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Federal Crop Insurance Ratemaking and Profitability Projections

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... 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 ... – PowerPoint PPT presentation

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Title: Federal Crop Insurance Ratemaking and Profitability Projections


1
Federal Crop Insurance Ratemaking and
Profitability Projections
October 25, 2010
Richard Bill, FCAS, MAAA R. A. Bill
Consulting Bill.consulting_at_frontier.com
2
Overview
  • Coverage
  • Perils Insured
  • Federal/Private Partnership
  • Coverage Examples
  • Ratemaking Considerations
  • Profitability Considerations
  • Standard Reinsurance Contract (SRA)
  • Projected Profitability

3
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

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

5
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
6
Federal/Private Partnership
  • Began strictly as a Govt Program in 30s
  • Small program until Private Industry began
    participating in the early 80s
  • Private Companies took over all delivery in the
    90s
  • Safety Net for Nations Farmers
  • Intended to replace Free Ad Hoc Disaster Payments

7
Growth of Crop Program
8
Federal Government Role
  • Programs and Policy language
  • Rates (All companies charge same rates)
  • AO Expense reimbursement to the companies
    (Expenses are not built into the rate)
  • Pays a portion of the Farmers 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)

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

10
Two Types of Plans
  • Individual Farmer Plan
  • Guarantee based on Farmers 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

11
Individual Farmer Guarantee
12
Yield Product Guarantee
  • Yield GuaranteeActual Production History (APH) X
    Coverage Level
  • Example-200 Bushels per acre X 75 Coverage Level
    150 Bushels per acre

13
Revenue product Guarantee
  • Revenue GuaranteeAPH X Anticipated Price Per
    Bushel X Coverage Level
  • Example-200 Bushels per acre X 4 per Bushel X
    75 600 per acre

14
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

15
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16
Expected Yield Bushels Per Acre
  • Minimum of 4 years of average yield for
    individual Farmer
  • Building up to 10 years of history

17
Expected Price CBOT Corn Futures Feb 2011
18
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19
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20
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

21
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

22
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

23
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.

24
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 1.5M and liability were
    100M, the pure premium would be .015 or 1.5.

25
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.

26
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27
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28
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 countys own
    pure premium.
  • Base Rate Loadings.

29
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.

30
Example of Coverage Level Factors
31
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.

32
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33
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

34
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.

35
Simulated Revenue Risk
  • Yield Distribution x Price Distribution Revenue
    Distribution
  • Assumes negative price-yield correlation.
  • Losses are simulated from the theoretical revenue
    distribution.
  • Loss costs are calculated from the simulated
    losses.

36
Simulation Example
37
Private Industry Profitability Considerations
38
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

39
Federal Crop Loss Ratios
40
Aggregate Loss Ratio, 1981 - 2002
Source Joe Glaubers Presentation
41
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42
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 (AO)
  • Can Companies make Money???

43
Categories of Funds
44
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

45
2010 Final SRA Commercial Fund Gain or (Loss)
Applies to each State Separately
46
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

47
State XYZ-Commercial Fund Lognormal Loss Ratio
Distribution Mean 110 Median
88 Coefficient Of Variation 75
48
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49
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50
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 AO
    Expense Allowance

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