Managing Risk With Revenue Insurance
Revenue insurance may
do a better job of stabilizing farm income and may
protect more farms than other risk management tools
Robert
Dismukes and Keith
H. Coble
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Crop
revenue insurance offers farmers a way
to manage revenue variability that results
from yield and price risks. |
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Commodity-level
revenue insurance, particularly for
corn, soybeans, and wheat, has become
a major part of the subsidized Federal
crop insurance program. |
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Whole-farm
revenue insurance, based on combined
revenue from all commodities produced
on a farm, is a more broad-based approach,
but is difficult to administer. |
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Farming is an inherently risky
business. Uncertain weather conditions, market shifts,
and other events beyond a farmer’s control
affect farm yields and commodity prices, creating
variability in farm revenue. Since the early 1980s
the Federal Government has promoted insurance as
a tool for managing crop losses. In its simplest
form, insurance reduces risk by making payments
to insured farmers when yields or revenues fall
below a guaranteed level. Farmers can choose from
a variety of insurance plans in the subsidized Federal
crop insurance program, including yield insurance
plans, which have been part of the program from
the outset, and revenue insurance plans, which were
added in the mid-1990s.
As a tool based on revenue shortfalls
rather than on yield or price shortfalls, revenue
insurance can be more effective at stabilizing income
than insurance plans or farm programs that protect
against yield and price risks separately or that
provide fixed-income transfers. A revenue-based
program may also offer a simple way of assisting
a wider variety of farms than programs linked to
current or historical production of particular commodities,
a practice that focuses risk management support
only on certain segments of the farm sector. Finally,
revenue insurance plans are designed to match costs
of risk protection with benefits and to base coverage
on the market value of the item insured.
What Causes Revenue Variability?
Revenue depends on production,
prices, and interactions between the two. Prices
received by farmers depend largely on world market
conditions, while yields depend on localized factors,
such as weather. Thus, revenue variability across
farms is largely the result of yield variability
and differences in the relationship between prices
and individual farm-level yields.
The relationship between prices and yields is “negative”
when changes in yield and aggregate production result
in offsetting changes in prices. In other words,
when yield and aggregate production of a commodity
increase, price decreases; when yield falls, price
rises. The price-yield relationship, measured by
the price-yield correlation, tends to be strongest
in areas where most farm-level yields are closely
related to areawide production and where the area’s
production normally accounts for a significant share
of world production. Corn and soybeans, for example,
show the strongest negative price-yield correlation
in the Midwest. Negative price-yield correlations
moderate revenue variability, thus they are often
referred to as a “natural hedge.”
Not surprisingly, many areas with
large amounts of corn and soybean production tend
to be areas of low yield variability. Yield variability
for corn, for example, is low in Illinois and Iowa,
which together account for about a third of the
U.S. corn crop. The U.S. crop typically accounts
for about 40 percent of world production. Because
of the low yield variability and the strong price-yield
correlations, revenue insurance costs are relatively
low in these areas and producers tend to see a correspondence
between revenue variability on their farms and the
protection offered by revenue insurance. In contrast,
for crops in areas with high yield variability and
weak price-yield correlation, such as cotton in
Texas, revenue insurance costs are higher.
The benefits from revenue insurance
depend on the type of program and the type of subsidy
offered with revenue insurance. The Federal crop
insurance program pays premium subsidies that encourage
producers to buy revenue insurance and pays administrative
subsidies to private insurance companies that sell
and service revenue insurance. These subsidies are
based on a share of the premium value of the revenue
insurance policies sold.
While the subsidization of revenue insurance helps
producers reduce risk, the subsidies also transfer
income, although this income is realized only when
an insurable loss occurs and results in an indemnity
payment. A subsidy structure based on uniform proportions
of a premium across areas and crops transfers greater
amounts of income per dollar of insured value to
riskier crops and areas where premium rates are
higher. However, producers of risky crops in risky
areas face higher premiums due to greater revenue
variability, and may see little relationship between
their yields and market price; thus, they still
may be reluctant to buy revenue insurance.
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Revenue Insurance Participation Grows With
Subsidies
Revenue insurance was first available
under the Federal crop insurance program in 1996.
Initially, it was available for corn, soybeans,
wheat, and cotton in a limited number of counties.
In the late 1990s, availability of revenue insurance
for these crops increased and revenue insurance
plans for grain sorghum, canola, barley, rice, and
sunflower were added. In 2006, revenue insurance
accounted for 57 percent of all acreage insured
under the Federal crop insurance program, including
about three-quarters of the insured acreage of corn,
soybeans, and wheat, the top three crops in the
program.
When buying revenue insurance,
a farmer chooses, before planting, an insurance
plan and a coverage level (a share of expected revenue)
and pays a portion of the insurance premium that
is based on the risk covered. If actual revenue
at the end of the season falls below the coverage
level multiplied by the amount of expected revenue,
the insurance pays an indemnity equal to the difference.
Premium subsidies have been key
to inducing farmers to increase their crop insurance
coverage. Subsidies for crop insurance, especially
for revenue insurance, have been rising since the
1990s. Between 1996 and 2006, the share of subsidized
revenue insurance premiums grew from less than 30
percent to 56 percent. In 2006, the Government paid
$1.8 billion in revenue insurance premiums, and
producers paid $1.4 billion.
