, and wheat, through which farmers could paid to farmers to total premium payments (includ- purchase subsidized protection against yield losses ing government subsidies), the second is the ratio and adverse price movements. Generally, liabilities of indemnities received by farmers to the premiums and premium rates were higher for revenue products they paid, and the third is the ratio of the sum of than traditional multiple-peril yield insurance prod- indemnities paid to farmers and subsidies for ucts, resulting in increased per-acre total premiums A&O expenses paid to insurance companies to the and—because subsidies are proportional to total premiums farmers paid. The latter ratio is an indica- premiums—increases in total premium subsidies. tor of total government subsidies to both farmers

Premium Payments: Why Crop Insurance Costs Too Much Vincent H. Smith 7 Figure 4: Selected Federal Program Loss Ratios, 1981–2009

4.50 rates that, on average, would achieve a target

4.00 loss ratio of 1.075. To ensure that goal was

3.50 accomplished while building sufficient

s reserves for catastrophic losses, the RMA 3.00 o i t

a responded by targeting a loss ratio of 0.88, R 2.50 s s

o that is, indemnities should average 88 per- L 2.00 cent of total premiums. The second involves 1.50 reduced adverse selection. The substantial

9 1.00 8 7 0 6 0 5 0 4 0 0 3 0 0 2 0 0 increases in premium subsidies in 1994 and 1 2 0 0 0 2 9 0 0 2 8 0 0 2 7 0 0 2 6 9 0 2 0.50 5 9 0 2 4 9 0 2 3 9 9 2 2 9 9 2 1 9 9 1 0 9 9 1 2000 resulted in participation rates that 9 9 9 9 9 1 8 9 9 1 7 8 9 1 6 8 9 1 5 8 9 1 4 8 9 1 0.00 3 8 9 1 2 8 9 1 1 8 9 1 8 9 1 8 9 1 now exceed 80 percent, as compared to 1 9 1 9 1 9 1 1 1 Loss Ratio (Total Premiums) Loss Ratio (Farmer Premiums) Loss Ratio (Farmer Premiums and A&O) 20–30 percent in the 1980s. As a result, the overall insurance pool now effectively SOURCE: Author’s calculations (using data obtained from USDA RMA). includes almost all major farmers (80 percent of total output is produced by 20 percent of all farms, almost all of which now purchase and insurance companies relative to the out-of- crop insurance), and there is relatively little adverse pocket costs to farmers. selection. The third reason is more subtle: the In the 2000s, the ratio of indemnity payments to evidence suggests that fraud is now less extensive in total premium contributions has been close to, or less the program, in large part because of innovations by than, 1.00, with the exception of 2002 when the RMA in the practices used to monitor the actu-

1987 1989 1991 1993 199dr5 1oughts997 1999 2in001 the2003 20West05 2007 2and0 09 floods in the Midwest arial performance of individual farms. resulted in atypically high indemnity payments That is the relatively good news. The bad news is for insured crop producers. In 2007 and 2009, for that when the program is evaluated in terms of the example, the program’s loss ratios were 0.54 and ratio of total indemnities to producer-paid pre- 0.58, resulting in substantial underwriting gains miums, program performance has not improved in that were shared by private insurance companies and general. In the 1980s, loss ratios measured in these the federal government. The underwriting gains terms ranged from 1.23 (in 1981) to 2.45 (in 1988) received by the insurance companies in those two and averaged 2.02. In the 1990s, they ranged from years, over $1.6 billion in 2007 and over $2.3 billion 0.83 (in 1994) to 2.19 (in 1993, the year of the Mis- in 2009, were viewed as excessive (and even souri and Mississippi floods) and averaged 1.86, and grotesque) by many congressional delegations, as well in the 2000s they ranged from 1.47 (in 2009) to as by farm groups and the RMA.13 The program’s per- 3.46 (in 2002) and averaged 2.05. These data indi- formance in the 2000s and the mid-to-late 1990s, as cate the substantial costs at which taxpayers reduced reflected by the ratio of indemnity payments to total adverse selection in the 2000s. The loss ratios, premiums, was generally much better than in the which include A&O expenses as part of farmers’ 1980s and early 1990s. In part this was due to several benefits from the program (as farmers do not have to extremely high loss years (1985, 1988, and 1993), pay for the A&O costs as purchasers of nonsubsi- but in other years in the 1980s and early 1990s this dized insurance would), follow a similar pattern but loss ratio generally exceeded 1.25. are considerably higher. In the 2000s, these loss There are three major reasons why loss ratios ratios ranged from a low of 1.93 (in 2009) to a high declined after 1994. The first concerns an explicit of 4.00 (in 2002) and averaged 2.55. Essentially, legislative mandate. The 1994 Crop Insurance between 2000 and 2009 farmers received subsidies Reform Act required the RMA to establish premium that, relative to the approximate commercial costs of

