Significant losses forecasted for crop insurance industry due to 2012 drought

Private crop insurers and the federal government may face significant losses this year as a result of what the National Climatic Data Center is calling the worst drought since 1956.¹ Large portions of the Midwest have experienced significant deficiencies in rainfall since the 2012 growing season began. The rain that did fall was not enough to replenish the parched soil in many regions and worsening crop conditions and low forecasted yields have been announced. Forecasts by the National Weather Service’s Climate Prediction Team are not showing improving drought conditions through September 30, 2012, which could further lower crop yields and increase crop insurance indemnities.

Based on current crop conditions and prices, Milliman estimates underwriting losses for 12 major corn/soybean-producing states could top $2.8 billion, as shown in Figure 1. The 12 states mentioned in this analysis are Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota, and Wisconsin. Other states, including Arkansas and many western states, are also experiencing an intense drought and could see high crop insurance indemnities as well.

MPCI loss ratios

The federal multi-peril crop insurance program (MPCI) consists of crop insurance programs where private insurers write the primary layer of coverage and the federal government provides coverage in the event of catastrophic losses. The revenue protection (RP) plan, the most popular insurance plan, provides coverage against a farmer’s farm revenue falling below prescribed minimums. A key provision of RP is that it establishes the farmer’s guarantee using the higher of either the projected price or the harvest price. With the drought causing futures prices to increase, low yields may cause farmers’ revenues to fall below their insurance guarantees and lead to high losses for the crop insurance industry.

The MPCI loss ratios (indemnity paid to farmers divided by premium) for the major corn-producing states have been less than 100% for the most recent years. Figure 2 shows the annual MPCI loss ratios for all crops in 12 major corn-producing states combined since 1990.

In 2002, a minor drought led to poor yields resulting in a 138.3% loss ratio for the 12 states, but the last major drought in the Midwest precedes the availability of state-by-state loss ratios. In 1988, the overall loss ratio for all states was 242% and another $4 billion was paid out in special disaster relief to farmers. The high loss ratio in 1993 (281%) was due to that year’s significant spring flooding.

There have been many changes to the federal crop insurance program since 1993, including the introduction of catastrophe coverage and revenue products. Also, the number of insured acres has almost tripled in the 12 major corn-producing states, from 58 million in 1993 to 160 million in 2011. In 2002, the drought was located on the western and eastern sides of the major corn-producing areas, so the MPCI loss ratios by state varied significantly. As Figure 3 shows, Kansas, Nebraska, Ohio, and South Dakota had loss ratios over 200%, while the central states all had loss ratios significantly less than 100%.

Forecasted loss ratios in 2012

We modeled an expected loss ratio by state, using a forecasted yield and the current futures prices. RP policies use both yield and price to calculate the farmers' guarantees and indemnities, if any. The projected harvest price for corn in 2012 was established at $5.68 per bushel for most states. The guarantee for a policy is this price multiplied by the historical yield less the selected deductible. The value of the December 2012 corn future (which is used to calculate the actual harvest price) was $7.30 per bushel as of July 9, an increase of almost 30%. Most states use the average daily settlement value of the December corn future in October to establish the harvest price.

The National Agricultural Statistics Service (NASS) has recently lowered its 2012 forecasted corn yield from 166 to 146 bushels per acre, a decrease of 12%. NASS does not publish forecasted yields by state until August, but using the crop condition reports from NASS and historical yields, we can make rough approximations of state yields. Using these estimated yields and current futures prices, we estimated the loss ratios by state for corn.

For this analysis, we looked at actual annual corn yields as a percentage of the previous 10-year average. On average, the current year’s yield is 11% greater than the previous 10 years, due to improvements in farming techniques and higher yielding varieties. Figure 4 shows this ratio by year for the 12 major corn-producing states.

As Figure 4 shows, 1983, 1988, 1993, 1995, and 2002 were poor-yield years. This chart varies a lot more when you look at it by state, since poor yields in one state can be offset by better yields in other states.

Since NASS has not issued forecasted yields by state, we estimated yields by state using the crop conditions report by NASS. This report is based on a survey of extension agents and Farm Service Agency staff members for a report on excellent, good, fair, or poor crop conditions in their areas for the current week. Figure 5 shows the percentage of good or excellent conditions for all 12 corn states combined for various time periods.

As Figure 5 shows, the percentage of crop conditions rated good or excellent for 2012 is lower than most other years, but not yet as bad as 1988. Week 27 represents the 2012 conditions released July 9. Week 36 is the latest condition report provided for each state.

Conditions vary by state. Figures 6 and 7 show the declining conditions of corn in Indiana and Illinois.

Using an index of condition reports by state and year as well as the NASS forecasted corn harvest, we estimated corn yields by state. Using the forecasted yields, current futures price, and previous loss ratios by state, we estimated the loss ratios for 2012 by state and by crop. We also used the same process for soybeans, for which NASS reduced the overall 2012 yield forecasts by 8% to account for the drought. The overall forecasted loss ratio for corn and soybeans for the 12 states is 147%, as shown in Figure 8.

Because the impact of the drought varies from state to state, the loss ratios vary significantly by state. While 2012 premiums have not been fully reported yet, we can estimate these based on price and acreage estimates. Specifically, by adjusting 2011 premium for changes in price and acreage, we estimate total 2012 premium to be approximately $6.0 billion for these states for corn and soybeans. Using the estimated 147% loss ratio, the indemnity is forecasted to be about $8.8 billion for an underwriting loss of $2.8 billion. This underwriting loss excludes both the private insurance companies’ expenses and the A&O subsidy provided to the private insurers by FCIC. While the $8.8 billion in indemnity is a large amount, we estimate the insured liabilities in these states to be approximately $67 billion for corn and soybeans. Therefore, if yields decrease more than forecasted, a larger amount of indemnity is possible.

Retention of losses

The private insurers will not absorb all of the losses, due to the Standard Reinsurance Agreement (SRA) the private insurers make with the Federal Crop Insurance Corporation (FCIC). The SRA reduces the underwriting loss (or gain) that a private insurer has by state and fund. There are two SRA funds—the Assigned Risk fund, where the FCIC takes most of the risk, and the Commercial fund, for which the private insurer takes a substantial amount of the risk. Figure 9 shows the amount of underwriting gain a private insurer retains by loss ratio for each state and fund. State Group 1 includes Illinois, Indiana, Iowa, Minnesota, and Nebraska, while the remaining states in this study are State Group 2. For example, if the premium was 100 in State Group 1 and the losses were 150, the private insurer would retain 132.5 losses (100+50X.65) and cede 17.5 losses to FCIC.

There is a considerable amount of uncertainty to these projected underwriting losses. Other states and crops could provide offsetting underwriting gains and losses. The futures prices could change significantly and the drought could strengthen or wane over the coming months. Milliman will continue to monitor the drought and prepare updated loss ratio forecasts as new information becomes available.

¹ Pearson, M. & Abbey, M. U.S. Drought biggest since 1956, climate agency says. CNN. (2012, July 17.) Retrieved July 17, 2012 from http://www.cnn.com/2012/07/16/us/us-drought/index.html.