What Harm is Done by Subsidizing Crop Insurance?

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1 What Harm is Done by Subsidizing Crop Insurance? Barry K. Goodwin and Vincent H. Smith 1 Agriculture is subject to a wide variety of risks, including many hazards arising from wide-spread natural disasters. The U.S. federal crop insurance program, initially introduced on a small scale in 1938 in response to a campaign promise of President Franklin Roosevelt, now carries a total liability in excess of $114 billion and insures 262 million acres. The premiums paid by farmers in this program are highly subsidized (in excess of 60% of the total premium) and private insurance companies also receive significant taxpayer subsidies to operate and administer the program. Private insurance companies are also provided with an advantageous taxpayer supported reinsurance agreement. In recent years, the program has accounted for nearly $10 billion annually in subsidies to farmers and insurance companies, making it the most expensive agricultural commodity program. The program is currently being debated in Congress as the new 2012 Farm Bill is considered. If anything, indications are that the next farm bill may expand federal crop insurance programs by introducing a shallow loss program intended to offer higher coverage levels. Whether such a program is implemented through the federal crop insurance program or as a component of other farm commodity programs remains to be seen. However, all Congressional observers agree that crop insurance will continue to play a key role in US farm policy. Before proceeding to the central question of this paper what harm does subsidized crop insurance cause we must first address two fundamental issues. First, it is important to describe the various ways in which the U.S. government subsidizes the federal crop insurance program. There are several different dimensions to subsidies in the federal crop insurance program. The most obvious subsidies are those that are paid to farmers through subsidized premium rates. Most observers agree that the Risk Management Agency has done an increasingly effective job in determining actuarially sound premium rates for the various crop insurance programs currently available. However, from the viewpoint of a farmer buying insurance (or, for that matter, the taxpayer who is footing the bill) these unsubsidized premium rates are meaningless. Rather, it is the premium that farmers actually have to pay for coverage that is relevant to their participation in the program. Thus, the 1 Goodwin is William Neal Reynolds Distinguished Professor in the Departments of Economics and Agricultural and Resource Economics at North Carolina State University. Smith is a professor in the Department of Agricultural Economics and Economics at Montana State University. Research support from the North Carolina Agricultural Research Service and the American Enterprise Institute is gratefully acknowledged. 1

2 full premium amounts (including any portion paid by taxpayers) do not represent revenues being collected by the FCIC from farmers for the coverage being provided. Rather, in a trick of government accounting, a large share (approximately 60%) of the total premium paid into the insurance pool is covered by significant subsidies from the US Treasury. Table 1 presents annual statistics for the modern federal crop insurance program in the US from 1981 to A simple review of the data reveals several important insights. First, participation did not grow until subsidy rates were significantly increased in the 1990s. In the 1980 s, participation tended to be low and most likely was comprised from an adversely selected subset of growers (Goodwin 1993). The table also presents salient statistics on loss ratios, including both the reported loss ratio that reflects total premiums paid by farmers and the taxpayer and the actual loss-ratio that reflects premiums actually paid by growers. Two points are apparent. First, the program provides an illusory implication that it is actuarially sound, with loss ratios that have fallen in recent years and that are less than the 1.0 required for actuarial soundness. From the perspective of the accuracy of premium rates, that conclusion is valid. However, these loss ratios do not reflect the premium actually paid for protection. When loss ratios are instead calculated using the subsidy adjusted premiums farmers actually pay, it becomes apparent that each dollar of premium paid by farmers tends to yield approximately $1.90 in indemnity payments a strange insurance program but a transparently obvious income transfer policy. As we discuss in greater detail below, the fact that risk is subsidized in such a fashion and because the program involves significant transfers of wealth to farmers, the extent to which production decisions are distorted is of fundamental interest. A second important issue is the extent to which market failures justify government intervention in the crop insurance market. The current crop insurance system in the U.S. is often touted as a public private partnership. Such a label, however, should often be viewed with skepticism since such arrangements usually result in subsidies being paid by taxpayers the losers in such a program to the private industry involved in the partnership. 3 Proponents of the current program typically argue that, in the absence of subsidies, various market failures would lead to an absence of the risk management mechanisms that are important in production agriculture. 2 See the paper by Glauber in this session for additional crop insurance statistics. 3 Realistically, taxpayers should always be warned to cover their wallet when public private partnership programs are proposed. Such programs almost always involve a significant transfer of wealth from taxpayers to the private party to the agreement. 2

