Possible Future Roles for Crop Insurance
While there now appears to be much agreement that crop insurance will continue to be the primary program in the future farm safety net, there are alternative views on how to address program concerns and how crop insurance should evolve, including the extent to which it should be integrated with existing or new farm programs. These approaches are summarized next.
I—Reduce or Eliminate Subsidies. Reflecting higher participation, coverage levels, and commodity prices, the expected public cost of the program is now about $8 billion per year, raising criticism of underwriting gains, delivery costs, and premium subsidies—the components of program costs (Babcock, 2011; Smith, 2011). While the 2011 SRA and recent premium rate reductions at least partly address the first two cost components, premium subsidy rates are set in statute. One option to cut costs is to retain the current program structure but reduce premium subsidies. Premium subsidies are a fixed percentage of premiums which makes the dollar value of subsidies higher for higher risk producers of a particular crop, other things equal. High subsidy levels may encourage the purchase of insurance for the purpose of earning a return, rather than just protecting against a risky outcome. Record-high farm income and the need to cut Federal spending motivate suggestions to cut or end subsidies.
One suggestion, around for a while, has been to distribute limited premium subsidies through vouchers (for example, Glauber, 2004). Another idea would simply cap subsidies per farm (Smith, 2011) or impose eligibility criteria on subsidies. Another approach is to reduce subsidies for certain plans of insurance, such as charging premium rates for Catastrophic Coverage (CAT) rather than the current administrative fee or eliminating subsidies for the price component of revenue policies (Babcock, 2011). Other ideas include further reducing payments to companies. Proponents of lower subsidies argue such changes would help meet World Trade Organization (WTO) obligations, reduce the deficit, improve market orientation, and better reflect farm household well-being relative to nonfarm households.
The downside of reducing or ending crop insurance subsidies would be a likely reduction in participation and coverage levels, depending on the type of changes made to the program. Lower coverage levels would expose producers to more price, yield, and quality risk and could encourage the government to provide ad hoc payments in the event of a widespread declared disaster. Sharp cuts in premium subsidies, delivery cost payments to companies, and Federal reinsurance would likely generate significant opposition from producers, companies, and farm suppliers. For example, loss of subsidies for price protection in revenue insurance would likely limit producers’ ability to forward market, adding to risk exposure. In the extreme, with full privatization of the program, including loss of Federal reinsurance, premium rates would rise sharply and would have to include a delivery cost load, leading to much smaller sales and a contraction in delivery infrastructure with fewer companies and agents. Companies would no longer be required to sell to all farmers who want a policy, and in some cases, coverage may not even be offered to some producers and some areas. A possible response to avoid such outcomes could be a push for a Federal program, such as described in the next two sections. However, creating a free Federal program to substitute for crop insurance is simply a continuation of subsidies, but in a different form.
II—Wrap individual crop insurance around index plans of insurance. One idea is to provide a base level of coverage to program crop producers in the form of a free Federal area or another type of index plan of protection, with privately delivered insurance purchased by producers to cover added individual risks (Coble and Barnett, 2008; Babcock, 2010; Smith, 2011; Zulauf, 2011a). This wrapped, privately delivered insurance may be subsidized or not. The idea is that an index plan, based on area yields, revenues, vegetation conditions, or weather variables, would have low administrative costs and limited moral hazard—actions by the producer that increase the likelihood and severity of a loss. Such index plans are not currently integrated with individual plans, but could be integrated. For example, a Federal area revenue program that covers all area losses in excess of 15% could be provided free to cover more widespread correlated risks, with private insurance companies being left on their own to sell policies to cover other farm risks. Another approach would be to use payments made under a Federal index plan to offset indemnities paid under the current individual crop insurance policies, thus reducing crop insurance net indemnities. This concept was most recently proposed by the American Farm Bureau Federation (2011). Such options reduce program duplication, crop insurance program costs, and premium rates. Also, an index plan requiring a 30% loss to trigger a payment could potentially be exempt from penalties under the WTO.
The downside of wrapped approaches is that index plans work better the more highly related the producer’s loss is with the index’s loss. This means to be effective the index insurance would have to apply on a more local scale like the county or another small geographic area, which increases program cost and complexity.
Individual insurance does a better job of protecting against risk than index plans and is preferred by most producers (Bulut, Collins, and Zacharias, 2011). Index plans are unlikely to be effective for producers in regions that are very heterogeneous in terms of topography, climate, soil type, etc. Another issue is that, depending on the structure of the product, the index plan may just substitute for production or revenue currently covered by crop insurance, adding little to the overall risk reduction of the farm, although lower premium rates may encourage participation and higher coverage levels on individual policies. Greater reliance on crop insurance wrapped around index products that substitute for some of the risk protection now provided by crop insurance would likely require a rerating and a new SRA. Crop insurance companies would likely bear less risk and provide less risk protection, as Federal assumption of risk increased, with the likely effect of a smaller private crop insurance industry over time.
III—Expand farm programs to cover uninsured production and possibly enhance income. Some proposals maintain crop insurance as is, but supplement its coverage with free farm programs to reduce uninsured losses which occur due to the policy’s deductible and farm insurance yields being below expected yields. The Average Crop Revenue Election (ACRE) and the Supplemental Revenue Assistance Payments (SURE) programs are examples. The now-expired SURE program raised coverage levels of the underlying policies on an individual whole-farm basis and subtracted indemnities from SURE payments. The ACRE program tries to effectively raise a producer’s coverage levels using an area revenue guarantee of 90% of expected state revenue. Indemnities are not subtracted from the ACRE payment, but a maximum ACRE payment rate of 25% of the state revenue guarantee reduces the overlap with crop insurance indemnities (Zulauf, Schnitkey and Langemeier, 2010).
