TESTIMONY OF
ALAN S. WALTER
President, Agricultural Risk Management North America, Inc.
Before the
Senate Committee on Agriculture, Nutrition, and Forestry
regarding
Risk Management in Agriculture
April 17, 1997
Mr. Chairman and members of the Committee: Thank you for the opportunity to present my personal views on issues with respect to the future management of agricultural risks. I have been very fortunate to have had the opportunity to serve in various roles in both the private and public sectors during reform and growth of the crop insurance (see endnote for a listing of previous experience). I have spent a great deal of time and effort thinking about and analyzing some of the issues to be discussed today. Hopefully, this perspective will be of some value to the Committee. I want to stress that these are personal views and may not necessarily reflect those of our clients.
It is recognized that there are many types and sources of risk in the crop production part of agriculture including yield, market price of commodities, input costs, and finance costs. However, the focus of this presentation is on the potential for the management of agricultural risk, especially yield and price risk, in the future. Although there are important current program, budgetary, and reinsurance issues with respect to Federal Crop Insurance, I will focus on the longer term horizon. Specifically, I would like to address the natural and potential roles of both the private and public sectors in providing crop risk management services including bottlenecks or limitations that must be overcome.
A major development in the past year has been a substantial expansion in price/revenue coverage tied to the crop insurance program. The issues that relate to this type of coverage cannot be entirely separated from general crop insurance program issues. Therefore, I will address this type of protection as a part of the overall crop insurance program review attempted in these remarks.
I divide my remarks into three sections:
A brief recap of the events and policies that led us to where we are; An overview of risk exposure, capital needs and potential risk capital sources for agricultural risk management; A possible future in the supply, demand, pricing, and decision making in delivering risk management services to U.S. Agriculture.
Where Are We and How Did We Get Here
I will recap some history since it is relevant to future directions. Passage of the 1980 Crop Insurance Act was a critical milestone. Prior to its passage, we had a crop insurance system that had sound basic elements in design but with an underfunded and lackluster marketing effort resulting in low participation. Therefore, most risk protection was provided either through an ASCS disaster payments program as an adjunct to the commodity support programs or through nearly annual ad hoc responses to major or local crop failures.
Passage of the 1980 Crop Insurance Act led to several results. Risk premium subsidies were introduced. In addition, the private sector was brought into delivery both as sales agents for Federal Crop Insurance policies and as companies that could issue subsidized policies reinsured by the Federal Crop Insurance Corporation. The yield portion of crop insurance began to become individualized and based, at least partially, upon the yield history of the farmer. Crop insurance remained a program in parallel to the basic commodity price and income support programs, and participation was negatively impacted by the availability of the other forms of support. However, use of crop insurance did expand substantially.
The Federal program of crop reinsurance introduced in 1981 has had profound impacts upon the delivery of risk management in the U.S. Having an involvement in the design and operation of the reinsurance program in its early years, my colleagues and I thought that we were in effect creating a new industry—or at least a sub-industry. We did not realize the extent to which the types of incentives provided would impact upon the growth and formulation of this sub-industry.
The reinsurance program terms were based upon pragmatic considerations. Generally, there was limited if any private sector confidence in the basic actuarial structure, partially due to program experience and partially as a result of lack of private sector familiarity with the program. The industry had very limited technical abilities to administer program terms and to adjust losses; it continued to struggle for years in handling the tons of paper annually associated with multiple peril crop insurance administration. The agency force did not understand the program well. Program research and development as well as actuarial support remained in the public sector hands because that was where the data and the human resources resided.
There was also an extreme reluctance in the private sector in the early years to assume more than a minimal level of risk for several reasons. First, the catastrophe risk exposure was apparent; it was much greater than for crop-hail insurance, and this contingency was not easily managed. Second, the most aggressive companies at that time assumed little risk in their other lines of insurance—generally crop-hail—as they utilized the private reinsurance markets for most of their risk capacity. Third, the reinsurance terms negotiated did not especially encourage private risk retention. Thus, the incentives provided somewhat emphasized marketing efforts with some but lesser rewards for assuming normal insurance underwriting functions.
The program expanded after passage of the 1980 Act and then remained somewhat stable overall, although with a large share of the business shifting into private hands, until the 1988 drought. There was an attempt in the interim to near total privatization of all functions, even catastrophe exposure, but that died an early policy process death. Ad hoc disaster assistance continued, however. Federal budgetary support for the program and for mitigation of agricultural disasters did not seem to be an issue or major concern.
