Farmer utilization of crop insurance as a risk management tool has increased significantly over the past few years and “there's a high probability it will double over the next five years,” says Ross J. Davidson, Jr., administrator for the USDA's Risk Management Agency.

Still, he said at the annual Agricultural Outlook Forum at Washington, D.C., “sizeable segment of the agricultural community is not using crop insurance to its fullest potential.”

Although payments to producers in the “highly subsidized program” are reaching record levels, he notes, fine-tuning of the program continues, along with efforts to make it more affordable to farmers. With the subsidies, he says, producers are paying less than half the cost of premiums.

“Essentially, we have a fair, effective delivery system that is still evolving.” Drought in some sections of the country “is exposing some warts and deficiencies that we have to deal with.”

The Risk Management Agency's vision, Davidson says, is to provide U.S. growers with a broad array of effective, market-based management tools to deal with risk — “broader than just crop insurance” — in order to strengthen their economic stability.

Integrity of the program is critical, he says, as is excellent service. “It takes an inordinate amount of time to deliver new products to market, and we want to be sure we get it right.”

And, Davidson says, “We don't believe crop insurance should be the only tool for managing risk; rather, it should be used in concert with other products and programs.”

Crop insurance is “an extremely complex program,” says Barry J. Barnett, associate professor of agricultural and applied economics at the University of Georgia. “There's good reason the government got involved: because the private sector found it so difficult.”

The scope of the program further compounds its complexity, he says. “In 1979, the Federal Crop Insurance program consisted of one insurance product available for only 29 crops in slightly over 1,500 counties. In 1981, the program offered approximately 5,000 county/commodity/product combinations; in 2002, the program offered 38,454 combinations; and changes introduced by the 2000 Act will likely increase the number even more.”

Several insurance products were available for over 100 crops and livestock and at least one crop insurance product was available in almost 3,100 U.S. counties. Insurance liability of more than $37 billion was in place on more than 215 million acres.

Policymakers have had at least two major objectives for the Federal Crop Insurance Program, Barnett points out:

Reducing the demand for disaster insurance. “Policymakers often cite insufficient crop insurance participation to justify continued ad hoc disaster assistance. Yet, both acres insured and liability have increased dramatically since 1980. If catastrophic coverage is included, participation since 1999 has been between 70 percent and 80 percent. Even so, ad hoc disaster assistance has been provided in all but 8 federal fiscal years since 1981 and every year since 1999.”

Actuarial soundness. “A loss ratio greater than 1.00 indicates the program paid more in indemnities than was collected in premiums. The loss ratio has exceeded 1.00 every year between 1981 and 1993. In 1993, a long-run loss ratio target of 1.075 was set and since 1994 it has been exceeded only once, in 2002.” Aggregate loss ratios have been highest in the South and in the Plains states, with relatively low loss ratios in the Midwest.

The program involves a large number of stakeholders, he notes, ranging from agricultural lenders, private insurance companies, retail insurance agents, Risk Management Agency employees, private reinsurance companies, to farmers, and taxpayers, who are currently paying about $2 billion to $3 billion a year for the program.

The inherent complexity of insurance “is compounded when trying to insure agricultural risks,” Barnett notes. “Risk exposure varies widely by commodity and region, and even by individual farmers. Assessing this risk exposure and classifying applicants accordingly has been one of the major challenges faced by the program.”

It's extremely difficult to monitor the behavior of insured farmers, he says. “While most are careful and honest, stories of fraud and abuse abound in many rural communities.”

Agricultural perils, such as drought, can create widespread losses, requiring an insurance provider to pay on a very high percentage of policies. “Contrast this to other insurance, such as automobile or life, where the provider can predict with very high accuracy the percentage of policies on which claims will be paid in any given year.”

Now, Barnett says, the Federal Crop Insurance Program “is at a crossroads,” with a number of important challenges and opportunities to be addressed.

How much expansion is desirable? “There are thousands of crop and livestock commodities produced in the U.S. Is it possible, or even desirable, to provide insurance protection for all of them? If not, how do we determine which to include and which to exclude? How many insurance products are necessary for each commodity? Should legislative authority be changed to allow new insurance product submissions to be evaluated, in part, on their similarity to existing products?”