3 Table 2 reports budget statistics for the federal crop insurance program and includes reinsurance year statistics for the returns to the approved insurance providers (AIPs), which represent implicit subsidies. Under the terms of the public private partnership, federally crop insurance can only be offered through these select private companies. Several points are relevant. First, in addition to the substantial premium subsidies paid to farmers, the program also provides subsidies to the private AIPs for administrative and operating (A&O) expenses. These subsidies have been substantial in recent years in excess of $2 billion in These statistics reflect the fact that A&O subsidies were determined in proportion to total premium, thereby moving in concert with commodity prices. The statistics also reflect recent changes to the Standard Reinsurance Agreement that have attempted to constrain costs. The statistics demonstrate that the companies that make up the private part of the partnership have enjoyed substantial returns from the program. In addition to A&O subsidies, they have realized significant underwriting gains in all but one year between 2000 and As Smith (2011) pointed out, over the period, the combination of A&O subsidies and underwriting gains resulted in a return of $1.44 to the private insurance companies for each subsidy dollar returned to farmers (in terms of the excess of indemnities over farmer paid premiums). Another aspect of the costs of the program merits mention. The 2000 Agricultural Risk Protection Act (ARPA) established several initiatives to encourage private interests to submit proposals for new subsidized crop insurance plans. Such submissions are often referred to as 508(h) proposals after the section of legislation outlining the process. The RMA is obligated to undertake a review of such submissions at taxpayer expense. This provision was enhanced in the 2008 Farm Bill which amended section 522(b) of the Federal Crop Insurance Act to require the FCIC Board to establish procedures for approving advance payment of reasonable research and develop costs to applicants submitting insurance concept proposals. Though the precise number and cost of such proposals is elusive due to the confidential nature of the process, this legislative action has provided an incentive for developers to conceive programs for even the most minor crops. 4 Such crops are certainly important to the farmers that produce them but one must question the costs of developing, reviewing, and administering such plans of insurance when the total value of the crop 4 Examples include new plans for the coverage of cultivated oysters, pistachios, popcorn, pumpkins, and sesame seeds. 3

4 may be quite low. A review of the online summary of business statistics for 2011 revealed that programs for 15 crops had less than $1 million in total liability and programs for 14 crops had less than $100,000 in total premium. Likewise, programs for 31 crops had less than $10 million in total liability and programs for 35 crops had less than $1 million in total premium. Operating costs associated with the federal program are also presented in Table 2. These costs (included in the other costs category) include the costs of reviewing new proposals and have exceeded $100 million in every year since In short, the legislation has established strong incentives for private industry to generate rents at taxpayer expense for the development and administration of crop insurance plans that only apply to a very minor segment of the agricultural economy. Deliberations over the 2012 Farm Bill and the 2013 federal budget have included proposals for very modest cuts to crop insurance. The Administration s 2013 budget proposed cuts that would reduce the AIP s return on investment by about 2% and cap A&O subsidies at $0.9 billion. In addition, a modest reduction of 2 percentage points in the premium subsidy was proposed. More substantial cuts were proposed by the republican majority Congress. The reaction from the farm lobby was perhaps best reflected in a statement by National Farmers Union President Roger Johnson that once again, we see that Congress is attempting to balance the budget on the backs of rural America. 5 In spite of such proposals for minor reductions in the cost of subsidized crop insurance, no real progress in reducing the budgetary costs of such programs seems likely. In all, proposals for an expanded safety net in the form of shallow loss programs that would essentially reduce the existing deductible on crop insurance seem the most likely outcome of current policy discussions. Table 3 presents the projected costs of the suite of programs currently comprising the 2008 Farm Bill. The statistics demonstrate an important point among the commodity programs that comprise the safety net of US agricultural policy, crop insurance has assumed an increasingly costly role and under current conditions will continue to be the most costly farm program. Annual budgetary outlays are projected to exceed $8 billion each year and to total nearly $90 billion over the next decade. 5 Quoted by Truitt (2012). 4