8 American Boondoggle: Fixing the 2012 Farm Bill their insurance, amounted to 60 percent of those and Hewitt (1994) and Smith and Goodwin (2009) costs, even though program performance improved point out, these arguments place little or no weight relative to the actuarially fair premium rate. on the ability of private reinsurers to take on large sector-specific risks within portfolios that are genuinely highly diversified among sectors and The Economics of Crop Insurance countries.15 In fact, private reinsurers handle much larger potential liabilities in the form of hurricane Arguments For and Against. While some commenta- insurance and terrorism insurance than the potential tors continue to use market failure as a rationale for liability associated with worst-case events for the government intervention to supply subsidized MPCI entire US federal crop insurance portfolio.16 Thus, and index insurance products, it is difficult to justify the systemic-risk argument for market failure in such intervention based on economic efficiency. Four agricultural insurance is almost surely a red herring. studies, each focused on high-production-risk areas, have examined farmers’ willingness to pay for multiple- peril and area-based index crop insurance products. The current crop insurance program The findings of these studies are summarized in table 4. None has provided any evidence that the over- disproportionately redistributes federal whelming majority of farmers are willing to pay more taxpayer funds to the relatively rich. than a 10 percent loading factor for MPCI, and the studies showed that index (rainfall) insurance was an even less attractive option. In fact, most farmers do not appear willing to pay the actuarially fair premium rate If there is no credible economic-efficiency/ for multiple-peril coverage, perhaps because of cash- market-failure argument for government interven- flow concerns and adverse-selection problems. tion, why does the program exist? The answer is Commercial insurance casualty and property relatively simple: it is a politically viable program. products typically carry loading factors of approxi- Farmers like the subsidies the program provides and mately 50 percent, and confidential information private crop insurance companies and insurance from private insurers indicates that somewhat simi- agents may like them even more,17 and both groups lar loading factors are required for a small-scale have powerful and effective lobbies. In addition, mandatory MPCI product for wheat producers in the federal agricultural insurance program is “sell- New Zealand. This evidence strongly suggests that able” to the general public from a Good Samaritan the “choke price” at which the amount of MPCI perspective: farmers receive benefits when they demanded by farmers falls to zero is lower than the suffer relatively large crop or revenue losses but, for minimum price at which private insurers would be the most part, not when they have reasonable or willing to offer the product. In other words, there is good crops and revenues. no market for the product; like pet rocks, it is not From an economic-welfare perspective, however, wanted by consumers at the minimum price pro- political “sellability” is not a reasonable criterion for ducers are willing to sell it. introducing, expanding, and continuing a program. The claim has regularly been made that the In fact, as with many farm programs, the current underlying reason for “excessive” loading factors for crop insurance program disproportionately redis- crop insurance is systemic risk; losses among tributes federal taxpayer funds to the relatively rich. insured farmers are highly correlated because Subsidies are directly tied to a farm’s total liability drought, other adverse weather events, and pest because insurance premiums and premium subsi- infestations affect large areas.14 However, as Wright dies are proportional to the farm’s total liability.

Premium Payments: Why Crop Insurance Costs Too Much Vincent H. Smith 9 Table 4: Studies on Willingness to Pay for Crop Insurance

Author(s) Data Methodology Results

Bardsley, Abey, and Yield data from forty-eight Supply-and-demand model for yield insurance, Maximum willingness to pay (WTP) for individual 1 Davenport (1984) shires (counties) in New South assuming an opportunity cost of self- yield insurance is (implicitly) 5 percent. If loading Wales (Australia). insurance against insolvency (bankruptcy) for factors for A&O exceed 5 percent, even an almost farmers and varying degrees of risk aversion risk-neutral insurer will sell no insurance contracts. on the part of insurance sellers.

2 Patrick (1988) Cross-section sample of sixty Direct elicitation of WTP estimates by Rainfall index insurance: 56 percent of the whole wheat farmers in a high-risk farmers for farm-level yield insurance sample would not buy rainfall insurance with a area of Australia (the Mallee and rainfall index insurance. Analyzed 75 percent trigger. Given a loading factor of River Valley in Victoria). using Tobit regressions, sample means, 10 percent, only 12 percent of farmers offered and data enumeration. WTPs sufficient to cover that cost. Almost no farmer would pay a loading factor in excess of 20 percent.