Maintaining core products. The Risk Management Agency currently lists about 100 agricultural commodities for which federal crop insurance products are available.” Even so, Barnett notes, 74 percent of total crop insurance premiums in 2002 were for corn, soybeans, cotton, and wheat. “Unless additional federal resources are made available, investments in rapid expansion may limit the RMA's ability to maintain these core commodity/product combinations.”

Premium subsidies. “Premium rates are higher in riskier areas and for riskier commodities, so the subsidy structure transfers more federal dollars to those who produce riskier commodities or grow them in riskier areas. The highest premium subsidies per acre are for high value crops in California and Florida and in cotton/peanut producing regions.

Some have questioned why the federal government should be disproportionately subsidizing these producers who, by their own decisions, take on the most risk. To the extent that risky production regions are also more environmentally fragile, the current subsidy structure may be working at cross purposes with federal conservation programs.”

Changes in the delivery system. Beginning with the 2003 crop year, one private insurance company will begin selling federal crop insurance policies over the Internet, with a premium discount. “This may have profound implications for crop insurance delivery. If farmers are willing to buy insurance over the Internet, this will likely put downward pressure on insurance agent commissions. On the other hand, the complexity of crop insurance decision-making and the amount of money at risk may make farmers uncomfortable purchasing over the Internet.”

Barnett notes that private companies selling and servicing policies are reimbursed by the government for administrative and operating expenses. Commissions received by insurance agents are based on a percentage of the total premium.

“This creates incentives for insurance companies and agents to target the largest farmers, since the administrative costs associated with selling and servicing a large policy are not significantly higher than for a small policy.” Even though an increasing number of insurance products are being offered, he says, some local insurance agencies are specializing in selling only one or two products — “not surprisingly, these tend to be those that generate the most premiums.”

The crop insurance industry has become more concentrated in recent years, Barnett notes. “While policymakers emphasize future product development and expansion, there may be a limit to the number of products local agents are willing to sell for a specific commodity in a specific region. The private sector delivery system will not respond to policymakers' desires for expansion, but rather to the financial incentives that are in place.”

There are several important considerations that should guide efforts to address challenges and opportunities facing the Federal Crop Insurance Program, Barnett says.

“Risk exposure varies widely across the U.S. Cotton production in the Texas High Plains is more risky than in the Mississippi Delta. Soybean production in the South is riskier than in the Midwest. These differences in risk exposure can create geographical differences in both intended federal transfers, through premium subsidies, and unintended transfers, through high loss ratios.”

Not all risks are insurable, Barnett says. “If potential insurance purchasers have better information about their risk exposure than the insurer, the resulting pool of insurance buyers will be disproportionately weight toward the riskiest individuals, tending to cause high loss ratios.”

Problems in risk classification “can make it very expensive to try and simultaneously meet the objectives of actuarial soundness and participation.” Insurers must be able to calculate the frequency and severity of loss for each risk calculation, and an objective third party must also be able to verify that any loss was accidental and unintentional. “This typically means being able to verify that the farmer employed best management practices.”

Barnett says “moral hazard” occurs if a farmer, unknown to the insurer, changes management practices in order to increase the probability of loss or severity of loss. “This can only be corrected by costly monitoring of policyholder behavior.”

Some farmers don't want, or maybe don't need insurance, he says. “Farmers use many methods to manage risk, including forward pricing, diversification, irrigation, improved varieties, participation in federal farm income support programs, off-farm income, and other methods. Some will not want, or even need federal crop insurance products. It's also important to note that the federal marketing loan program and counter-cyclical payment program provide price risk protection to producers of eligible crops. To the extent that these programs reduce farmers' exposure to price risk, they also reduce demand for federal crop insurance products.”

Large scale expansion of the federal crop insurance program into new commodities and new products could crowd out private sector risk management initiatives, Barnett says. “Private sector suppliers of risk management tools simply can't compete against highly subsidized federal crop insurance products.”

And, he says, things change. Production technologies, many of which have risk management implications, continue to evolve. Marketing methods change. Farms are becoming larger and more dependent on off-farm sources of income. Changes in insurance and other tools are occurring and “may one day create new ways to re-insure agricultural risks in private markets.”

Limited federal resources will require, Barnett says, “that the Federal Crop Insurance Program respond aggressively and creatively to change. This will involve continually reassessing the appropriate federal role in this public/private partnership.”

e-mail: hbrandon@primediabusiness.com