oversight

Crop Insurance: Additional Actions Could Further Improve Program's Financial Soundness

Published by the Government Accountability Office on 1999-03-17.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                    United States General Accounting Office

GAO                 Testimony
                    Before the Committee on Agriculture, Nutrition, and
                    Forestry, U.S. Senate




To Be Released
on Delivery
at 8:00 a.m. EST
                    CROP INSURANCE
Wednesday
March 17, 1999

                    Additional Actions Could
                    Further Improve Program’s
                    Financial Soundness
                    Statement for the Record by
                    Lawrence J. Dyckman, Director,
                    Food and Agriculture Issues,
                    Resources, Community, and Economic
                    Development Division




GAO/T-RCED-99-123
Mr. Chairman and Members of the Committee:

This statement for the record summarizes our completed work on the
federal crop insurance program since 1995. Our statement today is based
on our reports issued in 1995, 1997, and 1998.1

Let me place our work in the context of concerns about this issue. As you
know, farming is an inherently risky enterprise. Federal crop insurance is
one of the primary mechanisms used by participating farmers to protect
against the risk of losses caused by events such as droughts, floods,
hurricanes, and other natural disasters. As the U.S. Department of
Agriculture (USDA) has rapidly expanded the availability of crop insurance,
from 59 crops insured in 1994 to 75 in 1999, and introduced new insurance
products to protect farmers’ revenue, so too have the federal government’s
costs for crop insurance increased. Since 1995, the federal government has
expended an average of about $1.4 billion each year for the crop insurance
program—including premium subsidies, insurance company
reimbursements, and underwriting losses. The program will cost an
estimated $1.6 billion in 1999.

Because of the program’s rapid expansion and its significant financial
costs to the government, we have been asked to examine various aspects
of the crop insurance program. Our statement today focuses on our work
examining whether USDA (1) has set adequate insurance rates to achieve
the legislative requirement of actuarial soundness,2 (2) appropriately
reimburses participating crop insurance companies for their
administrative costs, and (3) has established methodologies in the revenue
insurance plans that set sound premium rates.

In summary, we reported that several aspects of the program are of
concern and need attention. First, in 1995, we reported that premiums
charged farmers for crop insurance were not adequate to achieve the
actuarial soundness as mandated by the Congress. Our review showed that
the basic premium rates for the six crops reviewed—barley, corn, cotton,

1
 Crop Insurance: Additional Actions Could Further Improve Program’s Financial Condition
(GAO/RCED-95-269, Sept. 28, 1995); Crop Insurance: Opportunities Exist to Reduce Government Costs
for Private-Sector Delivery (GAO/RCED-97-70, Apr. 17, 1997); and Crop Revenue Insurance: Problems
With New Plans Need to be Addressed (GAO/RCED-98-111, Apr. 29, 1998).
2
 At the time of our report, the Federal Crop Insurance Reform and Department of Agriculture
Reorganization Act of 1994 (P.L. 103-354, Oct. 13, 1994) required that USDA achieve a target loss ratio
no greater than 1.10. Stated differently, insurance rates were to be set to generate revenue from
premiums to cover at least 91 percent of the anticipated claims payments—termed 91 percent
adequate. The Reform Act currently requires that USDA achieve a target loss ratio no greater than
1.075, or 93 percent adequate.



Page 1                                                                           GAO/T-RCED-99-123
grain sorghum, soybeans, and wheat—were approaching actuarial
soundness in 1995, but USDA’s rates for some crops and locations and for
some coverage and production levels were well below the legislative
requirement. For example, about 24 percent of the crop insurance
premiums for the six crops we reviewed in 1994 had basic rates that were
less than 80 percent adequate for actuarial soundness. USDA subsequently
took actions to improve the program’s actuarial soundness, but some rates
remain too low.