The program participation nearly doubled following the 1988 drought in major production areas. A transition to totally private delivery began. The insurance products offered remained constant, although actuarial improvements were sought and probably accomplished. The program became more complicated, however, with the actuarial refinements and rules that were added.
The terms of reinsurance became increasingly important to both the private and public sectors. These terms, negotiated every year or two, guided billions of dollars of protection and hundreds of millions of dollars of subsidies. Thus, rather than market forces guiding the allocation of resources for crop insurance, decisions became heavily based upon the negotiated terms. Overall, the program direction remained centrally controlled to a high degree, and this central control remains a fact today. The FCIC became increasingly proficient or inclined to respond to local or regional crop disasters or problems and in issuing frequent, and generally late, directives to change the program.
The Crop Insurance Reform Act of 1994 made further substantial changes in the program. At least a basic level of nearly free coverage was required for most farmers with benefits linked to other programs, especially the price and income support system. Crop insurance premium subsidies were increased. New crop insurance options were authorized with a procedure mandated for consideration by the FCIC of new programs proposed by the private sector. This flexible language provided authorization for Federal support for a broad spectrum of agricultural risks, including commodity price or revenue.
The major change in agricultural policy with passage of the FAIR Act also had substantial implications on potential value of the crop insurance programs. With the phase-out of price and income support programs, the interest in using crop insurance as the vehicle for this risk management intensified.
We have, thus, witnessed substantial change in agriculture and crop insurance program scope, features, and operations since 1980. However, in several key parameters, there has been precious little change since the middle of the previous decade.
I would like to digress briefly with a short note on agriculture. Agriculture itself is increasingly subject to market forces. The change in U.S. policy and the increase in global trade results in a price discovery and resource allocation process based upon global events. There has been debate about whether these changes are risk increasing or decreasing; there is agreement that risk factors will at least be different although it may take a few years to fully understand the parameters. It can be expected that annual decision-making in agriculture has become more important with market forces impacting more upon the production and marketing of crops. Risk Management in agriculture has become a buzzword with it being talked about seemingly everywhere. Crop insurance has become part of something that is bigger and more important. However, while the major production decisions in agriculture will now be made based upon market conditions, risk management decisions remain heavily impacted by government policy and programs.
The basic crop insurance coverage offered to farmers remains nearly the same as a decade and a half ago, but with a few added options including price or revenue protection and area yield coverage. Delivery is primarily through the private sector. Subsidization of risk premium and administrative overhead drives a lot of decisions, and has made it competitively difficult to offer any alternatives to the Federally supported program. A large share of the capital associated with catastrophe exposure and a significant share of the capital required for normal risk assumption is provided by the public sector via a reinsurance agreement. These reinsurance terms are renegotiated periodically through a process of trauma and turmoil with arguments on both sides whether the risk-reward terms are equitable. Paperwork and administrative complexities seem to continually increase. A major innovation has been in privately developed products—especially revenue or price protection, but the lengthy process justifiably required (due to Federal participation in subsidization and in the risk) for review and approval has slowed down their introduction. Most major decisions in terms of retail product--price of coverage, terms of coverage and administrative rules--are made centrally at a Federal agency.
Although the industry has become intensively competitive in some aspects of delivery, the market process is not utilized in decisions with respect to product pricing or risk capital allocation. The process has been based upon a presumption that if enough trained and educated people are involved through a centrally directed process that the right decision can result. The risk of using this process is that it will allocate an inefficient level of capital into the program and possibly under-price the government capital that is provided. It will also retard changes in the risk capital markets that could result in additional capital being provided based upon more complete pricing information.
Risk in Agriculture and Capital Implications
I would now like to address the risk inherent in agriculture, especially those related to crop yield and revenue insurance products associated with yield insurance. The level of risk, in simple terms depends upon:
The perils or risks covered The level of coverage provided (or, inversely, the amount of risk that is deductible) The scope of the program, or participation
This listing does not identify who bears the risk, but simply catalogues the factors that define the level. The level of coverage provided does not seem a significant issue, although there is a general lack of recognition in the user market as to how much more risk there is for a higher level of coverage—such as increasing a yield guarantee from 75% to 85%. An issue has been the degree to which the Federal program of crop insurance should take on involvement in the price risk.
