What Percent Level and Type of Crop Insurance Should Winter Wheat Growers Select? 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. What Percent Level and Type of Crop Insurance Should Winter Wheat Growers Select? 1 Farmer-paid premiums will be lower for 2014, 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 2014 has dropped from $8.78 to $7.02 and volatility has declined from 24% to 19%. Those values are set by the market and out of RMA s control. The fourth factor for setting a premium is the farmer s APH. In the examples below, RMA made a small rate change in SW Kansas, but this may be nothing more than rounding error. The analysis does suggest a small rate increase because the calculated rate increase at 85% coverage was 6.6% (Table 1, line 16). RMA cut the wheat rate in Central Kansas, but they increased the rate in Oklahoma (Tables 2 and 3). Even with a rate increase, Oklahoma wheat farmers will still pay lower premiums per acre in 2014 because of lower volatility and lower price. The farmer s APH also affects the premium and coverage. If the APH declines from the prior year, then farmers rates will increase and their coverage will decline. The good news is that the farmer-paid premium will be lower in 2014, but the bad news is the coverage will also be lower. The lower winter wheat strike price of $7.02 will drop the coverage for the example SW Kansas farmer from $263 to $211 at the 75% coverage level, assuming no change in the farmer s APH (Table 1, line 2). However, the lower coverage also cuts the premium at the 75% level from $8.78 to $6.69 per acre (Table 1, line 8). Therefore, per acre premium costs were lower because the price was lower and 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 25, 2013, Phone , e- mail barnaby@ksu.edu.

2 the volatility was lower. However, in Oklahoma the premium cost would have been even lower if RMA had not raised the rate (cost per $100 of coverage). Using the 2013 rating model, the author entered this year s $7.02 price and 19% volatility (down from 24% volatility and $8.78 last year). The result was that RMA increased the Oklahoma rate by 12.2% for 80% coverage (see table 3, line 16). There are 4 items that affect the premium paid per acre; the strike price, volatility, the farmer s APH, and RMA rate adjustments. The volatility has a major impact on corn premiums in the Corn Belt and on irrigated corn in the Great Plains, but it also affects wheat. A 30% volatility would have increased the premium 28.3% at the 80% RP coverage level in Central Kansas (Table 4, line 7). That would have wiped out the RMA rate cut for Central Kansas. In 2008, the strike price was $5.88 and volatility was 33%. Using 2014 RMA rates, the premium cost would have been larger than this year s premium, but provided much lower coverage with a $5.88 strike price versus $7.02 for For 80% coverage, farmers would have paid $9.68 in 2008 versus $8.46 in 2014 (Table 4, line 18 vs. line 15). Even with the higher premium, farmers in 2008 received less coverage for the same farm because the 2008 volatility was 33% versus the 2014 volatility of 19%. Based on 80% RP coverage, the 2008 coverage was $235 versus the higher 2014 coverage of $281 for less premium per acre (Table 4, line 17 vs. line 2). It should not be a surprise that RMA increased the Oklahoma premium rates, because they have had some recent claim years. One would doubt that many farmers will notice the rate increase, because their premium per acre will be lower than a year ago due to lower coverage and lower volatility. The question is, will the RMA rate increase be enough if the future volatility drops from about the 30% level generated from to about the 20% level that was normal in the prior years? If 20% volatility is the norm, then likely RMA will add more to the rate in Oklahoma, but they shouldn t cut rates in the Corn Belt for the same reason. The fact is that the lower volatility is cutting premiums, but with little impact on the claim side. The lower volatility means lower premiums paid by farmers for a given coverage level and that is good news for famers. However, that means the insurance companies and RMA collected less premium, but unless it affects the claim side, there will be higher underwriting losses or smaller gains. The lower premium also cuts the agent s income. Higher Enterprise Coverage vs. Optional Unit coverage. Table 5 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 famer 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 $1.69 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 $5.62 versus $4.91 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 $30 less coverage than the enterprise unit. 2