The overall increase in premium
subsidy has included increases in the subsidy rates
for higher coverage levels. In response to the increased
subsidies and reduced premium costs, producers have
insured higher proportions of their expected revenues.
In 1999, for instance, about half of the acres insured
under revenue insurance were covered at the 70-
percent level or higher. By 2002, about three-quarters
of the revenue-insured acres were at coverage levels
of 70 percent or higher. The most popular coverage
levels have been 70 and 75 percent of expected revenue.
The variety of options under the
Federal crop insurance program gives producers several
choices for determining their revenue coverage.
Two have been especially popular: coverage that
increases if the harvest-time price of the crop
is higher than the pre-planting-time price and coverage
that is based on separate insured units on the farm.
The increasing price feature, called “replacement
cost” or “harvest-price option,”
is attractive to producers because an increase in
commodity price can be associated with a drop in
yield. The higher coverage would allow a producer
to replace lost production at the higher price.
Subdividing insured acreage is attractive because
if units are insured separately, losses on one unit
are not offset by production on another.
Revenue Insurance Guarantees
Fluctuate With Markets
Crop revenue insurance covers
variation in market revenue only over a growing
season. Revenue is determined from market prices
at the beginning and end of the season. Revenue
insurance does not cover interyear revenue variation.
The dollar amount of revenue coverage can rise or
fall from year to year to reflect different market
conditions.
Allowing insurance coverage to
vary with market conditions reduces interference
with market signals. If prices used to calculate
revenue for insurance purposes exceeded expected
market prices, producers would have an incentive
to alter production merely to collect on the insurance.
If prices were below expected market prices, the
risk protection provided by the insurance might
be insignificant and producers would have little
interest in the protection offered. Such “overinsurance”
or “underinsurance” would also undermine
an insurance program’s balance between premiums
and indemnities and could make the program unsustainable.
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Canada’s experience in the
1990s with the Gross Revenue Insurance Plan (GRIP)
illustrates the problem of overinsurance. In 1991,
the Canadian Government offered farmers a commodity-level
revenue insurance that used historical prices rather
than current prices to set guarantees. Specifically,
GRIP used average prices over the previous 15 years,
which included the relatively high prices of the
late 1970s and early 1980s. Because indemnities
(insurance payments) were based on the difference
between high historical prices and prices in the
insured years, indemnities greatly exceeded premiums.
By 1998, GRIP was largely discontinued due to financial
pressure on the government.
The revenue insurance plans in
the U.S. Federal crop insurance program use prices
that reflect market conditions in the insurance
period and that are observable by both producers
and insurers. In particular, the plans use prices
of futures market contracts to determine the value
of the insured commodity at the beginning and end
of the season, which simplifies calculation of revenue
guarantees and losses and ensures that coverage
is consistent with current market prices. The availability
of data on market expectations is critical to operation
of the revenue insurance policies of the crop insurance
program.
Whole-Farm Revenue Insurance:
Simple Idea, Difficult To Administer
A more broad-based form of revenue
insurance—whole-farm revenue insurance—covers
all farm enterprises and thus may have wider appeal
than commodity-based insurance. Like single-commodity
insurance, whole-farm insurance charges risk-based
premiums and makes payments (indemnities) when revenue
drops below expectations. But, instead of covering
revenue for each crop on the farm separately, whole-farm
revenue insurance covers combined revenue.
USDA’s Risk Management Agency
operates two small programs of whole-farm revenue
insurance: Adjusted Gross Revenue (AGR) and Adjusted
Gross Revenue-Lite (AGR-Lite). Intended for producers
of commodities for which single-commodity crop yield
and revenue insurance are available, AGR and AGR-Lite
have limits that keep them from being full-fledged
whole-farm insurance programs. Although simple in
concept, developing and operating a whole-farm revenue
insurance program that would be available to all
farmers is not likely to be simple.
A major issue would be determining
and measuring the risks covered. Developing premium
rates for whole-farm insurance is complex because
coverage includes all prices and yields and their
interrelationships on a particular farm. Expanding
the limited AGR and AGR-Lite insurance plans into
a program for all farms would likely mean covering
risks from more farm enterprises, particularly more
specialty crop and livestock enterprises, which
would make such a program even more complex. Moreover,
if the insurance were to cover net, rather than
gross, revenue, input cost variability would have
to be considered in determining coverage and measuring
risk.
Determining the level of income
and the farming activities covered by a whole-farm
insurance policy would challenge both producers
and insurers. AGR and AGR-Lite rely heavily on tax
records but often have to make adjustments to account
for changes in inventory to make insured income
levels correspond to production in a calendar year.
Most farmers report income on their tax schedules
when the money is received or paid, which may not
reflect the underlying annual revenue risk.
How well a farm’s historical
income indicates expected income in the insurance
year is also critical. Farm operations often change
size and commodities from year to year. For example,
expanding a farm by renting additional land or switching
land from corn to soybeans can dramatically change
overall expected gross revenue. These changes result
in variability in income that is not simply the
result of risk or unexpected variability. Unless
income data are adjusted, a process that is likely
to be complex, farms can be significantly overinsured
or underinsured.
