Lower Rates Mean Lower Crop Insurance Cost 1

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1 Disclaimer: This web page is designed to aid farmers with their marketing and risk management decisions. The risk of loss in trading futures, options, forward contracts, and hedge-to-arrive can be substantial and no warranty is given or implied by the author or any other party. Each farmer must consider whether such marketing strategies are appropriate for his or her situation. This web page does not represent the views of Kansas State University. Lower Rates Mean Lower Crop Insurance Cost 1 Farmer-paid winter wheat premiums will be lower for 2015, regardless of the Risk Management Agency (RMA) rate changes. The reason for lower premiums per acre is the winter wheat crop insurance price election for 2015 has dropped from $7.02 to $6.30 and volatility has declined from 19% to 17%, an all-time low over the past 17 years. In 2013 the winter wheat approved volatility value was 24%. Those volatilities and prices are set by the market and out of RMA s control. The third factor for setting a premium is the farmer s APH, also outside of RMA s control. RMA does set the rate and the premium cost is then adjusted based on the APH, volatility, and base price. Table 1 shows a comparison of a Great Plains wheat premium in 2015 vs. 2014, based on an APH of 40 bushels and a $6.30 base price. The rate comparisons were based on an enterprise unit. The farmer-paid premium for this farm in 2015 at the 85% coverage level declined by 6.59%. This means for the exact same coverage in 2014, farmers will pay 6.59% less premium in This was surprising given this county suffered one of its worst yield losses in 50 years. The volatility caused a 2.61% premium reduction, but RMA also reduced the rate by 3.87%, resulting in a total premium reduction of 6.59% at the 85% coverage level. All but the 50% coverage level showed rate reduction. However, with the exception of the 80% and 85% coverage, all of the rate reductions and resulting premium cuts were due to lower volatility. Coverages from 50% to 75% all showed a rate increase from 1 Prepared by G. A. (Art) Barnaby, Jr., Professor, Department of Agricultural Economics, K-State Research and Extension, Kansas State University, Manhattan, KS 66506, September 22, 2014, Phone , barnaby@ksu.edu. 1

2 RMA. Without the volatility decline, premium rates for coverages below 80% would have increased (Table 1). Rate reduction caused by either lower volatility or RMA rate cuts means farmers pay lower premiums without a reduction in coverage. This is clearly to the advantage of farmers, but the rate reductions on winter wheat are small compared with the rate reduction on the 2014 Corn Belt soybean contract. Volatility has a larger impact on Corn Belt rates than it does on the Great Plains rates, where yield risk is dominant over price risk in a revenue guarantee. However, the small rate reductions do have an impact on crop insurance companies and their reinsurers in Europe and other multinational companies, because those small cuts do aggregate to large dollar amounts at the industry level. Higher Enterprise Coverage vs. Optional Unit Coverage Table 2 compares buying coverage 10 points higher with an enterprise unit versus optional units. This is a really simple concept, but one that is rarely promoted by crop agents, so farmers may need to ask for the comparison. A farmer is simply trading optional units for a lower deductible (higher coverage) enterprise unit, but any losses are averaged across the entire crop within a county. An 80% enterprise unit in this example cost $1.19 an acre less than 70% optional units. The price change is measured the same on both contracts, but the 80% enterprise unit has a higher effective strike price at $5.04 versus $4.41 for 70% optional units. The effective strike price is the price that RP will start making indemnity payments without a yield loss. Also, optional units have $25.20 less coverage than the enterprise unit. Because an enterprise unit averages all losses across all acres, the effective hail coverage is less than the effective hail coverage provided by optional units. However, farmers may add private hail-wind-fire coverage in the spring, if there is a crop. FYI, the Federal crop policy does not cover fire unless it is a lighting strike. Supplemental Coverage Option (SCO) SCO is new for 2015 wheat, but available in only selected counties. There are no SCO offers on fall-planted winter canola in the Great Plains. Kansas has SCO wheat offers in 102 of 105 counties. The type of SCO coverage depends on the type and level of crop insurance purchased. For example if farmers buy 80% RP, then SCO will cover the risk from 86% to 80% of the farm s revenue and includes the harvest price option. If farmers exclude the harvest price from their revenue contract, then they also exclude the harvest price from their SCO coverage. If farmers buy Yield Protection (YP) then their SCO will be yield coverage only. SCO calculates the percent loss at the county level only, so it is possible for a farm to have a total loss and receive no SCO payments. The reverse is also true. Once the percent county loss (either revenue or yield) is determined, then that percentage loss is applied to their farm level SCO coverage. 2

