Lecture 24 Insurance.xlsx Insurance Lecture 24

Insurance is a risk management tool Buy insurance to cover a specific risk of a loss to the business –Low yield due to fire, hail, drought, flood, etc. –Low prices –Low revenue due to low production of price –Health, auto, and home insurance most popular –Liability insurance Insurance transfers a part of the risk to a third party Principal of Insurance

States risk to protect against –Conditions for a loss –Amount of loss that must occur for a payment States the premium to be paid States indemnity payment conditions –Amount of the deductible (losses not paid) –Formula for calculating a payment Terms for an Insurance Policy

Premiums are set to cover the expected loss plus a risk premium and a profit for the insurance company Premium = E(losses) + RP + Profit Calculate the E(Losses) with simulation –Simulate the type of loss and use the losses in the formula for calculating the premium –Calculate the average loss over a given time period, usually a year –Profit is a set fraction by the company –RP covers risk not fully captured in PDF for risk Insurance Premiums

Crop Yield insurance –Low yields insured against hail, fire, insects, drought, flood Revenue insurance –Protects crop farmers from low revenues relative to historical averages Insurance for Agriculture

Agricultural risks widespread due to weather affecting large regions when drought of occur If an insurance co. covered all the risk they would be wiped out Solution was for the federal government to back up these companies –USDA-Risk Management Agency (RMA) write insurance policies and set premiums and terms –Private cos. sell these policies Sell most policies to RMA, keep the lower risk policies as an investment Agriculture Insurance Presents Unique Problems

US Drought: Current Conditions

Texas is actually looking pretty good relative to 2011 … … but parts of Texas are still in an exceptional, multi-year drought … September 13, 2011February 3, 2015

1930’s USDA offered yield insurance in the Great Plains for wheat –Experimental project Expanded to other crops gradually 1971 Farm program offered Disaster Program –Paid farmers for low yield and prevented plantings –Replaced with FCIC insurance in 1983 In ‘83 FCIC yield insurance expanded to all crops in all counties Brief History of Federal Crop Insurance

Production guarantee = APH * coverage level percentage elected –APH = 10 year yield history on the farm unit –Premium set by RMA based on announced price guarantee and coverage level percentage Indemnity = Max[0, (Actual Yield – Production Guarantee) * Projected Price * Acreage Covered] FCIC Yield Insurance

50 acres of corn, RMA projected price of $3.50/bu, APH yield 145 bu/acre, 85% coverage level Production guarantee = 0.85 * 145 = If actual yield = 115 so lost yield is Indemnity = ( ) * 2.25 * 50 FCIC Yield Insurance

Crop Revenue Coverage (CRC) –Producers buy a fraction of the historical revenue –65% to 85% in 5% fractions –Insure with a projected price or the harvest price Indemnity = Max[0, (Guaranteed Revenue – Actual Revenue) * Acres ] –Actual Revenue = actual yield * (RMA projected price OR harvest time price) Revenue Insurance

50 acres of corn, RMA projected price of $3.50/bu, APH yield 145 bu/acre, 85% coverage level Revenue guarantee = 50 * 145 * 0.85 * 3.50 Actual yield = 100 Indemnity = Max[0, (revenue guarantee – 50 * 100 * 3.50 or actual harvest time price)] Electing the RMA projected price is referred to “Harvest Price Exclusion” and is cheaper Revenue Insurance

Simple simulation problem Simulate yield and price Compare yield or revenue to alternative coverage levels, calculate indemnities and premiums Pick insurance policy which is best at reducing risk and increasing net income, NPV, or cash flows Analyzing Insurance Options

General Policies and Provisions Actual Revenue History (ARH) Pilot Endorsement (14-arh). Area Risk Protection Insurance (14-ARPI) Commodity Exchange Price Provisions (CEPP) Catastrophic Risk Protection Footnote 5. Ineligibility Amendment (15-Ineligibility) Footnote 1. Farm Bill Amendment (15-ARPI-Farm-Bill) Footnote 6. Catastrophic Risk Protection Endorsement (15-cat). Footnote 3. Common Crop Insurance Policy, Basic Provisions (11-br) Commodity Exchange Price Provisions (CEPP) Contract Price Addendum (CPA) Ineligibility Amendment (15-Ineligibility) Footnote 1. Farm Bill Amendment (15-CCIP-Farm-Bill) Footnote 2. Other Information Supplemental Coverage Option (SCO-15) High-Risk Alternate Coverage Endorsement (HR-ACE)(13-HR-ACE) High-Risk Alternate Coverage Endorsement Standards Handbook High-Risk Alternate Coverage Endorsement Frequently Asked Questions Livestock Quarantine Endorsement Pilot (11-qe). Rainfall and Vegetation Indices Pilot Whole-Farm Revenue Protection (WFRP) Pilot Policy RMA Insurance Policies Insurance policies must be purchased prior to planting to reduce: Moral hazard -- buying insurance when farmers know the crop will fail xxx