Individual yield insurance: 25 percent of farmers would not buy 75 percent yield coverage, 50 percent would only pay the actuarially fair premium, and only 20 percent had a WTP that would cover a 10 percent loading factor.

3 McCarter (2003) Cross-section data for farm Probit and logit regression models estimated Median WTP estimates varied by contract and households in four regions for three basic contracts (payments triggered region, ranging from 96 percent to 117 percent in Morocco with forty-eight when, relative to average rainfall at the of the actuarially fair value, but these estimates households from each region. nearby weather station, actual rainfall is first potentially overstate the WTP because responders 50 percent or less, then 33 percent or less, were constrained to consider only “take it or leave and then 25 percent or less). it” premium rate offers in contracts. For contracts with low premium rates, in responses to open- ended questions, farmers generally stated lower WTPs than implied by the “take it or leave it” lower-bound premiums.

Sarris, Karfakis, Data obtained from 957 house- Probit regression models estimated for two Over 55 percent of all households surveyed would and Christiaensen holds from forty-five villages in types of rainfall index contract (indemnity not purchase rainfall insurance at a positive 4 (2006) the Kilimanjaro region (a relatively paid when rainfall was 10 percent below premium. The average WTP was less than wealthy area) and 892 households normal and indemnity paid when rainfall 50 percent of the actuarially fair premium from thirty-six villages in the was 30 percent below normal) and data for all contracts offered in both regions. Very Ruvuma region of Tanzania enumeration. few households had WTPs that exceeded (the poorest area of Tanzania) the actuarially fair premium. interviewed in November 2003 and November 2004.

SOURCES: 1. Peter Bardsley, Arun Abey, and Scott Davenport, “The Economics of Insuring Crops against Drought,” Australian Journal of Agricultural Economics 28, no. 1 (1984): 1–14. 2. George E. Patrick, “Mallee Wheat Farmers’ Demand for Crop Insurance,” Australian Journal of Agricultural Economics 32, no. 1 (1988): 37–49. 3. Nancy McCarter, “Demand for Rainfall-Index Based Insurance: A Case Study from Morocco” (Environmental and Production Technology Division Working Paper No. 106, International Food Policy Research Institute, Washington, DC, 2003). 4. Alexander Sarris, Panayiotis Karfakis, and Luc Christiaensen, “Producer Demand and Welfare Benefits of Rainfall Insurance in Tanzania” (Commodity and Trade Policy Working Paper No. 18, Food and Agriculture Association of the United Nations, Rome, 2006).

10 American Boondoggle: Fixing the 2012 Farm Bill Large farming operations have large liabilities encouraging the expansion of crop production on because they insure large areas of crops, and the marginal lands.21 farmers who typically own those large operations are much wealthier than the average taxpayer and enjoy much higher average real incomes (although the The federal agricultural insurance tax laws generally allow them to disguise the effects of their gross incomes on their effective average net program has become an increasingly incomes). Small farming operations with genuinely and perhaps ridiculously expensive low incomes and low levels of wealth receive much fewer benefits from the crop insurance program way of providing subsidies to farmers. because they simply do not raise many acres of crops. As a result, even Good Samaritans should oppose the program because they like to help Who Benefits from the Program? The issue of who in people in real trouble, not the rich—who, when fact benefits from the current US crop insurance incomes are lower than average, can manage by program deserves more detailed discussion. Rela- relying on their wealth (effectively through self- tively little work has been carried out on the supply insurance). side of the US agricultural insurance market. How- However, one factor in favor of the current US ever, while farmers clearly receive regular and crop insurance program is that, when compared substantial income transfers from the program, with several other forms of income transfer (for agricultural insurance companies and agricultural example, price supports or import quotas for insurance agents also receive significant benefits. In specific commodities like sugar and dairy products), both figure 3 and table 3, the data presented illus- the program appears to provide relatively few dis- trate by source of income how private agricultural tortions to relative returns from different crops. insurance company incomes have increased since Nominal subsidy rates are identical for similar levels 1981. In the early 1980s, total company incomes of insurance coverage among crops, and effective averaged $37 million. By the late 1980s and early subsidy rates may be relatively similar.18 As a result, 1990s, when private insurance companies had subsidies provided through crop insurance may effectively become the sole suppliers of insurance generate relatively few distortions in farm-level products to farmers, annual company incomes had land-allocation decisions. increased by 800 percent to $227 million, solely While impacts on land-allocation decisions may because of increases in A&O subsidies (as the com- be small, other elements of the farm’s production panies on average experienced underwriting losses decisions are affected by the availability of, especially, between 1988 and 1992, caused especially by large subsidized APH MPCI. Moral hazard plays an losses in 1988). The companies were the major important role. Several papers have reported that beneficiaries of the requirement in the 1994 Crop farmers with crop insurance use fewer chemical Insurance Reform Act that the RMA establish pre- inputs.19 Recent work indicates that the introduction mium rates that would result in loss ratios of about of the SURE disaster program, which effectively 0.88 on average and of the structure of the 1992 reduces the deductible associated with the most Standard Reinsurance Agreement (SRA), which commonly purchased insurance contracts, has required them to take on more risks but also increased incentives for moral-hazard behavior in provided them with larger shares of underwriting Corn Belt states and wheat-producing states.20 The gains. From 1994 to 2001, underwriting gains evidence also suggests that the US crop insurance became increasingly positive. The 2000 ARPA, program has had some “extra marginal” impacts by by increasing participation through even larger

