Originally published Vol. 4,
Issue 5 (November 2006)
Managing Risk With Revenue Insurance
Revenue
insurance may do a better job of stabilizing farm
income and may protect more farms than other risk
management tools.
Robert
Dismukes and Keith
H. Coble
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Crop
revenue insurance offers farmers a way
to manage revenue variability that results
from yield and price risks. |
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Commodity-level
revenue insurance, particularly for
corn, soybeans, and wheat, has become
a major part of the subsidized Federal
crop insurance program. |
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Whole-farm
revenue insurance, based on combined
revenue from all commodities produced
on a farm, is a more broad-based approach,
but is difficult to administer. |
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Farming is an inherently risky
business. Uncertain weather conditions, market shifts,
and other events beyond a farmer’s control
affect farm yields and commodity prices, creating
variability in farm revenue. Since the early 1980s
the Federal Government has promoted insurance as
a tool for managing crop losses. In its simplest
form, insurance reduces risk by making payments
to insured farmers when yields or revenues fall
below a guaranteed level. Farmers can choose from
a variety of insurance plans in the subsidized Federal
crop insurance program, including yield insurance
plans, which have been part of the program from
the outset, and revenue insurance plans, which were
added in the mid-1990s.
As a tool based on revenue shortfalls
rather than on yield or price shortfalls, revenue
insurance can be more effective at stabilizing income
than insurance plans or farm programs that protect
against yield and price risks separately or that
provide fixed-income transfers. A revenue-based
program may also offer a simple way of assisting
a wider variety of farms than programs linked to
current or historical production of particular commodities,
a practice that focuses risk management support
only on certain segments of the farm sector. Finally,
revenue insurance plans are designed to match costs
of risk protection with benefits and to base coverage
on the market value of the item insured.
What Causes Revenue Variability?
Revenue depends on production,
prices, and interactions between the two. Prices
received by farmers depend largely on world market
conditions, while yields depend on localized factors,
such as weather. Thus, revenue variability across
farms is largely the result of yield variability
and differences in the relationship between prices
and individual farm-level yields.
The relationship between prices
and yields is “negative” when changes
in yield and aggregate production result in offsetting
changes in prices. In other words, when yield and
aggregate production of a commodity increase, price
decreases; when yield falls, price rises. The price-yield
relationship, measured by the price-yield correlation,
tends to be strongest in areas where most farm-level
yields are closely related to areawide production
and where the area’s production normally accounts
for a significant share of world production. Corn
and soybeans, for example, show the strongest negative
price-yield correlation in the Midwest. Negative
price-yield correlations moderate revenue variability,
thus they are often referred to as a “natural
hedge.”
Not surprisingly, many areas with
large amounts of corn and soybean production tend
to be areas of low yield variability. Yield variability
for corn, for example, is low in Illinois and Iowa,
which together account for about a third of the
U.S. corn crop. The U.S. crop typically accounts
for about 40 percent of world production. Because
of the low yield variability and the strong price-yield
correlations, revenue insurance costs are relatively
low in these areas and producers tend to see a correspondence
between revenue variability on their farms and the
protection offered by revenue insurance. In contrast,
for crops in areas with high yield variability and
weak price-yield correlation, such as cotton in
Texas, revenue insurance costs are higher.
The benefits from revenue insurance
depend on the type of program and the type of subsidy
offered with revenue insurance. The Federal crop
insurance program pays premium subsidies that encourage
producers to buy revenue insurance and pays administrative
subsidies to private insurance companies that sell
and service revenue insurance. These subsidies are
based on a share of the premium value of the revenue
insurance policies sold.
While the subsidization of revenue
insurance helps producers reduce risk, the subsidies
also transfer income, although this income is realized
only when an insurable loss occurs and results in
an indemnity payment. A subsidy structure based
on uniform proportions of a premium across areas
and crops transfers greater amounts of income per
dollar of insured value to riskier crops and areas
where premium rates are higher. However, producers
of risky crops in risky areas face higher premiums
due to greater revenue variability, and may see
little relationship between their yields and market
price; thus, they still may be reluctant to buy
revenue insurance.
Revenue Insurance Participation
Grows With Subsidies
Revenue insurance was first available
under the Federal crop insurance program in 1996.
Initially, it was available for corn, soybeans,
wheat, and cotton in a limited number of counties.
In the late 1990s, availability of revenue insurance
for these crops increased and revenue insurance
plans for grain sorghum, canola, barley, rice, and
sunflower were added. In 2006, revenue insurance
accounted for 57 percent of all acreage insured
under the Federal crop insurance program, including
about three-quarters of the insured acreage of corn,
soybeans, and wheat, the top three crops in the
program.
When buying revenue insurance,
a farmer chooses, before planting, an insurance
plan and a coverage level (a share of expected revenue)
and pays a portion of the insurance premium that
is based on the risk covered. If actual revenue
at the end of the season falls below the coverage
level multiplied by the amount of expected revenue,
the insurance pays an indemnity equal to the difference.