5 What Market Failure? Proponents of subsidized crop insurance argue that government provision of such insurance is necessary because the private market has failed to provide such coverage. The perceived failure of market mechanisms is often ascribed to the significant catastrophic exposure that the systemic risks of agriculture represent to private insurers and reinsurers. The argument is that private markets are unable to handle the potential losses associated with a program that had nearly $115 billion in liability in Two facts tend to bring such assertions into question. The first fundamental fact is that international financial markets for risk sharing are both deep and wide and offer many instruments for reinsuring such risks. Recent estimates assess the size of the international credit default swap market one form of risk sharing at over $32 trillion (Brown 2012). The magnitude of such risk transfer potential would certainly seem to raise questions about arguments that adequate reinsurance for agricultural risks is unavailable. A second fact can be gleaned from the historical experience reported in Table 2. Two benchmark years characterize the downside risk potential of agricultural insurance the drought year of 1988 and the floods of In these two cases, the loss cost ratio, which represents the proportion of exposure that actually resulted in indemnities, was 15.3% and 14.6%. Thus, even at today s high levels of liability, total indemnities for similar conditions would only amount to less than $17 billion. The total is substantial but is still small relative to the private sector s capacity for reinsuring such systemic risks. A guiding principle for the federal crop insurance program in theory at least is that the highly subsidized plans should not duplicate or displace private insurance market offerings. Of course, a classic chicken and the egg conundrum applies here is the government involved because private markets have failed or has the provision of such significant subsidies displaced any incentives for private insurance? Although this principle is often appealed to as insurance plans are conceived and implemented, ample evidence exists that subsidized insurance does indeed displace and duplicate coverage already provided by the private market. The most prominent example is revenue coverage, which is now the dominant form of federal crop insurance. Commodity options markets that provide private insurance contracts on agricultural commodity prices have been in existence for over twenty years. An argument of convenience is that such contracts do not precisely match the insurance needs of individual farmers. However, such an argument presupposes the lack of any private intermediary 5

6 that could tailor price protection to individual producers needs by using private market options. Language in a recent Senate Farm Bill proposal implied that subsidies would be provided for private weather insurance plans that are not currently subsidized and reinsured by the RMA. 6 The likelihood that this provision will be enacted is unclear at present but it does at least signal that Congress is aware of the potential displacement of private insurance plans by subsidized insurance. A large literature has examined farmer demand for crop insurance around the world. Smith and Goodwin (1996) and Smith and Goodwin (2010) survey much of this literature and conclude that most empirical evidence suggests that farmers willingness to pay for multiple peril crop insurance often does not exceed the costs associated with operating an actuarially sound commercial program. This is not prima facie evidence of a market failure but rather reflects a situation where supply and demand for insurance do not intersect at a price that would allow for a viable commercial market to exist. Abundant evidence of this is reflected in the fact that significant premium subsidies are almost always required to induce significant participation in crop insurance programs. As Smith and Goodwin (2010) note, many factors may explain this fact and it is in no way indicative of a lack of risk aversion by farmers. Rather, it is consistent with a situation in which farmers have alternative risk management mechanisms, including a number of other legislative safety nets, diversification, self insurance, and off-farm employment. Goodwin and Vado (2007) point out one rare case in which there may be spillover benefits from subsidized insurance the only obvious case of a market failure. This arises in situations where a lack of mitigation of risks may expose other agents to risk, thereby changing their own likelihood of loss. Examples may arise for animal and plant diseases, which if unreported, may expose a wider population to risk. In such rare cases, subsidized insurance may be welfare enhancing. However, one is hard pressed to conceive of many such examples within the context of a $115 billion crop insurance program. The Harm of Subsidies Given the absence of market failures, the harm of subsidies and other forms of government intervention is in the distortions that the policies bring about. In the case of subsidized crop insurance, 6 See Section of the Senate s Agriculture Reform, Food and Jobs Act of 2012 that states that it amends section 523(a)(2) of the Federal Crop Insurance Act to allow the Corporation to conduct a pilot program to provide financial assistance for producers of underserved crops and livestock (including specialty crops) to purchase an indexbased weather insurance product from a private insurance company. 6

7 the answer is clear subsidizing risk leads agents to assume more risk. This may take the form of changes in production patterns (i.e., the quantity and allocation of acreage to individual crops) and changes in production practices (i.e., moral hazard). Smith and Goodwin (1996), for example, presented evidence that Kansas wheat growers who purchased crop insurance tended to use less fertilizer and chemicals than those that did not insure. Production distortions may occur at several margins as a result of subsidized insurance. At the intensive margin, producers may elect to produce the same crop on the same acreage but alter their production practices in ways that alter risk. The fact that positive returns exist for crop insurance coverage for most crops and locations would be expected to enhance this effect. At the extensive margin, producers may elect to grow riskier crops and bring additional riskier land into production. Using data from the 1980s and 1990s, Goodwin, Vandeveer, and Deal (2004) found that higher crop insurance subsidies did induce statistically significant increases in acreage though the effects were quite modest. The geographic distributions of participation and relative returns to insurance are presented in figure 1. To the extent that the benefits of subsidized crop insurance are heterogenous across regions and crops, distortions in production patterns may result. The figures show that participation and returns to insurance vary substantially. Participation (in terms of total liability) is particularly high in the Corn Belt, the Mississippi Delta, and in the Upper Great Plains. At the same time, the relative returns to insurance as represented by the ratio of indemnities to subsidy adjusted premiums, are lower in the Corn Belt but appear to be particularly high in Western Texas, the mid south, and in certain portions of the Northern Plains. This suggests the potential for production distortions as certain crops and growing areas receive significantly higher subsidies. 7 To examine these potential distortionary effects, we estimate a simple, reduced form model of acreage response to changes in the crop insurance program using county level experience data and USDA NASS statistics on planted acreage. Planting time quotes for harvest time futures contracts are used to represent expected prices and were deflated using the BLS index of prices paid for inputs by farmers. Five year historical averages of the subsidy rates (the ratio of subsidies to total premiums) and subsidy adjusted loss ratios were included as regressors. In addition, the preceding year s level of participation (liability per planted acre) and planted acreage are included 7 It should be acknowledged that the federal crop insurance program has evolved significantly over time. Changes in rating methods and program design are obscured in any examination of aggregate statistics. At the same time, a focus on a shorter time period may yield statistics that are not representative of long run experience. 7

