Federal Crop Insurance Ratemaking and Profitability Projections

Casualty Actuarial Society Seminar on Ratemaking San Antonio Marriott RivercenterSan Antonio, TexasMarch 27-28, 2003COM-7

Richard Bill, FCAS Country Insurance & Financial Services

Whose Line is it Anyway?

Overview• Perils Insured• Coverage• Federal/Private Partnership• Ratemaking Considerations• Profitability Considerations• Standard Reinsurance Contract

(SRA)• Projected Profitability

Perils Insured• Too Dry (Large Area)• Too Wet• Hail• Insects• Prevented Planting• All other Risks except poor farming

practices• Price (Revenue products only)

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

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 Ins) at the end of the season

Yield Product Guarantee• Yield Guarantee=Actual Production

History (APH) X Coverage Level

• Example - 100 Bushels per acre X 75% Coverage Level = 75 Bushels per acre

Revenue product Guarantee• Revenue Guarantee=APH X

Anticipated Price Per Bushel X Coverage Level

• Example - 100 Bushels per acre X $2 per Bushel X 75% = $150 per acre

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

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

Size of Industry• Almost 80% of US cropland Insured

• $37 Billion of Liability

• $2.9 Billion of Premium

• Less than 20 companies participating

Federal Government Role• Programs and Policy language• Rates (All companies charge same rates)• Expense reimbursement to the companies

(Expenses are not built into the rate)• Premium subsidies to the Farmers (about

60% in 2002)• Oversight• Provides Reinsurance to Private

Companies

Private Industry Role• Provides distribution system

through their agents• Issues policies on their paper• Adjusts Claims• Retains risk after Government

Reinsurance

Unique Ratemaking Considerations• Paper in the Winter 2000 Forum by

Schnapp, Driscoll, Zacharias, and Josephson which describes ratemaking in detail

• Loss is not one event but is based on crop production at the end of the season

• Long Experience Period Needed– Variability of Loss Ratio– Cyclical Weather patterns

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

Profitability Considerations

Federal CropCW Gross

Loss Ratios

0%50%

100%150%200%250%300%

1981 1984 1987 1989 1992 1995 1998 2001

Loss Ratios 100%

Less than 11 - 1.5Greater than 1.5

Aggregate Loss Ratio, 1981 - 2002

Source: Joe Glauber’s Presentation

A&O per dollar written premium

$0.00$0.05$0.10$0.15$0.20$0.25$0.30$0.35

Joe Glauber’s Presentation

Projected Loss Ratios• 1980-2002 Average Loss Ratio was

127%• Loss Ratio in the Federal Budget is

107.5% for 2003 Fiscal Year• Little if any investment income

•How do Companies Make Money???

Standard Reinsurance Contract (SRA)• Combination of Stop Loss and

Quota Share• Each State stands on its own• Three Categories of Funds with

each having three different product types for a total of 9 separate funds

• Each of the 9 funds have different reinsurance terms for Stop Loss and Quota Share

3 Categories of Funds (Companies choose)

Assigned Risk

Developmental

Commercial

Policies that are significantly under priced with the risk being primarily born by the Federal Govt.

Policies that are better, but not good enough for the companies to take full risk

Policies that the companies chose to take the maximum amount of risk

3 Types of PoliciesCat Revenue All Other

Low level of coverage, fully subsidized (except small policy fee)

Guarantee based on anticipated Price X Yield Per Acre X Coverage Level

All other including Yield guarantee

Commercial Fund Stop Loss Cover-All Other Policies (101.6% Max loss Retention)

Retention:

100% LR

Layer Ceded toGovt

Points Retained

1st Layer 60 Pts 50% 30 pts

2nd Layer 60 Pts 60% 24 pts

3rd Layer 280 Pts 83% 47.6 pts

4th Layer Above 500%

100% 0 pts

Stop Loss Premium (Max Profit Ret. 48.9%)

Below 100% LR

Layer Charge Pts Retained

.1st Layer 35 Pts 6% 32.9 Pts

2nd Layer 15 Pts 30% 10.5 Pts

3rd Layer 50 Pts 87% 5.5 Pts

Modeling Profitability• I used Lognormal Distribution for

illustration purposes

• Most states appear to have Lognormal Distribution with Original Coefficient of Variation of between 50% and 125%

State XYZLognormal Loss Ratio Distribution

Mean = 107.5% Coefficient of Variation = 100%

0% 50% 100% 150% 200%

Loss RatioProbabilityMedianMean

Calculation Of Expected ProfitabilityState XYZ-Commercial Fund-All other

Loss Ratio = 107.5%; COV = 100%

(1) (2) (3) (4) (5)Cumulative Company

Loss Distribution Incremental Avg Loss RetainedRatio F(x) Area Ratio Gain*

From To 0% 50% 30.7% 30.7% 31.8% 45.4%50% 65% 42.5% 11.8% 57.3% 38.3%65% 100% 62.9% 20.4% 81.1% 17.7%100% 160% 81.4% 18.5% 126.0% -13.0%160% 220% 89.9% 8.5% 186.4% -40.5%220% 500% 98.8% 8.9% 304.4% -68.3%500% Plus 100.0% 1.2% 693.8% -101.6%

Weighted Average of Col (3) and Col (5) = Expected Gain = 9.0%

*Based on Reinsurance Contract (SRA)

Expected Profit -Commercial FundBased on Lognormal Distribution

ExpectedLoss Ratio Coefficient of Variation*

0% 50% 75% 100% 125%

92.5% 7.1% 12.0% 13.7% 15.3% 16.8%100.0% 0.0% 7.5% 10.0% 12.1% 13.9%107.5% -3.8% 3.2% 6.4% 9.0% 11.2%115.0% -7.5% -0.9% 2.9% 5.9% 8.5%122.5% -11.3% -4.8% -0.5% 3.0% 5.9%130.0% -15.0% -8.6% -3.8% 0.2% 3.4%137.5% -18.8% -12.2% -6.9% -2.5% 1.0%145.0% -22.5% -15.6% -9.9% -5.2% -1.3%

* Coefficient of Variation for Original Distribution

Final Considerations• Profitability varies considerably

from state to state• Complex models are available to

help decide which funds each policy should be assigned to

• Underwriting Gain is reduced because expense reimbursement is inadequate to cover actual expenses

Future-Random Thoughts• Revenue policies may become, by far,

the predominate coverage sold

• Should a different procedure be used to weight County loss cost with surrounding Counties (see Christopherson and Werland, “Using a Geographic Information System to Identify Territory Boundaries”, 1996 Winter Forum)

Future (Cont.)• Federal Money is tight and perception is

that companies are making too much money

• Federal Govt. will renegotiate a new Standard Reinsurance Agreement (SRA) next year

• The federal budget includes a provision to reduce industry expense reimbursement by 2 points in spite of the current shortfall

• Will there be an impact on the number of companies participating