Crop Insurance: Further Actions Could Strengthen Program's Financial Soundness

Published by the Government Accountability Office on 1999-04-21.

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

For Release
on Delivery
Expected at 8:30 a.m. EDT
                            CROP INSURANCE
April 21, 1999

                            Further Actions Could
                            Strengthen Program’s
                            Financial Soundness
                            Statement of Lawrence J. Dyckman,
                            Director, Food and Agriculture Issues,
                            Resources, Community, and Economic
                            Development Division

Mr. Chairman and Members of the Committee:

We are pleased to have this opportunity to discuss our work on the federal
crop insurance program. Our testimony today is based on our reports
issued in 1995, 1997, and 1998.1

Let me place our work in context. 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 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 testimony 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, (3) can deliver catastrophic crop insurance at less
cost to the government than private insurance companies, and (4) has
established methodologies in the revenue insurance plans that set sound
premium rates.

In summary, we have 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 mandated by the Congress. Our review showed that

 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).
 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-99-161
the basic premium rates for the six crops reviewed—barley, corn, cotton,
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 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.

Also in 1997, we reported that the government’s costs to deliver
catastrophic insurance in 1995 were higher through private companies
than through USDA. Although the basic costs associated with selling and
servicing catastrophic crop insurance through USDA and private companies
were comparable, delivery through USDA avoids paying an underwriting
gain to companies in years when there is a low incidence of catastrophic
loss claims.

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.

Page 2                                                   GAO/T-RCED-99-161
             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

             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

             Page 3                                                     GAO/T-RCED-99-161
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
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-99-161
                        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

                        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

                         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-99-161
                    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-99-161
    Therefore, we reported that these expenses should not be considered in
    determining an appropriate future reimbursement rate for administrative

    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, further
    downward adjustments to the reimbursement rate may be warranted.

    We also reported that although the current arrangement for reimbursing
    companies for their administrative expenses has certain advantages,
    including ease of administration, expense reimbursements based on a
    percentage of premiums do not necessarily reflect the amount of work
    involved to sell and service crop insurance policies and may create
    incentives to focus sales to larger farmers. Alternative reimbursement
    arrangements, such as (1) capping the reimbursement per policy and
    (2) paying a flat dollar amount per policy plus a reduced fixed percentage
    of premiums, offer the potential to have reimbursements more reasonably
    reflect expenses and encourage more service to smaller farmers than does

    Page 7                                                   GAO/T-RCED-99-161
                     the current arrangement. While these alternative reimbursement methods
                     may result in lower cost reimbursements to insurance companies, they
                     may increase USDA’s own administrative expenses for reporting and
                     compliance. In 1995, we found that companies generally preferred USDA’s
                     current reimbursement method because of its administrative simplicity.

                     In 1997, we also reported that the government’s costs to deliver
Government’s 1995    catastrophic insurance policies in 1995 were higher through private
Cost to Deliver      companies than through the local offices of USDA’s Farm Service Agency.
Catastrophic         The basic cost to the government for selling and servicing catastrophic
                     crop insurance was comparable for both delivery systems. However, when
Insurance Through    private companies delivered the insurance, they received an estimated
USDA Was Less Than   $45 million underwriting gain, which did not apply to USDA’s delivery.
                     Underwriting gains are not guaranteed and vary annually, depending on
Through Private      crop losses. Our report did not conclude or recommend the insurance
Companies            industry should have its role in catastrophic insurance delivery reduced.
                     However, we recommended that USDA needs to more closely monitor the
                     level of underwriting gain paid to the participating insurance companies.
                     For 1996, 1997, and 1998, underwriting gains for catastrophic coverage
                     totaled $58 million, $87 million, and $105 million, respectively. Beginning
                     with crops harvested in 1997, the Federal Agriculture Improvement and
                     Reform Act of 1996 required that USDA phase out its delivery of
                     catastrophic crop insurance in areas that have sufficient private company
                     providers. In May 1997, the Secretary of Agriculture authorized the
                     movement of all catastrophic insurance policies away from USDA to
                     commercial delivery.

                     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.
                     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 presents. We

                     Page 8                                                    GAO/T-RCED-99-161
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

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

Page 9                                                     GAO/T-RCED-99-161
           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 and some of
           the recommendations 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. In addition, USDA needs to
           closely monitor the catastrophic insurance program to ensure that over
           time the underwriting gain earned by insurance companies is not
           excessive. 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.

(150136)   Page 10                                                   GAO/T-RCED-99-161
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