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In the years ahead, crop farmers are likely to face greater financial risks and long-term income instability than in the past. This is because their dependence on export markets exposes them to other nations' farm, economic, trade, and foreign policies, and to the vagaries of global weather. Although the public has long shared some of the risks in crop farming through commodity programs and federal crop insurance, commodity policy has undergone a long-term transition that has made farmers more dependent on markets. Moreover, beyond their expense, current programs are not very effective in reducing the income instability caused by international events and conditions.

This special study, requested by the Senate Agriculture, Nutrition, and Forestry Committee, examines the role that revenue insurance could play in agriculture policy. The principal author is James G. Vertrees. The study was prepared in the Natural Resources and Commerce Division under the supervision of David L. Bodde and Everett M. Ehrlich. The author wishes to acknowledge the contribution of Andrew S. Morton who provided many constructive comments and suggestions. Francis Pierce edited the manuscript, with the assistance of Nancy H. Brooks. The author owes special thanks to Kathryn Quattrone for typing the several drafts and preparing the manuscript for publication. In keeping with the Congressional Budget Office's mandate to provide an objective and nonpartisan analysis of issues before the Congress, no recommendations are offered.
 

Alice M. Rivlin
Director
August 1983
 
 

SUMMARY

CHAPTER I. INTRODUCTION

• Policy Perspective
• Farm Revenue Insurance: An Alternative

CHAPTER II. HOW FARMERS MANAGE THEIR RISKS AT PRESENT

• Decision making Under Risk and Uncertainty
• Bearing Risks Directly
• Transferring Risks to Others in the Private Sector
• Sharing Risks with the Federal Government
• Policy Implications

CHAPTER III. FARM REVENUE INSURANCE AS A NEW APPROACH TO RISK MANAGEMENT

• Farm Revenue Insurance
• Potential Consequences of Farm Revenue Insurance
• Practical Challenges to Farm Revenue Insurance
• Conclusion

APPENDIX. FORWARD CONTRACTING

• Futures Markets
• Commodity Futures Options
• Forward Contracting and Public Policy

Farmers' incomes are subject to wide swings from year to year. Farm revenue insurance has been suggested as a way of stabilizing incomes at less cost to the taxpayer than present programs. Its purpose would be to reduce the variability of farmers' incomes, not to raise the average level. This paper reviews the conditions that have given rise to the concern over farm income instability, and the options currently available to farmers for dealing with it. The paper then analyzes a hypothetical revenue insurance program.

The Changing Policy Perspective

Public policy has long acknowledged the risk and uncertainty facing grain and cotton farmers that arise from weather, biological processes, and the relative insensitivity of supply and demand to price changes. Federal programs since the 1930s have sought to assist crop farmers by transferring some of their price and income risks to the public sector through agricultural price support programs.

But these commodity programs have, over time, transferred risks back to farmers and made them more dependent on the markets for their crops. These markets, in turn, have grown increasingly international in character, especially in the last decade. In the 1970s, U. S. agricultural exports grew at an extraordinary rate--20 percent per year, increasing from about $7 billion in fiscal year 1970 to nearly $41 billion in fiscal year 1980. This growth was driven by an expanding world population, rising real per capita incomes in many nations, production limitations in food-deficit nations, the emergence of the Soviet Union as a major grain importer, favorable shifts in exchange rates, and U. S. farm policies that generally encouraged exports. Today, exports take the production from about two of every five acres, and generate about one-fourth of gross farm income. Producing for export markets has allowed farmers to make fuller use of the land and capital resources available to them: virtually all of the one-third increase in crop output in the 1970s was for export.

While the expansion of world trade benefited U. S. agriculture, it forged links that were to prove troublesome for farm income in the early 1980s. Farm prices and incomes have become highly sensitive to global weather and crop production, population changes, and economic growth. Perhaps more significantly, they have also become sensitive to the farm, economic, trade, and foreign policies of other nations. Changes in foreign crop production and the policies of other nations are rapidly transmitted to the U. S. crop sector through the international financial system and through flexible exchange rates. The United States, because of its relatively open agricultural markets, bears most of the burden of adjustment to changes in world trade. The result has been to increase farmers' uncertainty as to the prices they will receive for their crops.