3 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. The premium savings for the enterprise unit will not be this great in all markets. It is probably more common that a farmer will only be able to increase one s coverage by 5 points rather than 10 points for about the same premium costs. This strategy makes the most sense if one is worried about drought or freeze. On irrigated corn, heat stress during pollination, wind and hail are normally the greater concern and farmers may not wish to make this trade. In years with high strike prices, then a higher coverage enterprise unit is more likely to be preferred because price risk may be the greatest concern. Area Risk Protection Insurance (ARPI) replaced the Group plans in The area plans that trigger payments based on county revenues or county yields are not widely available in the Great Plains. The ARPI is not offered on corn and soybeans and only in selected counties for wheat and sorghum. Effectively, ARPI is a put option on expected county revenue, and farmers bear the basis risk. Large farms are the ones most likely to select ARPI. If a farmer farms the whole county then the enterprise unit and county unit in ARPI are the same thing. The bigger the farm, the better ARPI transfers risk. One needs to be careful analyzing the ARPI to make sure that the RMA expected county yields are realistic. One condition where large farms have used ARPI 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 ARPI is reduced too. There have been very few ARPI 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. What is the best Crop Insurance Coverage? The economist answer is it depends. Not a real useful answer for a farmer that must make a decision. The first decision is should one buy revenue vs. yield coverage. Using the Oklahoma premium calculation as the example, at the 80% coverage level it cost 31% more in premium for RP than YP (Table 3, line 18). What if one were to eliminate the harvest price to make the revenue coverage less expensive? The RP premium was 15.8% higher than RP-HPE at the 80% coverage level. While cheaper, an increase in the harvest price will reduce or may even eliminate the indemnity payment. This means a farmer has a production loss greater than the deductible, receives no indemnity payment, and must still write a check for the premium. This was a hard lesson a few Iowa corn growers learned in 2012, when prices increased and they lost half of their crop, but they received no indemnity payment. Things to Think About When Making the Crop Insurance Decision: 1. 80% has the largest dollar subsidy per acre, but on some crops and markets 85% will have the largest dollar subsidy per acre. 3

4 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. The largest percent rate increase was at 50% coverage for Oklahoma, but the reverse was true for Central Kansas that had the largest percent rate cut at the 50% coverage level. 5. At 85% coverage, the effective strike price is $5.67; price point where payments trigger and no yield loss. 6. If one is willing to sell covered puts, then the higher strike price in RP and lower deductible becomes more valuable. 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 adverse. 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 ARPI (GRIP) available? 6. Are optional units worth the extra premium over enterprise units? The author discussed this decision with Dr. Bryan Schurle who has become interested in behavioral economics. Dr. Schurle cited some new literature that suggest when confronted with too many choices that people give up and default to the status quo. This probably explains why insurance agents have intuitively figured out that when they make a sales pitch they focus on only two or three choices. Crop insurance is a continuous contract and unless a farmer cancels the coverage by September 30, their coverage automatically rolls over to the coverage they purchased in the prior year. This rule has been in place since the 1930 s and one has to wonder if someone at that time figured out that too many choices caused people to select the default by just letting the coverage roll over? 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 lender before they make their final decision. 4

5 Table 1. Example of a Southwest Kansas Wheat Premium Cost for 2014 Wheat 2014 SW Kansas Summer Fallow Wheat Premiums 40 APH/No Trend Yield, 500 Acres Enterprise Unit APH Wheat 40 $7.02 Price Election 0.19 Volatility 2. Coverage Farmer Paid Premium 4. YP Marginal Rate RP-HPE Marginal Rate RP Marginal Rate Subsidy Dollars per Acre 11 YP RP-HPE RP RP Rates vs 14 RP Rates Rates Rate Change -0.9% 0.7% 2.1% 3.4% 2.2% 1.3% 2.6% 6.6% from YP to RP 25.3% 25.9% 27.3% 28.6% 29.7% 29.9% 30.2% 28.8% from RP-HPE to RP 24.6% 24.8% 24.5% 25.5% 25.7% 25.5% 24.4% 22.2% Yield/bu "Put"/Cents bu "Call"/Cents bu RP Effective "Put" Strike Price