Premium Payments: Why Crop Insurance Costs Too Much Vincent H. Smith 11 Figu) re 5: Total US Agricultural Insurance Company Income by Source and Policy, 2001–2009 n o i l l i m $ ( $4,500 $16 2005 and 2009, however, delivery costs e m o c $4,000 $14 C per dollar of transfer averaged $1.44. An n o I m y p n alternative perspective on company a

a $3,500 n p $12 y m I

o income is provided in figure 5, which n C

$3,000 c l o a $10 m t shows more detailed information for e o T

$2,500 p d e n $8 r the period 2001–2009. Total company

a Total income from A&O and underwriting gains I n s s t $2,000 u n

r income per insured acre increased by e $6 e d m

y $1,500 A

a about 300 percent from $4.81 in 2001 to c P r

Income per insured acre e

O $4 ( $ & $1,000 $14.36 in 2009, over a period when the A p l e a r t Total A&O payments $2

a consumer price index increased by

o $500 T c r e $0 $0 ) approximately 22 percent. 2001 2002 2003 2004 2005 2006 2007 2008 2009 The above data indicate that the

Income per Insured Acre Total A&O Payments Total Company Income federal agricultural insurance program

SOURCE: Author’s calculations based on data published by the USDA RMA. has become an increasingly and perhaps ridiculously expensive way of providing subsidies to farmers. Fundamentally, premium subsidies, inherently reduced adverse insurance companies and the agents with whom selection and implicitly further increased expected they work were willing to supply all the insurance underwriting gains. Subsequently, total underwrit- services required to support the federal program in ing gains accruing to the companies were positive 2001 at a real cost that was about one-third of the and, apart from 2002, increasingly substantial. average amount they received between 2005 and A major consequence of the 1994 and 2000 2009. One reason why company incomes increased legislative initiatives, therefore, was a massive so rapidly was the rapid increase in prices for increase in company incomes from both A&O major insured commodities (corn, soybeans, and reimbursements (because of increased participation wheat) that took place between 2005 and 2007, and increased levels of coverage) and underwriting but changes in the underlying riskiness of crop gains. Annual average company incomes increased insurance portfolios may also have been important. from $200 million between 1993 and 1996 to The 2008 Farm Bill attempted to address the $780 million between 1997 and 2000, $1.087 bil- delivery-cost issue by reducing the A&O rates for lion between 2001 and 2004, and $2.697 billion the most popular APH yield and revenue insurance between 2005 and 2009. Essentially, therefore, products from 21 to 18.6 percent, and, as a result, agricultural insurance company incomes rose by A&O reimbursements declined in 2009—although, over 1,200 percent over the seventeen-year period because of large underwriting gains, company between 1993 and 2009. Moreover, the costs of incomes increased by almost $1 billion. delivering income transfers to farmers also rapidly The 2011 SRA has attempted to address the issue increased. Between 1985 and 1988, as shown in of high delivery costs by altering the rules that deter- table 3, agricultural insurance companies received mine company underwriting gains to increase the $0.28 for each dollar of subsidies paid to farmers. share of total underwriting gains that accrue to the Between 1993 and 2004, delivery costs per dollar of federal government. However, the 2011 SRA also transfer ranged from about $0.54 (2001–2004) to introduced a cap on the payments that companies $0.82 (1997–2000), although the average for the are allowed to make to insurance agents because the period 2001–2004 is skewed downward by the companies claimed that rapid increases in those company underwriting losses and exceptionally costs were a primary reason why they needed much large government subsidies made in 2002. Between higher incomes to stay in the agricultural insurance