It is generally agreed that agriculture is subject to considerable systemic risk, which is contrary to a fundamental principle for operation of a normal insurance program. That means that there is a probability of catastrophic scope of losses. When drought hurts the corn yield of a farmer in Iowa or Indiana, there is a good chance that yields suffer in many states on numerous crops. Price is also a systemic risk—related to world market conditions.
The crop insurance program experience demonstrates the systemic risk in offering yield insurance. Since 1981, we have seen the overall program loss ratio range from a low of 63% (1994) to a high of 245% (1988).
I made a statistical estimate of the exposure to loss in the current program based upon a simulation analysis. It should be recognized that these estimates are at the tail of a distribution, which implies an uncertain level of accuracy. With this caveat, using 1996 premium levels and assuming that all policies were for yield coverage only (no price or revenue exposure), there is a 5% chance for an underwriting loss of at least $2.3 billion. An underwriting loss is defined as total indemnities minus total premium (farmer-paid plus Federal risk premium subsidy) This underwriting loss is for the system; it could be borne by the private sector, the public sector, or shared.
If 25% of the coverage were policies covering price and revenue similar to the Crop Revenue Coverage (CRC) concept, the overall underwriting losses in excess of the additional premium would increase by another $200-250 million with the occurrence of the one year out of twenty event. Delivery costs are also excluded. This estimate of added price related risks may be under-stated somewhat due to the pattern of states and crops on which a disaster would strike, but it is used since no better estimate could be constructed in the time available. Thus, the potential underwriting exposure in the system with a one in twenty year event is about $2.5 billion.
Table 1 summarizes an estimate of underwriting losses for more frequent events, as well.
As shown in the Table, an underwriting loss of about $1 billion is probably akin to a one in five year event at current participation levels with a $1.9 billion loss, with CRC coverage, about a one in ten event.
The added catastrophe exposure for the price/revenue coverage is perhaps surprisingly small, even with the caveat expressed earlier. However, for the type of catastrophic event considered, there first must be widespread yield loss. In a catastrophe event, the payments are made at a higher amount per unit of production (bushel or pound) because of a run-up in prices. Actuarially, about 75-85% of the risk in a CRC type coverage can be attributed to the yield component with 15-25% incrementally added for the price or revenue exposure. The CRC type of added loss is limited to the relative increase in price between pre-season and harvest. This increase has seldom exceeded 30% for any of the CRC crops. However, this increase may have been softened by the general farm programs, which often resulted in a heavy accumulation of stocks. Thus, for this analysis, it has been assumed that the change in price in a year with catastrophe losses, such as a drought, is an increase of 40%. So, assuming that a fourth of the buy-up coverage is on the CRC style of policies and an increase in loss payments of 40% on policies in force, we get added losses in the magnitude shown.
Capital Availability for Volatile Risks
The question arises as to the extent to which this level of loss exposure could be handled in private markets. We can first highlight sources of capital that are being tapped for other types of exposures subject to catastrophic loss. Examples would be coverage relative to hurricane in coastal areas and earthquake coverage in California. I am not an expert in this area, but have some general familiarity with some of the trends.
First, the insurance companies writing the coverage often can assume major layers of risk with the amount depending upon the company. However, nearly all companies are increasingly emphasizing a thorough analysis to accurately quantify their exposure and the capital at risk. Although different industries, many of the risk concepts being employed could be extended to an analysis of the risk exposure in crop insurance.
Second, the reinsurance industry, which is a global business, offers capacity. In 1994, the global premium written by professional reinsurers was $66 billion with a compound growth rate of nearly 16%. With this rate of growth, the global reinsurance premium may exceed $100 billion this year. This industry has had a major infusion of capital in recent years to support the premium growth. Some of this increased capacity has focused specifically on handling catastrophe types of exposure.
Third, there are specialty insurance sources of capacity. Lloyds of London is one source. The Lloyds market has been a source of capacity for catastrophe exposure and for crop risks for many years, especially for some of the more difficult risks. Although I am not aware of the details, I understand there is now a computer network based catastrophe risk exchange. Apparently, this institution facilitates risk swaps for companies that have significant but different exposure. Presumably, an insurance company with California earthquake exposure could swap it for eastern hurricane exposure or, perhaps, Midwestern crop insurance risks. Over time, this concept could be applied to agriculture on a global basis.
Fourth, businesses or insurance companies exposed to catastrophe risk have had the opportunity to utilize catastrophe contracts traded on the commodity exchanges. These markets have been relatively new, and a lot of effort has been expended in making them responsive to market needs. It takes considerable time and effort to develop futures and options contracts that match the risks incurred through insurance. Several years have been invested in developing a property casualty catastrophe contract acceptable to the insurance industry.
