Subject: comments on price volatility factor methodology 

Wednesday, October 29, 2014 10:35:50 AM Date: 

Munich RE appreciates the opportunity to comment on captioned SUMARIA study which discusses the rating

 methodology regarding the price component in RMA's revenue protection policies. 

Given the observation that RMA's volatility factor, derived from implied volatilities computed from agricultural

 commodity exchanges, has, over the past 20 years, not been an adequate measure for actually observed price

 changes between planting and harvest, and has contributed, over the past 3 years, to inadequate revenue protection

 rate levels, Munich RE provides the following comments regarding the adequacy and use of implied volatility for

 revenue protection rate making purposes: 

1. Adequacy of the BSM as the core of RMA's revenue protection rate making methodology regarding price

 volatility 

1.1 By using the information contained in option markets, the crop insurance and revenue protection rate making

 system becomes dependent on the current status of financial markets. Such spill-over effects introduce additional

 risks that do not originate from the fundamentals of crop markets. 

1.2 The BSM assumes market participants, that, like in a real market, can go into or out of the market depending on

 their perception of current prices or price trends. However, since it is in the interest of the crop insurance system

 that all stakeholders participate on a continuous basis, not as opportunistic risk takers depending on the price on a

 specific date, one of the main assumptions underlying the BSM is by construction invalidated. 

Both observations can be detrimental to the stability of the agricultural insurance sector and question the adequacy

 of the BSM. Counter measures need to be put in place or the BSM needs to be modified or replaced. 

2. Since the US Federal Crop Insurance System is designed as public-private partnership with the objective to be

 sustainable for all participants over time, alternative methods to the BSM should be considered. 

We follow the argumentation of SUMARIA that, for an (sub)annual period, alternatives to the BSM are hard to be

 justified. Long-term participants in the US crop insurance system, however, will by necessity be confronted with

 the inherent limits of predictability by the BSM, one because they are bound by the annual contract (SRA) between

 the government and the insurer (AIP), and second because they need to make significant investments to be able to

 participate in the US crop insurance system. In consequence, risk takers (AIPs, reinsurers) are forced to consider

 additional risk loadings in order to justify their investment over say 3-5 years minimum. The effect of higher longterm risks is also observable in capital markets, where volatility curves tend to trend upward in most of the cases.

 Given this need of additional risk loadings, an alternative estimate for price volatility needs to be considered. Due

 to the lack of an adequate market measure of long term price risks, an estimate based on historical (static) price

 variability presents a reasonable alternative methodology to the BSM, and would provide market participants a

 more reliable, average pricing basis. 

3. If a BSM type of volatility was continued to be used, at least the following adjustments need to be considered: 

3.1 The seasonality in the second moment implies, that risk (i.e. variance) will not accumulate linearly over time, as

 in the BSM. The study of Egelkraut et al., as cited by Summaria, gives a first constructive idea of how to solve this

 issue. In consequence, the non-linear risk trend needs to be reflected by an additional rate component. 
3.2 Historical price events with relevance to revenue protection have shown to be in the tail of the distributions.

 ATM volatilites by definition lack information about the likelihood of extreme events. However, the tail

 information available by the option prices is not used. The study of Summaria itself gives plenty evidence, that

 higher moments are relevant. They discard using higher moments due to thinly traded markets. Using actively

 quoted options to extract the skew, while maintaining the calculation of ATM volatilities from traded options, can

 remedy this problem. 

Thank you for your consideration of our comments. 

Lambert Muhr 

Karl Murr 

Ralph Paschke 

for Munich RE 

Münchener Rückversicherungs-Gesellschaft (“Munich Reinsurance Company”) is a reinsurance company organized

 under the laws of Germany. In some countries, including in the United States, 

Munich Reinsurance Company holds the status of an unauthorized reinsurer. Policies are underwritten by Munich

 Reinsurance Company or its affiliated insurance and reinsurance subsidiaries. 

Certain coverages are not available in all jurisdictions. 

Münchener Rückversicherungs-Gesellschaft
 

Aktiengesellschaft in München
 

Königinstraße 107, 80802 München
 

Sitz der Gesellschaft: München
 

Amtsgericht München, HRB 42039
 

Vorsitzender des Aufsichtsrats: Dr. Bernd Pischetsrieder
 

Vorstand: Dr. Nikolaus von Bomhard, Vorsitzender;
 

Giuseppina Albo, Dr. Ludger Arnoldussen,
 

Dr. Thomas Blunck, Georg Daschner,
 

Dr. Doris Höpke, Dr. Torsten Jeworrek,
 

Dr. Peter Röder, Dr. Jörg Schneider,
 

Dr. Joachim Wenning