12 American Boondoggle: Fixing the 2012 Farm Bill business. Recent research indicates that those costs basis to minimize adverse income redistribution had in fact increased at a faster rate than company (taking from the relatively poor to disproportion- incomes because the companies were competing for ately benefit the relatively rich). the agents’ books of business, especially in states One way to accomplish this would be to change where underwriting gains were expected to be the entire structure of the program. Several private large.22 A rational solution to the companies’ prob- companies have developed weather-based products lem with insurance-agent costs, therefore, would that allow farmers to insure against complex multi- have been to reduce company incomes and, by ple adverse weather outcomes (such as frost in the implication, delivery costs, rather than to impose spring or fall, excessive growing-season heat, and wage controls on agent incomes and simply increase inadequate growing-season rainfall). One such company profits by legislation. A more fundamental product is being introduced in Canada’s public issue, not yet given serious consideration, is whether agricultural insurance program. Weather-based private delivery of the US subsidized insurance pro- insurance products can be delivered online at gram is optimal. Other countries deliver publicly extremely low delivery costs and allow farms to subsidized insurance programs in other ways, reduce basis risk by self-selecting the weather perhaps at lower costs.23 stations (or combinations of weather stations) that most closely conform to the farm’s actual weather Conclusions and and growing-condition environment. Persuading Recommendations for Change farmers who have had access to APH products to switch to such a product would be extremely difficult, but for specialty crops such as fruits, nuts, There is no market failure, obvious substantive and vegetables (which have proved extremely diffi- economic efficiency, or equity argument for the cult to manage from an actuarial and loss-adjustment existence of the current US crop insurance program. perspective), a complex weather insurance product However, the program has strong support from would work well and could be politically viable with farm organizations and the agricultural insurance the relevant commodity groups. industry lobbies. Moreover, it has the appearance of Ideally, such products—or other area-based prod- helping farmers when they are in trouble and, there- ucts based on county yield, satellite plant growth, and fore (much like agricultural disaster aid programs), weather information that substantially reduce basis is politically sellable to the general public. So the risk—would be the only products offered for major American taxpayer is likely to be stuck funding the row crops like corn, cotton, soybeans, and rice. These program for the foreseeable future—perhaps not products effectively remove most or all incentives for least because foreign farmers and policymakers also moral hazard at the farm level.24 In addition, they are find such programs appealing for similar reasons inexpensive to deliver because they can be sold and are likely to support modifications to World online. However, one important political challenge is Trade Organization agreements that allow for more that these products require no, or relatively few, direct rather than fewer crop insurance subsidies. If that is marketing efforts, and insurance agents therefore have the case, what changes should be made? a limited role in their delivery. Moreover, they also First, the insurance program should be designed require no farm-specific loss-adjustment efforts, so that the products it offers minimize incentives for which obviates the need for private insurance com- moral-hazard behavior, which almost always results panies to bear risk and raises substantive questions in wasted resources. Second, the program should be about the need for any private-sector involvement.25 structured to minimize delivery costs. Third, insur- Hence, company and agent lobbying groups, which ance subsidies should be capped on a per-farmer have proved increasingly politically influential, are

Premium Payments: Why Crop Insurance Costs Too Much Vincent H. Smith 13 likely to oppose the introduction of weather- or area- payment and other subsidies were capped in the based products. 2008 Farm Bill through the two-person restriction. An alternative and longer-run strategic approach Within the framework of the current program, caps to reducing delivery costs and moral hazard may be could be implemented in a relatively straightforward to introduce weather-related products as optional way. Premium subsidy rates exist for each insurance products and simultaneously increase subsidies policy, and the RMA already computes the govern- for those products and other area-yield products ment’s premium contribution for each policy a farm relative to farm-specific APH products. Essentially, purchases. It would be relatively simple to cap those Babcock’s proposal for introducing a “free” county- premium subsidy contributions to some maximum, based revenue or yield subsidy program in Title I of say ten thousand dollars per farm. The political heat the Farm Bill is one form of this approach. At the from farm groups and the insurance industry over very least, Congress should commission a third- such a cap would be considerable, but at least the party study of options for improving the economic New York Times, the Washington Post, and the Envi- efficiency and reducing the costs of the US crop ronmental Working Group would not complain— insurance program’s delivery system. nor, perhaps, would taxpayers concerned about Finally, on a per-farmer basis, insurance subsidies budget deficits, whose welfare may matter more to should be capped for equity reasons, just as direct policymakers in the next Congress.