Second, in 1997, we reported that the government’s administrative
expense reimbursement (commissions) to insurance
companies—31 percent of premiums—were greater than the companies’
reported expenses to sell and service federal crop insurance. Furthermore,
we stated that some of these reported expenses did not appear to be
reasonably associated with the sale and service of federal crop insurance.
The Agricultural Research, Extension, and Education Reform Act of 1998
subsequently revised reimbursement rates downward to 24.5 percent of
premiums for most crop insurance. However, continued oversight of the
reasonableness of the program’s administrative reimbursement rate is
necessary. Increased program participation and sales volume that could
result from crop insurance reform may lead to lower delivery costs,
warranting a downward adjustment in the rate.

Finally, in 1998, we reported our doubts about whether new
USDA-supported revenue insurance plans were actuarially sound over the
long term and appropriate to the risk each farmer presents to the program.
Specifically, with respect to the most popular plan, Crop Revenue
Coverage, we recommended that USDA’s Risk Management Agency require
the plan’s developer to base premium rates on a revenue distribution or
other appropriate statistical technique that recognizes the
interrelationship between farm-level yields and expected crop prices.
USDA, to date, has not fully acted on our recommendations.


This year the Congress is once again considering reforms to the federal
crop insurance program. As you explore the various proposals to expand
or restructure the program, changes should be considered in the context
of the above concerns. Continued oversight of the federal crop insurance
program is needed to help ensure, among other things, the adequacy of
premium rates, the reasonableness of administrative expense
reimbursements to companies, and the soundness of revenue insurance
plans.




Page 2                                                   GAO/T-RCED-99-123
             Farming has always been an inherently risky enterprise because farmers
Background   operate at the mercy of nature and frequently are subjected to
             weather-related perils such as droughts, floods, hurricanes, and other
             natural disasters. Since the 1930s, many farmers have been able to transfer
             part of the risk of loss in production to the federal government through
             subsidized crop insurance.

             Major legislation enacted in 1980 and 1994 restructured the crop insurance
             program. The 1980 legislation enlisted, for the first time, private insurance
             companies to sell, service, and share the risk of federal insurance policies.
             Subsequently, in 1994, the Federal Crop Insurance Reform and
             Department of Agriculture Reorganization Act revised the program to offer
             farmers two primary levels of insurance coverage, catastrophic and buyup.
             Catastrophic insurance is designed to provide farmers with protection
             against extreme crop losses for a small processing fee. Buyup insurance
             provides protection against more typical and smaller crop losses in
             exchange for a producer-paid premium. The government subsidizes the
             total premium for catastrophic insurance and a portion of the premium for
             buyup insurance.

             Farmers who purchase buyup crop insurance must choose both the
             coverage level (the proportion of the crop to be insured) and the unit price
             (such as, per bushel) at which any loss is calculated. With respect to the
             level of production, farmers can choose to insure as much as 75 percent of
             normal production or as little as 50 percent of normal production at
             different price levels. With respect to the unit price, farmers choose
             whether to value their insured production at USDA’s full estimated market
             price or at a percentage of the full price.

             In recent years, USDA has introduced a new risk management tool called
             revenue insurance. Unlike traditional crop insurance, which insures
             against losses in the level of crop production, revenue insurance plans
             insure against losses in revenue. The plans protect the farmer from the
             effects of declines in crop prices or declines in crop yields, or both. Like
             traditional buyup insurance, the government subsidizes a portion of the
             premiums. One of the plans, called Crop Revenue Coverage, is available in
             many states for major crops. Two other plans, called Income Protection
             and Revenue Assurance, are available to farmers in only limited areas.

             USDA reimburses the insurance companies for the administrative expenses
             associated with selling and servicing crop insurance policies, including the
             expenses associated with adjusting claims. Between 1995 and 1998, USDA



             Page 3                                                     GAO/T-RCED-99-123
paid participating insurance companies about $1.7 billion in administrative
expense reimbursements.

In addition to receiving an administrative expense reimbursement, the
insurance companies share underwriting risk with USDA and can earn or
lose money according to the claims they must pay farmers for crop losses.
Companies earn underwriting profits when the premiums exceed the crop
loss claims paid for those policies on which the companies retain risk.
They incur underwriting losses when the claims paid for crop losses
exceed the premiums paid for the policies that the companies retained.
Between 1995 and 1998, USDA paid participating insurance companies
about $1.1 billion in underwriting profits.

