Is there a viable market for area-based crop insurance?

From its inception in 1938 the U.S. Federal Crop Insurance Program (FCIP) has provided Multiple Peril Crop Insurance (MPCI) policies that protect against individual farm yield losses. Since the mid 1980s, MPCI yield guarantees have been based on the actual production history (APH) yield for the insured unit. In its most basic form, an APH yield is calculated as a rolling four- to ten-year average of realized yields on the insured unit subject to no more than a 10% annual reduction. (1) Various APH-based revenue insurance products are also offered through the FCIP. (2)

Since 1993 an area yield insurance product called the Group Risk Plan (GRP) has been offered through the FCIP for selected crops and regions. An area-based revenue insurance product called the Group Risk Income Protection (GRIP) is also offered for selected crops and regions (Edwards 1999). Farm-level yield and revenue insurance products currently account for approximately 76 % of total FCIP liability. However, the area-based products have grown from only 3% of total FCIP liability in 2002 to 9% of liability in 2005. (3)

The performance of area-based insurance products, relative to APH-based, farm-level insurance products, is an important issue within the FCIP. Some believe that the area-based insurance products provide farmers with a valuable, and less expensive, alternative to the farm-level insurance products (Baquet and Skees 1994). Others think that the basis risk associated with area-based products makes them unattractive for most farmers. Examples of the latter view are found in recent testimony by crop insurance industry representatives before the General Farm Commodities and Risk Management subcommittee of the U.S. House of Representatives Committee on Agriculture (Brost 2006: Parkerson 2006). From a farmer's perspective, the choice between the area-based and farm-level insurance products typically comes down to a trade-off between higher basis risk (with the area-based products) and higher premium cost (with the farm-level products).

This article uses farm-level yield data and actual insurance premium rates to determine the relative desirability of MPCI and GRP for heterogeneous production regions (selected South Carolina cotton and soybean and Georgia cotton production regions). Because it avoids two important shortcomings that exist in previous research, we believe that the analysis presented here is the most realistic comparison of the two insurance products published to date. Previous studies have either imposed a highly unrealistic assumption of actuarially fair MPCI premium rates (Barnett et al. 2005; Smith, Chouinard, and Baquet 1994; Miranda 1991) or utilized a representative farm approach in a fairly homogeneous production region (Wang et al. 1998).

By assuming actuarially fair premium rates, previous studies have implicitly ignored the wedges that exist in actual premium rates charged to farmers. This assumption biases results in favor of MPCI since premium rate wedges tend to be much higher for MPCI than for GRP. Barnett et al. (2005) recognize this limitation but assume actuarially fair premium rates to avoid the cumbersome task of calculating APH yields and associated actual MPCI premium rates for each farm included in the study. Wang et al. (1998) constructed actuarially fair premium rates for a representative farm and then artificially inflated those premium rates by up to 50% to simulate the effect of premium rates wedges. Since Wang et al. (1998) present no actual premium rate data it is unclear whether a 50% load is sufficient to reflect the true premium rate wedge in MPCI policies for the study crop and region. By comparison, the findings presented here show that MPCI premium rate wedges for South Carolina cotton and soybeans and Georgia cotton vary between 38% and 286%.

The relative performance of GRP and MPCI is inherently a farm-level question. GRP basis risk can vary greatly across different regions and even across farms within a given region. Thus, it is highly desirable to compare the performance of GRP and MPCI using actual yield data for a large number of farms. The analysis presented here is based on actual farm-level yield data so it more realistically accounts for GRP basis risk within heterogeneous production regions. In contrast, Wang et al. (1998) conduct their analysis using a representative corn farm in southwest Iowa. Their approach cannot account for differences in GRP basis risk across farms. While this may not be a major limitation for the relatively homogeneous production region considered by Wang et al. (1998), it does make it difficult to generalize their findings.

Thus, to the best of our knowledge, this is the only study that uses actual farm-level yield data for a large number of farms in a heterogeneous production region (to account for farm-level differences in GRP basis risk) and undertakes the time-consuming task of calculating the actual MPCI premium rates that would be applied to each farm (to accurately account for MPCI premium rate wedges).

MPCI Premium Rate Wedges

The term "wedge" is sometimes used to describe the difference between the premium cost and the expected indemnity for an insurance product (Wang, Hanson, and Black 2003). A positive (negative) wedge implies that the premium cost is greater (less) than the expected indemnity. Positive wedges are common since the premium revenue must be sufficient to cover desired profit margins, financial reserves for widespread loss events, and administrative and operating costs. FCIP premium rates are designed to have positive wedges that are smaller than those for most insurance products since the federal government pays for most of the administrative and operating costs. However, several studies have noted that MPCI is subject to misclassification (adverse selection) and moral hazard problems (Just, Calvin, and Quiggin 1999; Coble et al. 1997; Smith and Goodwin 1996; Quiggin, Karaginannis, and Stanton 1994). These problems increase the magnitude of MPCI premium rate wedges (Wang, Hanson, and Black 2003; Wang et al. 1998).

Federal premium subsidies increase participation in the FCIP by masking the impact of positive wedges (Wang, Hanson, and Black 2003). However, due to MPCI misclassification and moral hazard problems, some potential insureds still face positive wedges that more than offset the federal premium subsidy. In other words, despite significant federal premium subsidies, MPCI can still have a negative expected value (positive wedge) for many potential insureds (Skees 2001; Wang et al. 1998). For some crops and regions the impact of positive wedges on MPCI premium rates may be such that GRP is a more attractive risk management alternative.

GRP Basis Risk

GRP is essentially a put option on the average yield for a production region. Indemnities are triggered by shortfalls in the area average yield rather than farm-level yields. For this reason, GRP requires no farm-level risk classification. If the area is sufficiently large, GRP is not susceptible to moral hazard problems since the actions of an individual farmer will have no noticeable impact on the area average yield. GRP also has relatively low transaction costs since there is no need to establish and verify APH yields for each insured unit nor is there any need to conduct on-farm loss adjustment.

Because farm-level yields are not perfectly correlated with the area average yield, GRP purchasers are exposed to basis risk. It is possible for a GRP purchaser to experience production losses on his/her farm and yet not receive an indemnity because there has been no shortfall in the county average yield. On the other hand, it is also possible for a GRP purchaser to not experience production losses on his/her farm and yet receive an indemnity triggered by a shortfall in the county average yield. GRP basis risk is generally higher the more heterogeneous the production conditions in the county (Miranda 1991). Variability in elevation, soil type, drainage, and other relevant factors will cause farm-level yields to be less correlated with the county average yield (Chaffin and Black 2004).

GRP purchasers in the Southeast would likely be exposed to relatively high basis risk since the region has significant geographic variability in factors such as soil quality, drainage, and production practices (e.g., irrigated versus dryland production). Despite this, if MPCI premium rates contain large positive wedges, GRP may still be a viable alternative for many producers in the region.

Empirical Analysis

The certainty equivalents of MPCI and GRP are calculated under three premium rate schemes: actuarially fair premium rates, unsubsidized actual premium rates, and subsidized actual premium rates. Using actual MPCI premium rates implicitly incorporates the positive wedges paid by actual MPCI purchasers. The analysis is conducted using data from 1,282 Georgia cotton farms, 198 South Carolina cotton farms, and 265 South Carolina soybean farms.

Data