6 Table 2. Example of a Central Kansas Wheat Premium Cost for 2014 Wheat 2014 Central Kansas Non-irrgated Wheat Premiums 50 APH/No Trend Yield, 500 Acres Enterprise Unit APH Wheat 50 $7.02 Price Election 0.19 Volatility 2. Coverage Farmer Paid Premium 4. YP Marginal Rate RP-HPE Marginal Rate RP Marginal Rate Subsidy Dollars per Acre 11 YP RP-HPE RP RP Rates vs 14 RP Rates Rates Rate Change -21.5% -21.1% -19.5% -17.9% -17.4% -16.4% -15.6% -14.4% from YP to RP 27.5% 31.5% 36.4% 40.9% 43.9% 45.9% 47.4% 50.0% from RP-HPE to RP 32.7% 33.6% 34.8% 35.4% 35.0% 36.0% 36.0% 36.0% Yield/bu "Put"/Cents bu. (0.002) (0.001) "Call"/Cents bu RP Effective "Put" Strike Price

7 Table 3. Example of a North Central Oklahoma Wheat Premium Cost for 2014 Wheat 2014 Oklahoma Non-Irrigated Wheat Premiums 42 APH/No Trend Yield, 500 Acres Enterprise Unit APH Wheat 42 $7.02 Price Election 0.19 Volatility 2. Coverage Farmer Paid Premium 4. YP Marginal Rate RP-HPE Marginal Rate RP Marginal Rate Subsidy Dollars per Acre 11 YP RP-HPE RP RP Rates vs 14 RP Rates Rates Rate Change 15.0% 14.5% 14.2% 13.7% 13.2% 12.0% 12.2% 12.5% from YP to RP 22.9% 25.0% 26.6% 28.5% 29.5% 31.2% 31.0% 30.4% from RP-HPE to RP 14.6% 14.6% 15.0% 14.8% 14.9% 15.9% 15.8% 15.4% Yield/bu "Put"/Cents bu "Call"/Cents bu RP Effective "Put" Strike Price

8 Table 4. Impact of Volatility on Premiums for Central Kansas Non-Irrigated Wheat 2014 Central Kansas Non-Irrigated Wheat Premiums 50 APH/No Trend Yield, 500 Acres Enterprise Unit APH Corn 40 $7.02 Price Election 2. Coverage Dollar Farmer Paid Premium RP 0.19 Volatility RP 0.30 Volatility % increase Prem 23.1% 25.1% 26.7% 26.9% 26.2% 27.1% 28.3% 27.8% RP 0.18 Volatility % decrease Prem (1.5%) (1.8%) (1.8%) (2.5%) (2.3%) (2.2%) (2.2%) (2.3%) RP Subsidy based on Volatility, strike price and current policy rates vs Subsidy Paid Net RP Prem RP Subsidy RP Coverage Net RP Prem RP Subsidy % increase Subsidy 9.2% 11.4% 12.7% 12.9% 12.6% 13.6% 14.5% 13.7% Table 5. Compare Optional Unit Premium vs. Higher Coverage Enterprise Unit 2014 Oklahoma Non-Irrigated Wheat Premiums 42 APH, 500 Acres Enterprise Unit vs. Optional Unit APH Wheat 42 $7.02 Price Election 0.19 Volatility 2. $ Coverage Farmer Paid Premium 4. RP $2.20 $2.75 $3.38 $4.10 $5.00 $6.85 $11.41 $ Cut RP cover by 10 points and select Optional Units 6 % Coverage 50% 55% 60% 65% 70% 75% 7 $ Coverage Optional Unit Coverage Premium $4.93 $6.60 $8.00 $10.84 $13.10 $ $ Premium Change $1.55 $2.50 $3.00 $3.99 $1.69 -$ % Premium Change 31.4% 37.9% 37.5% 36.8% 12.9% (16.7%) 8