Critical to the success of achieving an actuarially sound crop insurance
program is aligning premium rates with the risk each farmer represents.
The riskiness of growing a particular crop varies from location to location,
from farm to farm, and from farmer to farmer. If the rates are too high for
the risk represented, farmers are less likely to purchase insurance,
lowering the revenue from premiums and the usefulness of the program to
farmers. Conversely, if the rates are too low, farmers are more likely to
purchase crop insurance, but because the rates are too low, the revenue
from premiums will be insufficient to cover the claims. Therefore, USDA
sets different premium rates for the various coverage and production
levels, which vary by crop, location, farm, and farmer. Consequently,
hundreds of thousands of premium rates are in effect. To set premium
rates, USDA calculates a basic rate for each crop in each county for the
farmers who buy insurance at the 65-percent coverage level and whose
normal production level is about equal to the average production in the
county. From this basic rate, USDA makes adjustments to establish rates for
other coverage levels and for those farmers whose production levels are
higher or lower than the county’s average.




Page 4                                                     GAO/T-RCED-99-123
                        In 1995, we reported that for the six crops we reviewed—barley, corn,
Changes in Premium      cotton, grain sorghum, soybeans, and wheat—basic premium rates overall
Rates for Traditional   were 89 percent adequate, on average, to meet the Congress’s legislative
Crop Insurance Have     requirement of actuarial soundness. However, we found that while overall
                        premiums were approaching actuarial soundness, USDA’s rates for some
Improved the            crops and locations and for some coverage and production levels were too
Program’s Actuarial     low.
Condition, but Some     For the 183 state crop programs3 we examined, 54 had basic premium
Rates Remain Too        rates that were adequate to achieve actuarial soundness. These 54
Low                     programs were generally those that had the greatest volume of insurance.
                        For the remaining 129 programs, 40 had premium rates that were near the
                        target level. However, the other 89 programs, representing about
                        24 percent of the crop insurance premiums for the six crops in 1994, had
                        basic rates that were less than 80 percent adequate for actuarial
                        soundness.

                        We reported that premium rates that were too low generally occurred
                        when the historical databases used for establishing rates added or deleted
                        years of severe losses, thus affecting USDA’s estimate of expected crop
                        losses. USDA did not increase the rates where necessary. For example, for
                        one of the crops we reviewed, USDA did not increase the rates as much as it
                        could have when (1) severe losses from 1993 were added to the database
                        for establishing the 1995 rates and (2) a year from the 1970s when losses
                        were lower was deleted from the database. According to USDA, it had not
                        sufficiently raised rates out of concern that higher rates would discourage
                        farmers from buying crop insurance.

                        Furthermore, when we examined the rates at various levels of coverage
                        and production, we found that the rates were (1) too high for coverage at
                        the 75-percent level and (2) too low for farmers with above-average crop
                        yields. As a result, the rates for both coverage and production levels were
                        not always aligned with risk. This occurred because USDA did not
                        periodically review and update the calculations it used to adjust rates
                        above and below the basic rate.

                        To set premium rates for the 75-percent coverage level, USDA applies
                        pre-established mathematical factors to the basic rate. However, these
                        factors have not resulted in rates that are aligned with risk. For crops
                        insured at the 75-percent coverage level, USDA set premium rates ranging

                        3
                         Each crop insured in a state is counted as a state crop program. An example of a state crop program is
                        corn in Iowa. In 1994, for the six crops reviewed, USDA offered insurance for a combination of 183
                        states and crops.



                        Page 5                                                                          GAO/T-RCED-99-123
                    from 19 to 27 percent more than required. As a result, the 1994 income
                    from premiums was about $30 million more than required for this
                    coverage. Although grain sorghum had the greatest percentage of rates in
                    excess of those required, corn had the greatest amount of additional
                    premium income because its program is much larger.