Fifth, private acquisition of debt capacity is sometimes utilized. These deals give the organization exposed to the risk the potential to issue bonds or other debt instruments should a catastrophe occur. There are obvious limitations to the use of debt capital in funding losses, but it can provide a means of cash flow and other benefits.
Sixth, there are agreed upon arrangements whereby the company exposed to the risk can issue equity instruments if the catastrophic event occurs. This provides the insurance company, as an example, with a means to replenish the policyholders surplus very quickly.
Seventh, there can be other private placements that provide risk capital when needed.
A key feature of all of these risk capital sources is that terms are determined by market conditions. There is little regulation of terms for these sources of capacity other than normal business law and the special regulations that apply to exchange traded instruments.
We can then focus more on how much capital availability there might be to support agricultural risks including the price or revenue component in crop insurance contracts. This question can then be answered as—it depends. I will now turn to future possibilities and the factors upon which this answer depends.
Options for Agricultural Risk Management We now can turn to a review of how the risks in agriculture can be managed. First, I would like to comment upon the unique aspects of the price/revenue products from the standpoint of identification of the relative source of the risk—yield versus price. Then, we can turn to the management and flow of agricultural risk through the system.
Identification of Risk in Revenue Type of Products
I would first like to emphasize that the primary within-season risk in agriculture from a statistical perspective remains a yield risk. Much of the price risk is multi-year—the possibility that prices will remain low for a several year period. However, the variability in price from the time of planting until harvest is less than the variability that can be expected in yield. Until a farmer has managed the yield risk, it proves difficult to deal with the intra-year price risk. The yield risk can be managed alone, as through a traditional crop insurance policy, or through a combination yield and price or revenue policy.
We have seen two forms of combination (yield and price/revenue) policies introduced broadly into the market. The CRC policy has the most features including protection against low yield, low revenue, or high price. This type of coverage gives a farmer a backstop so that forward marketing contracts can be executed with risk protection should there be a crop failure with an inability to deliver the crop.
The Income Protection (IP) and Revenue Insurance (RA) policies provide protection against low crop value—yield times price. They in effect combine certain benefits from the traditional crop insurance and price support programs. However, since they do not offer replacement value protection as does CRC, they are less valuable for use in supporting forward marketing of a crop.
The price/revenue risk component of a CRC policy can be identified; the mechanics allow a determination of what the premium and losses would be under a traditional MPCI policy and the increased premium and loss payments associated with the added coverage. It is at least theoretically possible for the added risk on these policies to flow separately—the added risk need not necessarily be assumed by the Federal Government through its reinsurance.
It is less straightforward to separate the price and yield risks in the IP and RA policies due both to the coverage and as a result of the mechanics of their administration. It would be less feasible to separate the reinsurance of the price and yield risks than with CRC.
Providing Risk Protection—General Program Options
I would like to suggest that there are two broad options for the future of yield and limited price risk management in agriculture. There are obviously many suboptions that could be stated, but these two highlight some of the key factors that will impact upon the future for risk management in agriculture and the capability of the agricultural system to respond to needs for a rapidly changing industry. The two options relate to both the Federal role in providing risk protection and in the acquisition and pricing of risk capital.
These options are summarized in Table 2. The first option is, more or less a continuation of current program structure, Federal role, and private sector responsibilities. It is consistent with a view that agriculture is a high risk industry and that it is in the public interest to continue to provide heavy support and intervention in managing the risk. This option also is consistent with the view that the public should subsidize most heavily the farmers who have the most risk. Primary keys to success are twofold: Having an agency responsible for management of the program that can make the thousands of annual decisions in a responsive and timely manner; and, second, having a stable source of public funding since the system rests heavily upon subsidies and public capital.
A continuation of this option means that Government will have an increasing role in the management and pricing of risk transfer. The public will make virtually all decisions with respect to the actuarial costing of crop insurance purchased by farmers. It will in effect decide how much of the risk capital will come from private and public sources. The public will also in effect decide how much effort should be expended in marketing and for product development. Public decision-making will determine how much expansion there will be in the revenue/price insurance coverage, and who will bear the risk. Innovation, change, and responsiveness will primarily be a function of Government funding and the human capabilities of the public sector.