A range of farm revenue programs that would supplement crop insurance proposals have been discussed for the 2012 Farm Bill (for example, Zulauf, 2011b). They would essentially replace ACRE and include area plans with guarantees as high as 95% of revenue but with a maximum payment rate as low as 10% of the guarantee to better target the deductible on most insurance policies and limit overlap with crop insurance. There are also plans based on individual farm losses. Overall risk protection would be increased as the plans supplement crop insurance. Multiyear protection and enhanced farm income are provided when the price component of the guarantee is set to exceed expected prices in low price years.
These supplemental plans have several disadvantages. Guarantees set at high levels to supplement crop insurance rather than replace it may generate WTO issues, encourage more risk taking and production, and thus impede production response in excess supply periods. This may be especially true for individual farm plans, which also have moral hazard. The area plans suffer from basis risk, or imperfect correlation between farm and area yields, potentially paying when a farm has little to no loss and not paying when a farm has a loss. Also, the more the supplemental coverage band overlaps higher levels of crop insurance coverage, the more the supplemental plan will reduce crop insurance demand at the higher coverage levels.
IV—Expand crop insurance to cover uninsured production and possibly enhance income. Another approach is to have no supplementary free farm programs and rely on the delivery assets and benefits of the crop insurance program. Unlike the supplemental farm program plans, crop insurance covers far more crops. As the sole program, there may be interest in expanding crop insurance features to address currently uninsured production for all crops, with coverage enhancements subsidized at alternative levels. Subsidies on existing underlying policies could be retained or reduced as budget and policy objectives require. A number of the following options could be used.
1. Expand maximum coverage levels under the policy. The maximum insurance coverage available is 85% of expected production or revenue on most individual polices. One idea is to provide crop insurance participants with a free five-percentage-point increase in coverage (Barnaby, 2011). While this would reduce uninsured coverage, it has cost implications for the government as suggested by premium rates which reflect expected costs and rise sharply at high coverage levels. The free coverage increase may also cause producers to buy less coverage on the underlying policy. This option would also add to administrative costs, as there would be more frequent loss adjustment. Moral hazard would also likely increase.
2. Expand maximum coverage levels and implement coinsurance payments. One way to reduce the cost and moral hazard of higher coverage levels is to raise maximum coverage levels but implement coinsurance. For example, a producer could buy an 85% policy that provides a 90% coverage level. Losses in excess of 15% would be paid in full, while losses in the 10% to 15% range would be paid in part, with part of the loss in that layer borne by the producer. Further, the producer could be permitted to select the range of coverage over which coinsurance would apply, for example 65% to 85%.
3. Permit a producer to buy an area plan to cover the deductible portion of the individual policy. This option was proposed for the 2008 Farm Bill by the Administration and Rep. Neugebauer and recently for the 2012 Farm Bill (National Cotton Council, 2011). This idea is similar to using a supplemental farm program area plan to cover uninsured production, as described earlier, so it has the same issues, such as basis risk, except now the plan would be sold by insurance companies. A producer with an individual crop insurance policy could buy two policies on the same acre. The current policy would cover individual risk and the area policy would partly cover the deductible. The area plan could be similar to area plans now being sold, or tailored to the producer’s selected deductible.
4. Provide disappearing deductible coverage. Under this idea, the producer’s indemnity would be multiplied by 1.0 divided by the coverage level. For example, the payment under a policy with 75% coverage would equal the indemnity paid on the individual policy multiplied by 1.333 (1.0/0.75). The added payment would cover only a small portion of the deductible for small losses but would completely eliminate the deductible at 100% loss. This option would be easy to administer and rate, require no new loss adjustment, but would not cover small losses and could encourage some moral hazard.
5. Provide a supplemental disaster payment through the crop insurance program.Under this idea, any producer in a disaster county who has crop insurance would receive a payment equal to a fixed percentage of any indemnity paid such that the payment and the indemnity do not exceed 100% of expected revenue. For example, a 33.3% disaster payment rate for a producer with a 75% policy would behave exactly as a disappearing deductible. However, with a lower payment rate, the deductible would not be fully covered. As this would be a disaster program funded by the government, delivered by crop insurance companies, and possibly free, it could be more costly than other options. It would be easy to administer, would incentivize the purchase of crop insurance, but would not cover small losses or help those without insurance.
Figure 4 illustrates how coinsurance, a supplemental crop insurance area plan, disappearing deductible, and a disaster payment might work to augment income with a 75% crop insurance policy. The line for the supplemental disaster payment assumes a 33% payment rate so it is coincident with the disappearing deductible. The area plan line depends on how the producer’s loss compares with the area’s loss. As drawn, the area plan covers 75% to 85% of the expected area revenue and is assumed to perfectly supplement the individual plan and provide protection up to 85%—assuming the farm and area have exactly the same expected revenue and losses. In reality, that would be the best case and highly improbable. The other extreme would be that the area plan never triggers when the producer has a loss. In that case the relevant line is the 75% crop insurance policy and the area plan is ineffective, again an improbable case.