3 SCO will look like cheap coverage but that is not true. For example if a farmer with 80% RP coverage adds SCO at this location, the SCO premium is only $1.87 per acre. However, the SCO only provides $15.12 of coverage based on a 12.37% rate ($1.87/$15.12) (table 3). By contrast the 80% RP provides $ of coverage for $10.15 in premium per acre based on a rate of 5.03% ($10.15/$201.60). The reason rate is important is because it tells the buyer how much coverage one receives per dollar of premium paid, so the lower the rate the more coverage a farmer receives per dollar spent. Why is the rate lower for RP than SCO? One would expect the SCO to pay first, but that is not always true, because if the county does not have a loss, then there is no SCO payment even if one s crop is a total failure. However, in the aggregate, it is likely that SCO will pay before the individual RP coverage, therefore SCO rates out higher. Also RMA pays a larger share of the premium for an 80% enterprise unit RP contract (68%) than is the case for SCO (65%). Should One Cut Their Crop Insurance Coverage and Buy More SCO? Probably the answer is no, because most farmers don t know which commodity program they will enroll their farm. If a farmer selects Agricultural Risk Coverage (ARC), then they cannot buy SCO if the planted crop is the same as the base crop. For example, if farmers enroll wheat base in ARC and plant wheat, then they cannot buy SCO coverage. However, if they plant sorghum on those wheat base acres and they don t enroll their sorghum in ARC, then they could buy SCO on the sorghum planted on wheat base and they would receive the wheat ARC payment, if any. At this point we don t know what counties will receive SCO offers on spring planted crops, but one would expect some counties will not receive an offer given there is no SCO offer on wheat in 3 Kansas counties. Therefore, the suggestion of the author is to purchase the level of crop insurance that makes sense, because there are so many unknowns about the commodity programs and its effect on SCO. It does make sense to add the SCO coverage and one can cancel the SCO coverage prior to acreage reporting and owe no premium for SCO. This will give farmers more time to evaluate the commodity program choice. If one doesn t cancel the coverage and next spring they enroll in ARC, then they will have their SCO coverage cancelled and farmers will owe 20% of the premium. For the example farm, with 80% RP coverage the SCO cancelation amount would be 37 cents (20% X $1.87) per acre (Table 3). Area Risk Protection Insurance (ARP) ARP replaced the Group plans. The area plans that trigger payments based on county revenues or county yields are not widely available in the Great Plains. The ARP is not offered on corn and soybeans and only in selected counties for wheat and sorghum. Effectively, ARP is a put option on expected county revenue, and farmers bear the basis risk. Large farms are the ones most likely to select ARP. If a farmer farms the whole county then the enterprise unit and county unit in ARP are the same thing. The bigger the farm, the better ARP transfers risk. 3