14 American Boondoggle: Fixing the 2012 Farm Bill Notes crop insurance in general. See Vincent H. Smith and Myles J. Watts, “The New Standing Disaster Program: A SURE Invitation to Moral 1. Randall A. Kramer, “Federal Crop Insurance: 1938–82,” Hazard Behavior,” Applied Economic Perspectives and Policy 32, no. 1 Agricultural History 57 (1983): 181–200; and Barry K. (2010): 154–69; and Anton Bekkerman, Vincent H. Smith, and Goodwin and Vincent H. Smith, The Economics of Crop Insurance Myles J. Watts, “The SURE Program: An Empirical Investigation of and Disaster Relief (Washington, DC: AEI Press, 1995), Moral Hazard and Adverse Selection Behavior” (working paper, www.aei.org/book/66. Montana State University, Bozeman, MT, 2010). 2. The FCIC was created in 1938 to “promote the economic 7. The farm’s APH yield is based on a minimum of four to a stability of agriculture through a sound system of crop insurance maximum of ten previous consecutive actual average annual and providing the means for the research and experience helpful yields for the area to be insured. A variety of rules determines how in devising and establishing such insurance.” In its current missing yield data should be handled and how farmers who have structure, management is vested in a board of directors, subject to not previously grown a crop should be allowed to establish an the general supervision of the secretary of agriculture, and the insurable yield. Many producers complain that the APH pro- FCIC is operated through the RMA of the USDA. cedure understates their expected yields because it does not 3. Randall A. Kramer, “Federal Crop Insurance: 1938–82”; account for long-run trends in yield performance. For example, in and Barry K. Goodwin and Vincent H. Smith, The Economics of most Corn Belt states, corn yields have steadily increased at an Crop Insurance and Disaster Relief. average annual rate of about two bushels since 1980, and soybean 4. In the mid-2000s, the RMA developed whole-farm yields have increased at an annual rate of 0.4 bushels over the same insurance products in the hope that they could be viewed as period. Thus, they argue, APH yields based on a simple arithmetic substitutes for cost-of-production products. Recently, the FCIC average of the previous four to ten years systematically understate board approved the development of a crop margin coverage their expected yields and result in their being “underinsured.” product for rice and wheat. The proposed margin product is 8. Mario J. Miranda, “Area-Yield Crop Insurance Recon- based on farm-specific yields but uses regional information on sidered,” American Journal of Agricultural Economics 73, no. 2 (May the per-acre use of some (but not all) variable inputs and regional 1991): 233–42; Vincent H. Smith, Hayley H. Chouinard, and or national prices for those inputs to compute expected and Alan Baquet, “Almost Ideal Area Yield Crop Insurance Contracts,” realized margins. Agricultural and Resource Economics Review 23, no. 1 (1994): 5. The most widely purchased RMA crop insurance policy is 250–61; and Vincent H. Smith and Myles J. Watts, “Index Based an APH yield or revenue product with a 65 or 75 percent yield- Agricultural Insurance in Developing Countries: Feasibility, coverage election. The federal government pays 59 percent of Scalability, and Sustainability” (working paper, Montana State what is described as the total premium. The RMA requires that University, Bozeman, MT, November 2009). the total premium be computed as about 113 percent of what is 9. A second concern and source of farmer resistance to otherwise estimated to be the actuarially fair premium (the AGR products is that they require tax-return information. For estimated actuarially fair premium rate divided by 0.88), where explicit examples of how AGR Lite performs relative to other the 13 percent surcharge represents a loading factor to account RMA product-based insurance strategies and for a description for catastrophic events that may not have been captured in the of AGR Lite, see James B. Johnson and Vincent H. Smith, data used to calculate the premium. The adjustment is essentially “Risk Management Options for Montana Farms” (Agricultural ad hoc but reflects typical practices in setting insurance rates in Marketing Policy Center Policy Issues Paper 29, Montana State all lines of business. Assuming that, in fact, the data used to University, Bozeman, MT, 2009). calculate the preloaded premium rate are reasonable and that 10. In 2010, the RMA reported that producers in the on average the preloaded premium is actuarially fair, the farmer twenty-five states in which the pasture and range insurance pays 41 percent of the total premium, or about 46 percent of products were offered insured over 30.9 million acres of pasture the actuarially fair premium. The federal government also pays a and rangeland. direct subsidy of 18.6 percent of the total premium to insurance 11. The 2010 A&O reimbursement rate in most states companies who sell and service the federally subsidized products was 18.5 percent of total premiums for revenue and yield insur- to cover their A&O costs. The government also provides more ance policies that base indemnity payments on a farm’s APH indirect subsidies through loss-sharing arrangements embedded and production or estimated revenue in the current year in the standard reinsurance agreements under which the private and provide 75 percent or less coverage levels for losses and insurance companies operate. 16.4 percent of total premium for policies with coverage levels of 6. In some states, the introduction of the SURE standing disaster 80 or 85 percent. In states with average loss ratios in excess of program for crops may also have increased participation since 120 percent, the A&O reimbursement rate was 19.6 percent. 2008, not least because, by effectively reducing deductibles Catastrophic-coverage individual-farm policies were reimbursed associated with insurance policies, the SURE program is likely on a different basis. A company received a $300 administrative to have increased gains from moral-hazard behavior and returns to fee paid by the farmer and, if loss adjustment was required, an