2014 Farm Bill is relying more on insurance and less on direct or indirect subsidies Agricultural Risk Coverage (ARC) Supplemental Crop Optionm(SCO) Insurance and Farm Policy

Agriculture Risk Coverage (ARC-CO) Payments when actual revenue for the covered commodity < ARC revenue guarantee, where: –Actual County Revenue = Actual county yield per planted acre * Max of {National Marketing Year Price or Marketing Loan Rate} –ARC Revenue Benchmark = (5 Year U.S. Olympic average marketing year price) * (5 Year Olympic average county) If any of the 5 years of prices are lower than Reference Price then replace with the Reference Price. If the actual county yield is < 70% of T-yield replace with the T-yield. –ARC Revenue Guarantee = 0.86 * ARC Revenue Benchmark ARC Payment = Minimum of [(ARC Revenue Guarantee – Actual County Revenue) OR 10% of the ARC Revenue Benchmark] * Base Acres * 0.85 No yield risk in year one’s calculation but that does not last –Olympic average starts with , but then moves to , , , with more and more risky yields in the Olympic Average each year of the farm program

Market Receipts MLG Revenue per cwt or bu Loan Rate Market Price Revenue Benchmark Crop insurance coverage 86% 76% Illustration of Government Support for Grains Under ARC-County [paid on base acres x.65 (individual) or.85 (county)] 86% of Revenue Guarantee

Supplemental Coverage Option (SCO) Gap insurance: payments for losses from 86% of APH or CRC coverage level down to the underlying insurance coverage level

Revenue per cwt Illustration of Government Support for Rice Under SCO Crop insurance coverage Supplemental Coverage Option 86% of Revenue Guarantee

Sales repre’s for the large companies Insurance actuarialists Adjusters –Seasonal employment that pays well –Work during growing season only –Visit damaged fields and prepare estimates of the damages –Experience with crop production and economics –Insurance companies complain there never enough adjusters Insurance Job Opportunities

Insurance Use in Texas for Cotton

Insurance Use in Texas for Corn

A new business may need a few months or years to grow sales to their potential May take months or years to learn how to reach potential for a prod function In either case, assume a stochastic growth function and simulate it, if nothing else is available, use a Uniform distribution Example of a growth function for 8 years Learning Curve or Demand Cycle

A new concept in project feasibility analysis Explicitly consider externalities –Such as cleanup costs at end of business Strip mining reclamation Removal of underground fuel tanks Removal of above ground assets Restoration of site –Prevention of future environmental hazards Removal of waste materials 100 year liners for ponds Life Cycle Costing

Steps to Life Cycle Costing Analysis –Identify the potential externalities –Determine costs of these externalities –Assign probabilities to the chance of experiencing each potential cost Assume distributions with GRKS or Bernoulli –Simulate costs given the probabilities –Incorporate costs of cleanup and prevention into the project feasibility –These terminal costs may have big Black Swans so prepare the investor Life Cycle Costing

Bottom line is that LCC will increase the costs of a project and reduce its feasibility Affects the downside risk on returns Does nothing to increase the positive returns Need to consider the FULL costs of a proposed project to make the correct decision J. Emblemsvag – Life Cycle-Costing: Using Activity-Based Costing and Monte Carlo Simulation to manage Future Costs and Risks John Wiley & Sons Inc Life Cycle Costing

LCA is a tool for determining the impact of a new process or project on the environment and climate change LCAs are concerned with quantifying –Energy Use and CO 2 Balance –Green House Gases (GHGs) –Water use and indirect Land use –Nutrient (N,P,K) use and other factors Thus far these are deterministic analyses – This will soon change Life Cycle Analysis

For those interested in a good example of LCA see MS thesis in our Department by Chris Rutland Life Cycle Analysis