Premium subsidies have been key
to inducing farmers to increase their crop insurance
coverage. Subsidies for crop insurance, especially
for revenue insurance, have been rising since the
1990s. Between 1996 and 2006, the share of subsidized
revenue insurance premiums grew from less than 30
percent to 56 percent. In 2006, the Government paid
$1.8 billion in revenue insurance premiums, and
producers paid $1.4 billion.
The overall increase in premium
subsidy has included increases in the subsidy rates
for higher coverage levels. In response to the increased
subsidies and reduced premium costs, producers have
insured higher proportions of their expected revenues.
In 1999, for instance, about half of the acres insured
under revenue insurance were covered at the 70-
percent level or higher. By 2002, about three-quarters
of the revenue-insured acres were at coverage levels
of 70 percent or higher. The most popular coverage
levels have been 70 and 75 percent of expected revenue.
The variety of options under the
Federal crop insurance program gives producers several
choices for determining their revenue coverage.
Two have been especially popular: coverage that
increases if the harvest-time price of the crop
is higher than the pre-planting-time price and coverage
that is based on separate insured units on the farm.
The increasing price feature, called “replacement
cost” or “harvest-price option,”
is attractive to producers because an increase in
commodity price can be associated with a drop in
yield. The higher coverage would allow a producer
to replace lost production at the higher price.
Subdividing insured acreage is attractive because
if units are insured separately, losses on one unit
are not offset by production on another.
Revenue Insurance Guarantees Fluctuate With Markets
Crop revenue insurance covers
variation in market revenue only over a growing
season. Revenue is determined from market prices
at the beginning and end of the season. Revenue
insurance does not cover interyear revenue variation.
The dollar amount of revenue coverage can rise or
fall from year to year to reflect different market
conditions.
Allowing insurance coverage to
vary with market conditions reduces interference
with market signals. If prices used to calculate
revenue for insurance purposes exceeded expected
market prices, producers would have an incentive
to alter production merely to collect on the insurance.
If prices were below expected market prices, the
risk protection provided by the insurance might
be insignificant and producers would have little
interest in the protection offered. Such “overinsurance”
or “underinsurance” would also undermine
an insurance program’s balance between premiums
and indemnities and could make the program unsustainable.
Canada’s experience in the
1990s with the Gross Revenue Insurance Plan (GRIP)
illustrates the problem of overinsurance. In 1991,
the Canadian Government offered farmers a commodity-level
revenue insurance that used historical prices rather
than current prices to set guarantees. Specifically,
GRIP used average prices over the previous 15 years,
which included the relatively high prices of the
late 1970s and early 1980s. Because indemnities
(insurance payments) were based on the difference
between high historical prices and prices in the
insured years, indemnities greatly exceeded premiums.
By 1998, GRIP was largely discontinued due to financial
pressure on the government.
The revenue insurance plans in
the U.S. Federal crop insurance program use prices
that reflect market conditions in the insurance
period and that are observable by both producers
and insurers. In particular, the plans use prices
of futures market contracts to determine the value
of the insured commodity at the beginning and end
of the season, which simplifies calculation of revenue
guarantees and losses and ensures that coverage
is consistent with current market prices. The availability
of data on market expectations is critical to operation
of the revenue insurance policies of the crop insurance
program.
Whole-Farm Revenue Insurance:
Simple Idea, Difficult To Administer
A more broad-based form of revenue
insurance—whole-farm revenue insurance—covers
all farm enterprises and thus may have wider appeal
than commodity-based insurance. Like single-commodity
insurance, whole-farm insurance charges risk-based
premiums and makes payments (indemnities) when revenue
drops below expectations. But, instead of covering
revenue for each crop on the farm separately, whole-farm
revenue insurance covers combined revenue.
USDA’s Risk Management Agency
operates two small programs of whole-farm revenue
insurance: Adjusted Gross Revenue (AGR) and Adjusted
Gross Revenue-Lite (AGR-Lite). Intended for producers
of commodities for which single-commodity crop yield
and revenue insurance are available, AGR and AGR-Lite
have limits that keep them from being full-fledged
whole-farm insurance programs. Although simple in
concept, developing and operating a whole-farm revenue
insurance program that would be available to all
farmers is not likely to be simple.
A major issue would be determining
and measuring the risks covered. Developing premium
rates for whole-farm insurance is complex because
coverage includes all prices and yields and their
interrelationships on a particular farm. Expanding
the limited AGR and AGR-Lite insurance plans into
a program for all farms would likely mean covering
risks from more farm enterprises, particularly more
specialty crop and livestock enterprises, which
would make such a program even more complex. Moreover,
if the insurance were to cover net, rather than
gross, revenue, input cost variability would have
to be considered in determining coverage and measuring
risk.
Determining the level of income
and the farming activities covered by a whole-farm
insurance policy would challenge both producers
and insurers. AGR and AGR-Lite rely heavily on tax
records but often have to make adjustments to account
for changes in inventory to make insured income
levels correspond to production in a calendar year.
Most farmers report income on their tax schedules
when the money is received or paid, which may not
reflect the underlying annual revenue risk.
