Federal Crop Insurance Ratemaking and Profitability Projections October

Federal Crop Insurance Ratemaking and Profitability Projections October 25, 2010 Richard Bill, FCAS, MAAA R. A. Bill Consulting Bill. consulting@frontier. com

Overview • • Coverage Perils Insured Federal/Private Partnership Coverage Examples Ratemaking Considerations Profitability Considerations Standard Reinsurance Contract (SRA) Projected Profitability RABill Consulting 2

Coverage Provided • The policy Guarantees the yield of the crop or the revenue from the crop • Loss is not one event but is based on crop production (and price for Revenue Insurance) at the end of the season RABill Consulting 3

Perils Insured • • Too Dry (Large Area) Too Wet Hail Insects Prevented Planting All other Risks except poor farming practices Price (Revenue products only) RABill Consulting 4

Seven Prerequisites of Insurable Risk #7 -”Unlikely to produce loss to a great many insured units at the same time” Mehr & Cammack; Principles of Insurance; 1972 RABill Consulting 5

Federal/Private Partnership • Began strictly as a Govt Program in 30’s • Small program until Private Industry began participating in the early 80’s • Private Companies took over all delivery in the 90’s • Safety Net for Nation’s Farmers • Intended to replace Free Ad Hoc Disaster Payments RABill Consulting 6

Growth of Crop Program RABill Consulting 7

Federal Government Role • Programs and Policy language • Rates (All companies charge same rates) • A&O Expense reimbursement to the companies (Expenses are not built into the rate) • Pays a portion of the Farmer’s premium (about 60% in addition to the expense reimbursement) • Oversight • Provides Reinsurance to Private Companies • Program administered thru the Risk Management Agency (RMA) which is part of the United States Dept. of Ag (www. rma. usda. gov) RABill Consulting 8

Private Industry Role • Provides distribution system through their agents • Issues policies on their paper • Adjusts Claims • Retains risk after Government Reinsurance RABill Consulting 9

Two Types of Plans • Individual Farmer Plan • Guarantee based on Farmer’s actual production • Up to 10 years of individual farmer yield history used to establish the guarantee • Group Plan • Guarantee based on yield history of a larger area or an index • Basis Risk RABill Consulting 10

Individual Farmer Guarantee

Yield Product Guarantee • Yield Guarantee=Actual Production History (APH) X Coverage Level • Example-200 Bushels per acre X 75% Coverage Level = 150 Bushels per acre RABill Consulting 12

Revenue product Guarantee • Revenue Guarantee=APH X Anticipated Price Per Bushel X Coverage Level • Example-200 Bushels per acre X $4 per Bushel X 75% = $600 per acre RABill Consulting 13

Coverage Level • Generally from 50% to 85% • Acts like a deductible • Example – 75% coverage level is really a 25% Deductible. • A 25% loss is needed before any payment is made RABill Consulting 14

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Expected Yield Bushels Per Acre • Minimum of 4 years of average yield for individual Farmer • Building up to 10 years of history RABill Consulting 16

Expected Price – CBOT Corn Futures Feb 2011 RABill Consulting 17

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MPCI Ratemaking • Simplified in the interest of time. • Rates controlled by RMA • Paper in the Winter 2000 Forum by Schnapp, Driscoll, Zacharias, and Josephson which describes ratemaking in detail • Also see RMA website www. rma. usda. gov– “A Comprehensive Review of RMA APH and COMBO Rating”

Ratemaking (Cont. ) • Losses and Liability are converted to common coverage level • Basic ratemaking unit is County. A Loss Cost per $100 of Liability is Calculated for each County by year • Catastrophe procedure

Ratemaking (Cont. ) • A maximum of 60% credibility is assigned to the County Loss Cost • The remainder of the credibility is assigned to “Simple circle Loss Cost “ which is a weighted average of the surrounding Counties Loss Cost • Loading for Unforeseen Losses

Ratemaking (Cont. ) • Pure premium method of ratemaking (also known as loss cost or loss cost ratio method). • Experience period is much longer due to volatility (introduces problems if current experience is different than older years). • Expenses are not loaded into the premium. • Revenue guarantees – every farmer could have a loss the same year • Basic unit of ratemaking is county.