4 One needs to be careful analyzing the ARP to make sure that the RMA expected county yields are realistic. One condition where large farms have used ARP is when their APH has been reduced due to recent claims, but be careful, because when areas have claims, often the expected county yield in ARP is reduced too. There have been very few ARP contracts sold in the Great Plains, and in one case it was driven by extreme moral hazard, but not over the line to make it fraud. Things to Think About When Making the Crop Insurance Decision: 1. 80% has the largest dollar amount of the premium paid by RMA per acre on Kansas wheat, but on some crops and markets 85% will have the largest dollar share of the premium paid by RMA. 2. Marginal farmer-paid premium (premium cost for an additional dollar of coverage) really jumps for coverage above 70%. 3. An added dollar of coverage for RP-HPE may not be real, because if price increases, it could eliminate payments even with an insurable yield loss. 4. At 85% coverage, the effective strike price is $5.36, the price point where payments trigger and no yield loss. 5. If one is willing to sell covered puts, then the higher strike price in RP and lower deductible becomes more valuable. Makes it less risky to buy at-the-money puts and sell out-of-the money puts. Other considerations: 1. Farmer s financial leverage and in some cases the lender may require some coverage. 2. Farmers aversion to risk. My observation is that few producers are extremely risk averse. If they were, it is unlikely they would have become farmers and ranchers. It sometimes appears farmers are risk-seeking. 3. Age of operator: does she need retirement income? 4. Does the APH equal the expected yield? 5. Is ARP (GRIP) available? 6. Are optional units worth the extra premium over enterprise units? There is no one size of crop insurance that fits all, and as a result, there is no right or wrong answer. Farmers might want to discuss the decision with their crop agent and lender before they make their final decision. 4

5 Table 1. Comparison of 2015 Great Plains Winter Wheat Premium Cost versus 2014 Premium Cost 1 50% 55% 60% 65% 70% 75% 80% 85% 2 APH Base Price $6.30 $6.30 $6.30 $6.30 $6.30 $6.30 $6.30 $ Coverage - $/Acre Farm Paid Premiums/AC Premium/ 19% Vol Premium/ 17% Vol Premium/ 17% Vol Farm Paid Rates Rate/ 19% Vol 1.66% 1.88% 2.11% 2.36% 2.63% 3.35% 5.22% 8.61% Rate/ 17% Vol 1.63% 1.83% 2.05% 2.3% 2.56% 3.26% 5.09% 8.39% Rate/ 17% Vol 1.67% 1.87% 2.09% 2.33% 2.59% 3.3% 5.03% 8.08% 11 Total Rate Change 0.95% (.39%) (.95%) (1.31%) (1.53%) (1.77%) (3.74%) (6.59%) 12 Volatility Rate Change (1.95%) (2.77%) (2.9%) (2.93%) (2.88%) (2.92%) (2.63%) (2.61%) 13 RMA Rate Change 2.84% 2.32% 1.9% 1.57% 1.31% 1.12% (1.08%) (3.87%) 5

6 Table 2. Comparison of Premium Cost for Revenue Protection (RP) Enterprise Unit Coverage versus Optional Units. 70% Optional Unit 1 Coverage Level 65% 70% 75% 2 Coverage Gross Premium RMA Paid Premium Share Farmer Paid Premium Effective Strike Price $4.10 $4.41 $ % Enterprise Unit 7 Coverage Level 75% 80% 85% 8 Coverage Gross Premium RMA Paid Premium Share Farmer Paid Premium Effective Strike Price $4.73 $5.04 $ Increase in Coverage $ % Increased Coverage 14.29% 15 Reduction in Premium ($1.19) Table 3. SCO Coverage and Premium Cost 1 APH Base Price $6.30 $6.30 $6.30 $6.30 $6.30 $6.30 $6.30 $ Coverage Level 50% 55% 60% 65% 70% 75% 80% 85% 4 Coverage $90.72 $78.12 $65.52 $52.92 $40.32 $27.72 $15.12 $ Farmer Paid Premium $4.05 $4.04 $3.97 $3.80 $3.47 $2.90 $1.87 $ SCO Rate 4.46% 5.17% 6.06% 7.18% 8.61% 10.46% 12.37% 14.68% 7 RP Rate 1.67% 1.87% 2.09% 2.33% 2.59% 3.30% 5.03% 8.08% 6