                    USDA  also adjusts the basic rates for a farmer’s individual crop yields.
                    USDA’s basic rate applies to the farmer whose average yield is about equal
                    to the average for all producers in the county. However, many farmers’
                    average yield is above or below the county’s average, and USDA’s research
                    shows that the higher a farmer’s yield, the lower the chance of a loss.
                    Therefore, USDA establishes rates for different yield levels using a
                    mathematical model. The rates per $100 of insurance coverage decrease as
                    a farmer’s average yield increases; however, the mathematical model
                    overstated the rate decrease. According to our analysis, the rates at higher
                    average crop yields were too low for the six crops reviewed. We reported
                    that for these above-average yields, USDA’s rates in 1995 should have been
                    from 13 to 33 percent higher than they were.

                    Subsequent to our 1995 report, USDA took action to increase premium rates
                    an average of 6 percent and developed a plan to periodically evaluate the
                    mathematical factors used to set rates. These actions have contributed to
                    the federal crop insurance program’s achieving a loss ratio well below the
                    target in recent years, thereby improving the program’s financial
                    soundness. However, although overall premium rates appear adequate,
                    rates for crops in some states remain too low. For example, since 1996, the
                    loss ratio has averaged 1.36 for cotton in Texas and 1.45 for peanuts in
                    Alabama, well exceeding the target loss ratio. Thus, premium rates for
                    these farmers may be too low. Consequently, USDA needs to continue to
                    monitor and adjust premium rates to ensure they are appropriately aligned
                    with risk.


                    In 1997, we reported that USDA’s administrative expense reimbursements to
Opportunities to    participating insurance companies selling traditional buyup insurance—31
Reduce Government   percent of premiums—were much higher than the expenses that can be
Costs for Private   reasonably associated with the sale and service of federal crop insurance.
                    For the 2-year period we reviewed, 1994 and 1995, the companies reported
Sector Delivery     $542.3 million in expenses, compared with a reimbursement of
                    $580.2 million—a difference of about $38 million. Additionally, about
                    $43 million of the companies’ reported expenses could not be reasonably
                    associated with the sale and service of federal crop insurance to farmers.



                    Page 6                                                     GAO/T-RCED-99-123
                        Therefore, we reported that these expenses should not be considered in
                        determining an appropriate future reimbursement rate for administrative
                        expenses.

                        The expenses that could not be reasonably associated with the sale and
                        service of federal crop insurance included the following:

                    •   payments of $12 million to compensate executives of an acquired company
                        to refrain from joining or starting competing companies,
                    •   fees of about $11 million paid to other insurance companies to protect
                        against underwriting losses,
                    •   bonuses of about $11 million tied to company profitability,
                    •   management fees of about $1 million assessed by parent companies with
                        no identifiable benefit to subsidiary crop insurance companies, and
                    •   lobbying expenditures of about $400,000.

                        In addition, we found a number of expenses reported by the companies
                        that, while in categories associated with the sale and service of crop
                        insurance, seemed to be excessive under a taxpayer-supported program.
                        These expenses included agents’ commissions of about $6 million, paid by
                        one company, that exceeded the industry standard.

                        Thus, we reported that opportunities existed for the government to reduce
                        its reimbursement rate for administrative expenses while still adequately
                        reimbursing companies for the reasonable expenses of selling and
                        servicing crop insurance policies. Subsequent to our report, the
                        Agricultural Research, Extension, and Education Reform Act of 1998
                        revised reimbursement rates downward to 24.5 percent of premiums for
                        traditional buyup insurance. However, as changes are made to the crop
                        insurance program that increase participation and sales volume,
                        downward adjustments to the reimbursement rate may be warranted.


                        In 1998, we reported shortcomings in the way premium rates are
Problems With           established for each of the three revenue insurance plans we reviewed.
USDA-Supported          Appropriate methods for setting rates for these plans are critical to
Revenue Insurance       ensuring the financial soundness of the crop insurance program over time.
                        We reported that the Crop Revenue Coverage plan did not base its rate
Plans Need to Be        structure on the interrelationship between crop prices and farm-level
Addressed               yields—an essential component of actuarially sound rate setting. For
                        example, a decline in yields is often accompanied by an increase in prices,
                        which mitigates the impact of the decline in yields on a farmer’s revenue.