How well a farm’s historical
income indicates expected income in the insurance
year is also critical. Farm operations often change
size and commodities from year to year. For example,
expanding a farm by renting additional land or switching
land from corn to soybeans can dramatically change
overall expected gross revenue. These changes result
in variability in income that is not simply the
result of risk or unexpected variability. Unless
income data are adjusted, a process that is likely
to be complex, farms can be significantly overinsured
or underinsured.
Verifying insurance losses and
paying claims pose an additional problem. Existing
revenue insurance payments at the commodity level
are triggered by readily observable prices and crop
losses. Whole-farm revenue insurance, in contrast,
incorporates prices and production of many farming
activities that are hard to verify. Complex rules
have been developed for measuring and validating
insured losses under AGR and AGR-Lite policies.
In addition, because tax filings are used for documenting
income, several months can elapse between the event
that caused a drop in income and the filing of the
documentation for a claim (see box, “Canadian
Agricultural Income Stabilization: A Whole-Farm
Revenue Program”).
Can Revenue Insurance Provide
Adequate Risk Management?
Although revenue insurance has
several characteristics that make it a valuable
risk-management tool, it may not provide farmers
with what policymakers and the farmers themselves
regard as adequate coverage. Because both single-commodity
and whole-farm revenue insurance combine risks,
they can mean less frequent, lower payments to farmers
when the risks offset each other. Single-commodity
revenue insurance combines price and yield coverage.
Whole-farm revenue insurance combines coverage of
individual commodities on a farm. Experience suggests
that farmers prefer to separate insurance protection.
For example, most participants in the Federal crop
insurance program subdivide their farm acreage for
insurance purposes, even though doing so requires
that they forgo a premium discount.
Because insurance design requires
that insured producers pay the first portion of
any loss (the deductible), it may seem that insurance
cannot provide adequate protection because coverage
will always be less than the full value of the item
insured. While reducing deductibles can make insurance
more attractive, it also increases costs as well
as loss claims, and tends to lead to overinsuring,
thus interfering with market signals.
Neither single-commodity nor whole-farm
revenue insurance provides coverage against multiple-year
income declines. These policies base coverage on
historical yields and expected market prices, in
the case of single-commodity insurance, and on historical
income, in the case of whole-farm insurance. If
these measures indicate a revenue decline, revenue
insurance coverage will decline. One way to counteract
this is to use fixed target prices or target revenues
instead. This modification, however, would make
the protection less of an insurance tool and more
of an income-support program.
Canadian
Agricultural Income Stabilization:
A Whole-Farm Revenue Program |
Since 2003, the Canadian Federal and provincial
governments have operated the Canadian Agricultural
Income Stabilization (CAIS) program for
Canadian farmers. Although not truly insurance,
CAIS has several characteristics of a fully
subsidized whole-farm income insurance program.
CAIS allows participants to shift the risk
of income declines to an insurer, the government
in this case. Participants establish insured
amounts of income based on recent history.
Like insurance, the program makes immediate
and ongoing protection available to all
participants. Unlike insurance, participants
are not charged a risk-based premium. Instead,
they pay a flat fee per amount covered.
Under CAIS, the amount of income to be
covered is based on a producer’s margin.
The margin is defined as income minus expenses
directly related to the primary production
of agricultural commodities on the farm.
In particular, income is the sale of agricultural
commodities and proceeds from production
(crop) insurance but excluding other government
payments; expenses are costs, such as feed,
fertilizer, and pesticides. CAIS payments
are made when a farmer’s claim-year
margin falls below his or her reference
margin, which is an Olympic average of the
producer’s margin for the previous
5 years. (An Olympic average is a 5-year
average that “drops” the highest
and lowest values.)
The CAIS participant annually selects
a level of protection, a proportion of his
or her historical margin. Substantial government
benefits are paid if the participant’s
margin falls. As the producer’s loss
deepens, government assistance increases.
The first 15 percent of a producer’s
loss (the part between 100 percent and 85
percent of the margin) would be shared 50-50
with the government. For the next 15 percent
of loss, the government’s share is
70 percent of the drop in margin. For the
portion of the decline less than 70 percent
of the reference margin, the producer would
receive 80 percent from the government.
CAIS provides for situations in which
the margin is negative, that is, when expenses
exceed income. If the producer satisfies
certain criteria, the producer is eligible
to receive 60 percent of the program-year
margin decline that falls within the negative
margin. However, the maximum total government
contributions that a farmer can receive
under CAIS in a given year is capped at
the lesser of C$3 million, or 70 percent
of the margin decline of the program-year
margin relative to the reference margin.
Any negative portion of the program-year
margin is included in the calculation of
the 70-percent cap.
CAIS has undergone two major changes since
it was introduced. One reduced the participation
cost to producers. In the first years of
the program, 2003-05, a participant was
required to maintain a deposit of 22 percent
of the reference margin in a CAIS account.
In 2006, the deposit was replaced by an
annual “participation fee” of
C$4.50 per C$1,000 of margin covered. The
other change was to include a “market
loss” in payments to producers. In
2006, the method of calculating inventory
changes was amended so that losses in inventory
values caused by declining commodity prices
are reflected in a producer’s payment.
This method is applied to market commodities
but not to productive assets such as breeding
livestock. Additional payments, based on
made to producers for 2003-05.
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