Verifying insurance losses and
paying claims pose an additional problem. Existing
revenue insurance payments at the commodity level
are triggered by readily observable prices and
crop losses. Whole-farm revenue insurance, in
contrast, incorporates prices and production of
many farming activities that are hard to verify.
Complex rules have been developed for measuring
and validating insured losses under AGR and AGR-Lite
policies. In addition, because tax filings are
used for documenting income, several months can
elapse between the event that caused a drop in
income and the filing of the documentation for
a claim (see
“Canadian Agricultural Income Stabilization:
A Whole-Farm Revenue Program”).
Can Revenue Insurance
Provide Adequate Risk Management?
Although revenue insurance has
several characteristics that make it a valuable
risk-management tool, it may not provide farmers
with what policymakers and the farmers themselves
regard as adequate coverage. Because both single-commodity
and whole-farm revenue insurance combine risks,
they can mean less frequent, lower payments to farmers
when the risks offset each other. Single-commodity
revenue insurance combines price and yield coverage.
Whole-farm revenue insurance combines coverage of
individual commodities on a farm. Experience suggests
that farmers prefer to separate insurance protection.
For example, most participants in the Federal crop
insurance program subdivide their farm acreage for
insurance purposes, even though doing so requires
that they forgo a premium discount.
Because insurance design requires
that insured producers pay the first portion of
any loss (the deductible), it may seem that insurance
cannot provide adequate protection because coverage
will always be less than the full value of the item
insured. While reducing deductibles can make insurance
more attractive, it also increases costs as well
as loss claims, and tends to lead to overinsuring,
thus interfering with market signals.
Neither single-commodity nor whole-farm
revenue insurance provides coverage against multiple-year
income declines. These policies base coverage on
historical yields and expected market prices, in
the case of single-commodity insurance, and on historical
income, in the case of whole-farm insurance. If
these measures indicate a revenue decline, revenue
insurance coverage will decline. One way to counteract
this is to use fixed target prices or target revenues
instead. This modification, however, would make
the protection less of an insurance tool and more
of an income-support program.
| Canadian
Agricultural Income Stabilization:
A Whole-Farm Revenue Program |
| Since 2003, the Canadian
Federal and provincial governments have operated
the Canadian Agricultural Income Stabilization
(CAIS) program for Canadian farmers. Although
not truly insurance, CAIS has several characteristics
of a fully subsidized whole-farm income insurance
program. CAIS allows participants to shift
the risk of income declines to an insurer,
the government in this case. Participants
establish insured amounts of income based
on recent history. Like insurance, the program
makes immediate and ongoing protection available
to all participants. Unlike insurance, participants
are not charged a risk-based premium. Instead,
they pay a flat fee per amount covered.
Under CAIS, the amount of
income to be covered is based on a producer’s
margin. The margin is defined as income minus
expenses directly related to the primary production
of agricultural commodities on the farm. In
particular, income is the sale of agricultural
commodities and proceeds from production (crop)
insurance but excluding other government payments;
expenses are costs, such as feed, fertilizer,
and pesticides. CAIS payments are made when
a farmer’s claim-year margin falls below
his or her reference margin, which is an Olympic
average of the producer’s margin for
the previous 5 years. (An Olympic average
is a 5-year average that “drops”
the highest and lowest values.)
The CAIS participant annually
selects a level of protection, a proportion
of his or her historical margin. Substantial
government benefits are paid if the participant’s
margin falls. As the producer’s loss
deepens, government assistance increases.
The first 15 percent of a producer’s
loss (the part between 100 percent and 85
percent of the margin) would be shared 50-50
with the government. For the next 15 percent
of loss, the government’s share is 70
percent of the drop in margin. For the portion
of the decline less than 70 percent of the
reference margin, the producer would receive
80 percent from the government.
CAIS provides for situations
in which the margin is negative, that is,
when expenses exceed income. If the producer
satisfies certain criteria, the producer is
eligible to receive 60 percent of the program-year
margin decline that falls within the negative
margin. However, the maximum total government
contributions that a farmer can receive under
CAIS in a given year is capped at the lesser
of C$3 million, or 70 percent of the margin
decline of the program-year margin relative
to the reference margin. Any negative portion
of the program-year margin is included in
the calculation of the 70-percent cap.
CAIS has undergone two major
changes since it was introduced. One reduced
the participation cost to producers. In the
first years of the program, 2003-05, a participant
was required to maintain a deposit of 22 percent
of the reference margin in a CAIS account.
In 2006, the deposit was replaced by an annual
“participation fee” of C$4.50
per C$1,000 of margin covered. The other change
was to include a “market loss”
in payments to producers. In 2006, the method
of calculating inventory changes was amended
so that losses in inventory values caused
by declining commodity prices are reflected
in a producer’s payment. This method
is applied to market commodities but not to
productive assets such as breeding livestock.
Additional payments, based on the new method,
were made to producers for 2003-05. |
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