8 to reflect insurance impacts on acreage and partial adjustment. OLS estimates for corn, soybeans, cotton, and wheat are presented in table 4. The results indicate that higher subsidy rates and higher participation (in the previous year) are associated with statistically significant increases in acreage once controlling for the preceding year s planted acreage. In contrast, after controlling for subsidies, a higher return to insurance does not appear to correspond to increases in planted acreage in subsequent years. These results suggest that the very substantial crop insurance subsidies and high participation may indeed be associated with important acreage distortions for these major crops. These results, though persuasive, only serve as a preliminary indicator of the potential distortions triggered by subsidized crop insurance. A more detailed structural model of the joint decisions underlying insurance program participation and acreage allocation is needed to permit definite conclusions. An update of the earlier work of Goodwin, Vandeveer, and Deal (2004) is an important topic for future research as the federal crop insurance program has undergone significant changes since their analysis. A final, fundamental aspect of the distortions associated with the crop insurance program should be noted. The preceding discussion has highlighted the significant budgetary implications of the US federal crop insurance program. The latest Congressional Budget Office (CBO) projections of the costs of current farm programs (table 3) highlights the fact that crop insurance has become the most costly farm program (outside of food and nutritional assistance). Under the current budgetary pressures and the significant deficits associated with US fiscal policies, crop insurance has become a major factor with annual costs projected to exceed $8 billion per year. Important distortions occur throughout the economy as resources to support this spending are collected from taxpayers. Concluding Remarks The harm associated with subsidized crop insurance arises from the distortions brought about by what amounts to significant budgetary transfers from taxpayers to farmers and private crop insurance companies. On a fundamental level, the burdens associated with collecting the tax revenues necessary to fund such a program will generate a wide range of distortions in the aggregate economy. More obvious are the potential distortions that may result from the significant subsidies that are provided to farmers and insurance companies. Although proponents of the programs 8

9 often claim that they are necessary because of a failure of the private market to provide efficient risk management mechanisms, no convincing evidence that such market failures exist is apparent. International financial markets have a range of mechanisms for risk sharing and the magnitude of systemic risk associated with agriculture in the US is dwarfed by other risks that are traded in financial markets. Perhaps of greatest concern is the fact that the costs of the US federal crop insurance program has risen to the point that it is the most costly form of intervention in agricultural markets, at least outside of food and nutritional assistance programs. Recent legislation has provided incentives for further expansions of crop insurance programs, with development and administration costs being borne by the taxpayer. Finally, recent proposals for the 2012 Farm Bill have included various versions of shallow loss programs that would raise coverage levels and exacerbate the distortions associated with subsidizing risk management. Proponents of such programs would, in the end, hope to see revenue guarantees approaching 90% of expected revenues, making farming unique in terms of taxpayer guarantees of income. In fact, removing all risk from an economic activity is a serious long run concern, effectively mitigating any incentives for innovation and raising concomitant adverse implications for productivity growth and the sector s long run global competitiveness. Such public policies are unlikely to enhance welfare in the long run. 9

10 table 1. US Federal Crop Insurance Statistics (nominal $millions) Adjusted Subsidy Loss Loss Year Acres Liability Rate Ratio Ratio , , , , , , , , , , , , , , ,

11 Adjusted Subsidy Loss Loss Year Acres Liability Rate Ratio Ratio , , , , , , , , , , , , , , ,

12 table 2. Federal Budget Statistics for the US Crop Insurance Program (Source: Shields (2010) in nominal $millions. AIP statistics reported on a reinsurance year basis.) Fiscal Underwriting Premium A&O Other Total AIP AIP Year Losses/Gains Subsidy Expense Costs Costs Loss Ratio Net Gains , , , , ,182 1, , , , , , , , , , ,068 3,544 1, , , ,717 5,301 2, , , ,198 1, , , ,523 4,680 1, ,671 N/A N/A 12

