1. Insurance Lecture 24
Lecture 24 Insurance.xlsx

2. Principal of Insurance
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 yield or price
Health, auto, and home insurance most popular
Liability insurance
Insurance transfers a part of the risk to a third party for a fee

3. Terms for an Insurance Policy
States the 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

4. Insurance Premiums
Premiums are set to cover the expected loss plus a risk premium and a profit for the insurance company
Premium = Expected($Lose) + RP + Profit
Calculate the Expected($Lose) w/ simulation
Simulate the type of losses 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

5. Brief History of Federal Crop Insurance
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
Congress eliminated the Low Yield Disaster Prog.

6. Insurance for Agriculture
Crop Yield insurance
Low yields insured against hail, fire, insects, drought, flood
Revenue insurance
Protects crop farmers from low revenues relative to historical average revenue
The federal government through the USDA FCIC (federal crop insurance corporation) aka. Risk Management Agency provides crop and revenue coverage policies for most crops and pasture in some locations

7. Agriculture Insurance Presents Unique Problems
Agricultural risks widespread due to weather affecting large regions when drought occurs
If a private insurance company 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) writes insurance policies and set premiums and terms
Private companies sell these policies
Sell most policies to RMA, keep the lower risk policies as an investment

8. Agriculture Insurance Industry
Very large (international) reinsurance companies, such as:
Zurich Insurance Group AG
Bermuda based Aspen Insurance Holdings Ltd.
Next layer of insurance companies actually have a sales force that sells insurance policies
Farmers Mutual Hail Insurance Co., Rain and Hail, AgriLogic, ARMtech Insurance
Cargill, John Deere, Wells Fargo recently exited the business
Local insurance agents who meet with farmers
All companies belong to NCIS

9. Some of the Major Crop Insurance Companies

10. Agriculture Insurance Industry
USDA-Risk Management Agency (RMA) is the “reinsurance agent”
Insurance companies sell the policies that RMA develops as well as their own
RMA will buy back the policies that it develops so the insurance companies do not have to cover the losses
Insurance companies face a portfolio problem:
Policies sold to RMA only earn a % of the premium
Policies they retain earn 100% of the premium if there is no indemnity, there in lies the risk of which policies to sell to RMA

11. US Drought: Current Conditions

12. Compare Conditions for Two years
September 13, 2011
February 3, 2015
… but parts of Texas are still in an exceptional,
multi-year drought …

13. FCIC Yield Insurance (YP)
Production guarantee = APH * coverage level percentage elected
APH = 10 year yield history on the farm unit
Based on actual yields for the farm unit
Farm unit can be a field
Premium set by RMA based on announced price guarantee, APH, and coverage level percentage
Indemnity = Max[0, (Actual Yield – Production Guarantee) * Projected Price * Acreage Covered]

14. 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 = 123.3
If actual yield = 115 so lost yield is
Indemnity = ( ) * 2.25 * 50

15. Revenue Insurance Crop Revenue Coverage (CRC)
Producers buy a fraction of historical revenue
Insured Revenue = APH * Price * Fraction
Revenue fractions are: 50% to 85% in 5%
Insure with a projected price or the harvest price based on the futures contract
Indemnity = Max[0, (Guaranteed Revenue – Actual Revenue) * Acres ]
Actual Revenue = actual yield * (RMA projected price OR harvest time price)

16. 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

17. Analyzing Insurance Options
Simple simulation problem
Simulate yield and price
Compare yield or revenue to alternative (insured) coverage levels, calculate indemnities and premiums
Pay premiums every year
Collect indemnities only when there is a loss
Pick insurance policy which is best at reducing risk and increasing net income, NPV, or cash flows

18. RMA Insurance Policies
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)
Contract Price Addendum (CPA)
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
Insurance policies must be purchased prior to planting to reduce:
Moral hazard -- buying insurance when farmers know the crop will fail
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19. Insurance and Farm Policy
2014 Farm Bill is relying more on insurance and less on direct or indirect subsidies
Agricultural Risk Coverage (ARC)
An insurance based program to act as a safety net on revenue
Based on a 5–year moving average of revenue
Supplemental Crop Option (SCO)

20. 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

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

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

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

24. Insurance Job Opportunities
Sales representative for the large companies
Insurance actuary
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

25. Insurance Use in Texas for Cotton

26. Insurance Use in Texas for Corn

27. Simulating a Learning Curve to Represent the Demand Cycle
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

28. Learning Curve or Demand Cycle

29. Life Cycle Costing 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

30. 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

31. 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. 2003

32. Life Cycle Analysis
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 CO2 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

33. Life Cycle Analysis For those interested in a good example of LCA see
MS thesis in our Department by Chris Rutland
Analyzed the carbon footprint for crop and dairy farms in principal production regions in the US
GREET Model developed by Dept. of Energy engineers at Argonne National Labs
Download it and use it for free
Contains NO risk variables