Present price support programs have the disadvantage of being unable to stabilize farm income sufficiently, and are also burdensome to the taxpayer. Farmers' incomes are far more variable than incomes of nonfarmers. Although crop farmers' incomes are less variable than would be the case without commodity programs, adjustments in these programs can do little to reduce income instability caused by unexpected changes in export markets. Equally important, these programs, which mainly finance farmers' inventories, expose taxpayers to large outlays: in fiscal year 1983, crop program outlays are estimated at $13.1 billion, or about two-thirds of total price support outlays of $21.3 billion. And even though crop program outlays are projected to decline to $7 to $8 billion annually in 1984-1988, they will still be roughly four times historical levels. The attempt to stabilize both prices and supplies in order to stabilize incomes is very costly to taxpayers.

Farm Revenue Insurance

Revenue insurance, provided by the federal government, would aim directly at stabilizing crop farmers' incomes. It would guarantee a farmer that revenue per acre of each crop would not fall below some proportion of expected revenues. For example, a corn farmer might insure 75 percent of average revenues per acre based upon recent experience. If revenue from the corn crop was less than the insured level--due to either low yields or low prices--the farmer would receive an indemnity equal to the difference. There would be no indemnity if revenue levels were inside the normal range of variation.

In this manner, revenue insurance would protect farmers against precipitous declines in gross income regardless of whether price or production variability was the cause. In exchange for this protection, farmers would ideally pay an annual premium that reflected their individual risks. This would minimize the possibility that farm revenue insurance would encourage inefficient farming.

As compared to the present system of commodity programs for stabilizing prices, and federal crop insurance for protecting against production losses, revenue insurance might provide crop farmers more effective protection against volatile incomes. A reduction in risk and income instability could contribute to a more efficient allocation of resources; the dampening of sharp swings in farm incomes would benefit farmers, rural communities, and agricultural supply industries. Furthermore, under a revenue insurance program, the federal government would not have to intervene as frequently in markets to stabilize prices as is now the case. This would reduce direct government influence on prices, production, and the allocation of supplies. Moreover, unanticipated changes in commodity programs would no longer be a source of market uncertainty. In the absence of commodity programs, however, prices most likely would be more unstable than they are now since nonrecourse loans and the farmer-owned reserves would not act to set either a price floor or a price ceiling. A special grain reserve could be set up to protect consumers against the adverse consequences of commodity shortages.

From a federal budget viewpoint, the costs of a revenue insurance program would depend upon the specific insurance provisions, the level of coverage, the premiums charged, and farmer participation. Revenue insurance could probably be provided at a smaller cost than that of continuing current programs. This tentative conclusion is based upon several considerations. First, under current programs 30 to 40 percent of price support outlays are for price stabilization activities that would not be necessary under farm revenue insurance. Second, the administrative and operating expenses of a farm revenue insurance program would probably be no more than the same expenses for continuing current programs. Third, under revenue insurance some share of costs would be paid by farmers through insurance premiums.

There would be some important constraints to a workable program. First, the principle of revenue insurance assumes random variation about an acceptable average level of income. The Congress would have to accept the mean level of farm income over time and adhere to the income stabilization objective of revenue insurance. For this reason, revenue insurance seems most applicable to a situation in which farmers produce for export markets that grow at an average rate sufficient to utilize U. S. production capacity, and in which average incomes provide adequate returns to resources, despite wide swings. For the same reason, revenue insurance seems less applicable in a long-term situation of sluggish export growth, excess production capacity, and low but stable incomes.

Second, there is a set of insurance problems to be addressed: measuring risks and predicting losses; determining premiums that reflect individual farm risks so that high-risk farmers are not encouraged to participate to the exclusion of others; encouraging, perhaps requiring, farmers to stay in the program for a multiyear period; and reducing the possibilities that farmers can take actions that directly influence insurance indemnities.

Third, there is a related problem of inducing sufficient farmer participation over time to have a large enough pooling of risks to make a workable program. Farmers' participation would depend upon their perceptions of the need for insurance, on insurance costs, and on expected net returns from insurance. Those most vulnerable to farm income variability would be most likely to participate. Among them would be farmers most dependent upon farm income; farmers with large debt-to-asset ratios; and new entrants. One way of increasing participation would be to subsidize the premiums. This would be consistent with the view that society would benefit from sharing farming risks. The larger the premium subsidy, however, the more farm revenue insurance would encourage inefficiency and tend to become simply an income transfer program.

Revenue insurance is worth further exploration as an alternative to current programs, despite the many difficulties in making such a significant policy shift. To obtain a better understanding of how revenue insurance might work, the Congress could take two initiatives. First, it could authorize studies of program design and implementation schemes. Second, if such studies provided evidence that revenue insurance could be workable, it could authorize a pilot revenue insurance program in selected areas or crops. Evaluation of a pilot program would help to determine the feasibility of revenue insurance.

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