The second option could be based upon a view that farming is a business with potentially high risks that can be managed through risk management services offered by the private sector with limited public support and intervention. It can be viewed that the management of the risk should be primarily based upon commercial transactions between the farmer and the professional risk management community. The professional risk management industry would offer services to the farm sector, but with a structure for public assumption of a degree of the catastrophic risk exposure and for subsidization of the use of risk protection to the extent decided in the policy arena. Although I am not a lawyer, it would appear to me that most of the features of this option could be implemented under current legislative authority. Several elements of program or institutional change would probably be required to facilitate this option. This option would take at least a short term transition to implement.
I would like to focus on the second option, and its implications upon both the public and private sector if this approach were adopted. First, that this option could even be considered is in large measure due to efforts of both the public and private sector over the past 15 years that resulted in actuarial improvements and in the development of a capability to efficiently deliver retail products to the farm community. Changes in the risk capital markets cannot be ignored either.
Factors that would slow or limit transition to this option would include the development a private capability to assume development and actuarial support functions. A second limiting factor for the private sector would be acquiring the necessary risk capacity. The third limiting factor would be in the public sector making a transition to its new role. This option implies a government role in assuming at least a part of the catastrophic or systemic risk exposure, which makes it much more possible and less costly to acquire private capital. This private capital would have to be supplied from nearly all of the sources cited in the previous section. Even though the capital would be provided by numerous sources, the skills and capabilities of the insurance industry in determining capital requirements and in managing the capital would seem imperative. This industry is experienced in computing its exposure, in making decisions with respect to the amount and types of reserves required, and in managing the reserves.
Institutional change may be required to provide some of the capital and specifically for the price/revenue component of the package. Options contracts can be a natural type of risk management device for the system to utilize. However, the current types of exchange traded options do not match totally with the risk that would be assumed. An Asian form of an option (based upon average prices over a period) would appear to more closely match the risk assumed through the current type of price/revenue products with a yield component (such as CRC). I would expect that over time most of the risk from the CRC types of policies could flow into the private risk capital markets, if the public did not under-price its risk capital.
A critical factor to providing the risk capital will be the rate of return available on capital invested. If this capital pricing is based upon market conditions, there will be an efficient solution that will provide important information about how much risk is in agriculture. To the extent that risk management might be under-utilized with more market based pricing, subsidization can make up the difference. This pricing will also assist the public in managing its resources as there has seemingly been a means to expose government capital to losses beyond what was intended. Thus, the 1981-95 loss ratio of 135% probably has not been corrected as quickly as were market forces more in play.
A transition to a more privatized system has obvious impacts upon the public sector. Important public functions would remain with responsibilities for providing systemic risk capacity, in delivering subsidy per public policy, and in carrying out some regulatory functions.
The easiest solution to current concerns and problems will perhaps be to apply limited fixes and continue on with more or less the present system. However, this choice will continue to involve the Congress and the program agency in numerous decisions as to how to best allocate a shrinking Federal budget. The amount and the process through which Federal dollars are available will have a substantial impact upon the responsiveness of the risk management system. Hopefully, this presentation offers an idea or two on how a new approach might provide a more efficient system with the potential for the right amount of public intervention. ENDNOTE Previous positions held by the Alan Walter include:
Staff Economist with the U.S. Department of Agriculture, 1974-79 including senior policy analysis responsibility that ultimately resulted in the formulation of the 1980 Crop Insurance Act. Economist on Detail to Congressional Budget Office, 1977, with responsibilities for the analysis of 1977 Farm Bill provisions including disaster assistance and Crop Insurance. Staff Economist to Federal Crop Insurance Corporation, 1979-81, with responsibility for implementation of the 1980 Crop Insurance Act. Director of Reinsurance for Federal Crop Insurance Corporation, 1981-84, with responsibility for the formulation and implementation of a program of reinsurance. Staff positions with Crop-Hail Insurance Actuarial Association and its successor National Crop Insurance Services, 1984-90, a technical support trade organization for the U.S. crop insurance industry. Responsibilities included actuarial analysis and development of crop insurance programs. During this period, there was active discussion and review of alternatives for privatization of crop insurance functions. President & CEO, National Crop Insurance Services (and positions with predecessor organizations), the major U.S. crop insurance technical support trade organization, 1990-93; NCIS activities included strategic planning for the U.S. crop insurance industry. Principal, Walter Agricultural Consulting, 1993-95; Consulting company providing services primarily to crop insurance and reinsurance companies in the U.S. and other countries.