Premium Payments: Why Crop Insurance Costs Too Much Vincent H. Smith 15 additional 7 percent of the net premium for the policy. For 17. After all, the agricultural insurance industry would not exist, policies in which indemnities were based on area yields or esti- apart from providing specific peril products (for fire and hail) for mated area revenues, Group Risk Plans, and Group Risk Income a relatively small market, if the government did not subsidize agri- Protection, the A&O reimbursement rate was 12 percent. cultural insurance products. 12. The SRA between the federal government and the insur- 18. Little research has been carried out on the extent to which ance companies defines the terms under which a company different crops receive different subsidy rates. Several analysts have operates in each state. In 2010, each company allocated crop noted that loss ratios are lower in the Corn Belt states where corn insurance policies within a state to one of three different insurance and soybean production is concentrated than in the southern pools or funds: the assigned risk fund, the commercial fund, and plains, Great Plains, and southeast (see, for example, Vincent H. the development fund. The funds differ in the required level of Smith and Barry K. Goodwin, “Private and Public Roles in Provid- retention and also in the shares of gains and losses from retained ing Agricultural Insurance in the United States”). Some explain business under the disproportional features of the agreement. In the differences in loss ratios through the use of “cups” in RMA rate- 2011, under the recently renegotiated SRA, the development setting procedures that place a lower limit on premium rates in fund will cease to exist, but the other funds will be retained, albeit areas like the Corn Belt states where risks of loss are relatively low. with some modifications in the share of premiums that can be Of course, if risks of loss are so low, there is no need to provide ceded, risk sharing, and the proportions of underwriting gains the agricultural insurance as a risk-management tool in those areas. companies can retain. Companies must place at least 25 percent 19. See, for example, Vincent H. Smith and Barry K. Goodwin, of the premium associated with their total book of business in “Crop Insurance, Moral Hazard, and Agricultural Chemical Use,” the commercial fund and retain at least a 35 percent interest in the American Journal of Agricultural Economics 78, no. 2 (1996): premium in that fund, ceding up to 65 percent (with respon- 428–38; Barry K. Goodwin and Vincent H. Smith, “An Ex-Post sibility for associated losses) to the government. In the commer- Evaluation of the Conservation Reserve, Federal Crop Insurance, cial fund, with respect to the premium they retain, companies pay and Other Government Programs: Program Participation and Soil 100 percent of the indem-nities associated with losses up to the Erosion,” Journal of Agricultural and Resource Economics 28, no. 2 amount of premium they retained, but, thereafter, the government (2003): 201–216; and Bruce A. Babcock and David A. Hennessy, pays an increasing share of additional losses until the loss ratio “Input Demand under Yield and Revenue Insurance,” American exceeds 500 percent, at which point a stop loss comes into effect Journal of Agricultural Economics 78, no. 2 (May 1996): 416–27. and the government pays all additional losses. A similar but less 20. Anton Bekkerman, Vincent H. Smith, and Myles J. Watts, onerous (for the companies) structure of copayments of indem- “The SURE Program: An Empirical Investigation of Moral Hazard nities exists for premiums retained by companies in the assigned and Adverse Selection Behavior.” risk fund. Companies’ indemnity copayment responsibilities are 21. Barry K. Goodwin and Vincent H. Smith, “An Ex-Post larger in states with lower historical loss ratios (the Corn Belt states) Evaluation of the Conservation Reserve, Federal Crop Insurance, than in other states, reflecting the expectation that underwriting and Other Government Programs: Program Participation and gains will generally be higher in the low-loss-ratio states. Soil Erosion.” 13. See, for example, the recent Government Accountability 22. Vincent H. Smith, Joseph W. Glauber, and Robert Dis- Office report, which identified major issues with the reimburse- mukes, “Rent Dissipation in the Agricultural Insurance Industry” ments received by the insurance industry: US Government (working paper, 2010). Accountability Office, Crop Insurance: Opportunities Exist to Reduce 23. Olivier Mahul and Charles J. Statley, Government Support to the Costs of Administering the Program (Washington, DC, 2009). Agricultural Insurance: Challenges and Opportunities for Developing 14. For a careful discussion of the systemic-risk issue, see Mario Countries (Washington, DC: World Bank, 2010). J. Miranda and Joseph W. Glauber, “Systemic Risk, Reinsurance, 24. Harold G. Halcrow, “Actuarial Structures for Crop Insur- and the Failure of Crop Insurance Markets,” American Journal of ance,” Journal of Farm Economics 31, no. 3 (1949): 418–43. Agricultural Economics 79, no. 1 (1997): 206–215. 25. The argument is as follows. To ensure that loss adjustment 15. Brian D. Wright and Julie A. Hewitt, “All Risk Crop is carried out accurately, companies need to share in underwrit- Insurance: Lessons from Theory and Experience,” in Economics of ing losses and gains, which are directly affected by the loss-adjust- Agricultural Crop Insurance: Theory and Evidence, ed. Darrell L. ment process. If there is no need for loss adjustment, there is no Hueth and William H. Furtan (Boston, MA: Kluwer Academic reason to provide the companies with incentives to accurately Publishers, 1994), 73–109; and Vincent H. Smith and Barry K. assess losses and no need for them to participate in underwriting Goodwin, “Private and Public Roles in Providing Agricultural gains. So there may be no need for the companies’ involvement Insurance in the United States,” in Public Insurance and Private in the program. An argument for a role for private companies is Markets, ed. Jeffrey Brown (Washington, DC: AEI Press, 2009) that, as long as they compete with one another, they may still be www.aei.org/book/100045. more efficient in providing the other services required for man- 16. Vincent H. Smith and Barry K. Goodwin, “Private and Pub- aging the program than a government agency, including data lic Roles in Providing Agricultural Insurance in the United States.” management, premium collection, and indemnity payments.