13 table 3. CBO 2008 Farm Bill Baseline Budget Score (Source: CBO and Monke 2012) Fiscal Year Title I CommodityPrograms 5,750 6,005 6,636 6,467 6,285 31,143 62,944 Directpayments 4,957 4,958 4,958 4,958 4,958 24,789 49,580 Counter-cyclical,ACRE,Marketingloans , ,113 6,881 Interestandoperatingexpenses ,139 Economicassistancetocottonmills MILCandotherdairyassistance Other ,262 4,365 Title II Conservation 6,093 5,992 6,113 6,320 6,438 30,956 65,275 Title III Trade ,722 3,442 13

14 Fiscal Year Title IV Nutrition(SNAP) 82,022 79,799 80,059 79,664 78, , ,773 Title VI RuralDevelopment Title IX Energy Title X HorticultureandOrganicAgriculture ,050 Title XII CropInsurance 8,412 8,528 8,702 8,788 8,903 43,333 89,817 PremiumSubsidy 5,924 6,007 6,138 6,210 6,305 30,585 63,750 DeliveryExpenses 1,352 1,368 1,385 1,386 1,387 6,878 13,831 UnderwritingGains 1,137 1,154 1,179 1,193 1,212 5,876 12,247 TotalFarmBillBaseline 102, , , , , , ,628 14

15 table 4. OLS Estimates of Acreage Response Equations Parameter Corn Soybeans Cotton Wheat Intercept (0.7201) (0.6952) (1.8702) (0.8186) Corn Price (0.3761) (0.3647) (0.9405) Soybean Price (0.4368) (0.4254) (1.1115) Cotton Price (0.6546) Wheat Price (0.4068) Mean Loss Ratio (0.0016) (0.0046) (0.0269) (0.0120) Numbers in parentheses are standard errors. An asterisk indicates statistical significance at the α =.10 or smaller level. 15

16 Parameter Corn Soybeans Cotton Wheat (Liability/Acres)t (0.4812) (0.6338) (1.3245) (2.4592) Mean Subsidy Rate (0.2926) (0.2875) (0.7473) (0.3825) Planted Acrest (0.0008) (0.0008) (0.0019) (0.0009) R Numbers in parentheses are standard errors. An asterisk indicates statistical significance at the α =.10 or smaller level. 16

17 (a) 2010 Total Liability (b) Subsidy-Adjusted Loss Ratios figure 1. U.S. Crop Insurance Program Experience 17

18 References Brown, E., How Greece Could Take Down Wall Street, online article at Global Researcher, available at accessed on May 25, Goodwin, B. K An Empirical Analysis of the Demand for Multiple Peril Crop Insurance, American Journal of Agricultural Economics, Vol. 75, No. 2, pp Goodwin, B. K. and V. H. Smith The Economics of Crop Insurance and Disaster Relief. Washington, DC: AEI Press. Goodwin, B. K. and L. Vado Public Responses to Agricultural Disasters: Rethinking the Role of Government. Canadian Journal of Agricultural Economics Canadian Vol. 55, Issue 4, pages Goodwin, B. K., M. Vandeveer, and J. L. Deal, An Empirical Analysis of Acreage Effects of Participation in the Federal Crop Insurance Program. American Journal of Agricultural Economics Vol. 86, No. 4, pp Monke, J Budget Issues Shaping a 2012 Farm Bill, Congressional Research Service Report R42484, Washington, DC, April 17, Shields, D. A., Federal Crop Insurance: Background and Issues, Congressional Research Service Report R40532, Washington, DC, December 13, Smith, V., Premium Payments: Why Crop Insurance Costs Too Much, paper in the series American Boondoggle Fixing the 2012 Farm Bill, American Enterprise Institute, Washington, DC, July 12, Smith, Vincent H., and Barry K. Goodwin Multiple Peril Crop Insurance, Moral Hazard and Agricultural Chemical Use. American Journal of Agricultural Economics 79 (2): Smith, Vincent H., and Barry K. Goodwin Private and Public Roles in Providing Agricultural Insurance in the United States, in Jeffrey Brown (editor), Private and Public Roles in Insurance, AEI Press, Washington D.C. 18

19 Truitt, G., More Cuts Proposed for Crop Insurance, online article at Hoosier Ag Today, available at accessed on May 25,

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