Pure Premium Method • Does not employ actual premiums charged to policyholder. • Pure Premium = Losses / Exposure • Exposure in crop insurance is the amount of coverage which is referred to as liability. • Example – if losses were $1. 5 M and liability were $100 M, the pure premium would be. 015 or 1. 5%.

First Steps-APH Rate • Loss experience by county for 1975 forward. • Losses and liability are adjusted to common level of coverage (65% Level). • Catastrophe procedure.

Next Steps • Adjust for Credibility – surrounding counties pure premium is weighted with the pure premium determined in the last slide. The higher the volume, the more weight given to the county’s own pure premium. • Base Rate Loadings.

Coverage Level Differentials • The rates derived above are for the 65% coverage level. • Rates for other coverage levels are derived from these rates using coverage level differentials. • The differentials are based on the historical experience of the various coverage levels.

Example of Coverage Level Factors

Average Yield Differentials The county rates developed to this point reflect rates for producers with APH yields at or near the county average yield. RMA research has demonstrated that, on average, the probability of a loss is greater for producers with a yield lower than the average for an area and vice versa. Thus, rates based on the average LCR for a county may be too low for producers with a lower APH and too high for producers with a higher APH. To address this, the RMA has developed a formula to adjust the base rate for yield differentials.

Revenue Ratemaking • All farmers can have a loss the same year if prices are low enough. • Difficult to insure Price • Adverse selection if Product is not Rated Correctly

Basic Approach • Yield Risk – APH rates at 65% coverage level. • Price Risk – Commodity Markets options based volatility measure. Black Scholes Model • Yield Risk x Price Risk = Revenue Risk – Distributions of yield and revenue risk by county must be developed in order to model revenue risk.

Simulated Revenue Risk • Yield Distribution x Price Distribution = Revenue Distribution • Assumes negative price-yield correlation. • Losses are simulated from theoretical revenue distribution. • Loss costs are calculated from the simulated losses.

Simulation Example

Private Industry Profitability Considerations

Standard Reinsurance Contract (SRA) • Standard Contract for all of the Private Companies that specifies all the Terms of the Govt/Private Sector Partnership • New Contact Just negotiated that went into effect July 1, 2010 for 2011 Crop Year • Savings to Govt of $6 B over 10 years RABill Consulting 38

Federal Crop Loss Ratios RABill Consulting 39

Aggregate Loss Ratio, 1981 - 2002 Source: Joe Glauber’s Presentation 40

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Projected Profitability • 1981 -2009 Average Loss Ratio was 115% • Much better recently (improvement in experience or weather cycle? ) • Little or no investment income • Highly catastrophe line requiring higher risk charge • Low expense reimbursement (A&O) • Can Companies make Money? ? ? RABill Consulting 42

Categories of Funds RABill Consulting 43

Terms-Commercial Fund SRA Differences by State • Each State stands on its own • States with favorable past loss ratios have different Reinsurance terms than all other States i. e. , IL, IN, IA, MN, NE (State group #1 representing 34% of the 2009 Premium • State Group 3 States are underserved States • All remaining States are Group 2 • Stop loss Terms for Groups 2 & 3 are the same and are much more favorable than Group 1 • Companies retain minimal risk for Assigned Risk policies RABill Consulting 44

2010 Final SRA Commercial Fund Gain or (Loss) Applies to each State Separately 45

Modeling Profitability • Most states appear to have Lognormal Distribution with Original Coefficient of Variation of between 50% and 125% • I used Lognormal Distribution for illustration purposes RABill Consulting 46

State XYZ-Commercial Fund Lognormal Loss Ratio Distribution Mean = 110%; Median = 88% Coefficient Of Variation = 75% RABill Consulting 47

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Other Considerations • The Profit on the previous pages only applies to the Commercial Fund. • Underwriting Gain Dollars reduced by: • Assigned Risk Fund cession • 6. 5% Mandatory Quota Share • Does not consider any shortfall of the A&O Expense Allowance RABill Consulting 50

Final Considerations • Profitability varies considerably from state to state • Complex models are available to help decide which fund each policy should be assigned RABill Consulting 51