16 American Boondoggle: Fixing the 2012 Farm Bill

Premium Payments Why Crop Insurance Costs Too Much by Vincent H. Smith

This paper examines the federally subsidized crop insurance program. Under this program, the federal government subsidizes about 60 percent of the premiums farmers pay for private insurance to protect them against financial losses due to drops in the value of their crops. The federal government also subsidizes the private insurance companies that sell the policies, paying them between 12 and 19.6 percent of the premiums farmers pay to cover the companies’ costs of marketing the policies. The paper’s main findings are:

1) Taxpayers spend billions of dollars annually to subsidize crop insurance, and this amount is rapidly growing: Since the 2008 Farm Bill, government subsidies for crop insurance have averaged $5.6 billion annually, a steep rise from the roughly $2 billion annual average spent between 2003 and 2007. The program is now over twenty-eight times larger than it was in 1994, when subsidized crop insurance cost roughly $200 million per year.

2) Crop insurance subsidies are now the single largest farm subsidy program: The $5.6 billion crop insurance program is nearly one-third of the total expenditures on programs directly targeted to farmers. It is rivaled in size only by the $5 billion farmers collect annually in direct payments. Farmers today rarely collect subsidies from the traditional farm subsidy programs because of historically high commodity prices.

3) Insurance companies are the real winners from crop insurance subsidies: The crop insurance program subsidizes the insurance companies’ overhead while letting them keep the bulk of any underwriting gains. This system of socialized losses and privatized gains is a windfall for companies and their agents; about 58 percent of crop insurance subsidies ultimately flow to them. Since 2005, the agricultural insurance industry has received $1.44 for every $1.00 received by farmers.

4) This program could be repealed without much harm to farmers: Farmers have repeatedly shown they will not buy crop insurance without massive government subsidies—that is, they do not think the benefits are worth the costs. Farmers could protect themselves against financial losses by making greater use of modern financial techniques, such as forward selling, puts, options, and derivatives.

5) If the program must remain, it should be dramatically reformed: Three simple reforms would significantly reduce crop insurance costs and increase its efficiency:

a. Replace the complex and confusing array of policies currently available with a single weather-based product that can be delivered online at extremely low delivery costs;

b. If this cannot be done for all crops now, reduce the subsidies for insurance companies to market the products so they bear some downside risks; and

c. Cap the amount any one farm entity can receive in crop insurance subsidies so that wealthy farmers do not receive government support.

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