                        Page 7                                                    GAO/T-RCED-99-123
Because this plan did not recognize this interrelationship, the premium
adjustments may not be sufficient over the long term to cover claims
payments and may not be appropriate to the risk each farmer brings to the
program. We were not able to determine whether premium rates for this
plan were too high or too low.

In contrast, the rate-setting approaches for the Revenue Assurance and
Income Protection plans were based on a likely statistical distribution of
revenues that reflects the interrelationship between crop prices and yields.
However, the two plans had several shortcomings that were not as serious
as the problem we identified for Crop Revenue Coverage. For example, in
constructing its revenue distribution, we found that the Revenue
Assurance plan used only 10 years of yield data (1985-94), which was not a
sufficient historical record to capture the fluctuations in yield over time.
Furthermore, 3 of these 10 years had abnormal yields: 1988 and 1993 had
abnormally low yields, and 1994 had abnormally high yields. Additionally,
Income Protection based its estimate of future price increases or
decreases on the way that prices moved in the past. This approach could
be a problem because price movements in the past occurred in the context
of past government programs, such as commodity income-support
payments, which were eliminated by the 1996 farm bill. In the absence of
the above government programs, the price movements may have been
considerably more pronounced. While favorable weather and stable crop
prices generated very favorable claims experience over the first 2 years
that the plans were available to farmers, these shortcomings raise
questions about whether the rates established for each plan will be
actuarially sound and fair—that is, appropriate to the risk each farmer
presents over the long term.

Furthermore, while the plans were initially approved only on a limited
basis, USDA authorized the substantial expansion of Crop Revenue
Coverage before the initial results of claims experience were available. In
doing so, USDA was acting within its authority to approve privately
developed crop insurance plans in response to strong demand from
farmers. USDA’s Office of General Counsel advised against the expansion,
noting that an expansion without any data to determine whether the plans
or rates are sound might expose the government to excessive risk. While
Crop Revenue Coverage was expanded rapidly, Revenue Assurance and
Income Protection essentially remain pilot plans with no nationwide
availability.




Page 8                                                     GAO/T-RCED-99-123
           As a result of the shortcomings with the revenue insurance plans’ rating
           methods and to ensure premiums were appropriate to the risk each farmer
           presents, we recommended that the Secretary of Agriculture direct the
           Administrator of the Risk Management Agency to address the
           shortcomings in the methods used to set premiums. Specifically, with
           respect to all three plans, we recommended that the Secretary direct the
           Risk Management Agency to reevaluate the methods and data used to set
           premium rates to ensure that each plan is based on the most actuarially
           sound foundation. With respect to Crop Revenue Coverage, which does
           not incorporate the interrelationship between crop prices and farm-level
           yields, we recommended that the Risk Management Agency direct the
           plan’s developer to base premium rates on a revenue distribution or
           another appropriate statistical technique that recognizes this
           interrelationship. While USDA subsequently took action to improve the
           actuarial soundness of the Revenue Assurance plan, it has not, to date,
           acted on our recommendations regarding the other two plans.


           As the Congress considers proposals to reform the federal crop insurance
           program and improve the safety net for farmers, the issues in our reports
           remain important to the success of the program. Specifically, premiums in
           all areas of the country should be set at levels that are actuarially sound
           and represent the risk each farmer brings to the program. Furthermore,
           continued oversight of the reasonableness of the program’s administrative
           reimbursement rate is necessary. Increased program participation and
           sales volume that could result from crop insurance reform may lead to
           lower delivery costs, warranting a downward adjustment in the rate.
           Finally, before revenue insurance plans are expanded to cover new crops,
           USDA needs to ensure that the plans are based on an actuarially sound
           foundation.




(150133)   Page 9                                                    GAO/T-RCED-99-123
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