To: RMA

Re: Actuarial Review for Price Volatility Factor Methodology

Date: 10‐29‐2014

The following comments are in response to the RMA public request for review and feedback of the Actuarial Review for

Price Volatility Factor Methodology, a contracted study performed by Sumaria Systems for RMA.

First, we would like to thank RMA for providing the Sumaria Review paper in a public forum, and the opportunity to

submit feedback on the study. We would also like to thank Sumaria systems for taking the time to fully document their

comprehensive work product for ease of understanding.

From our view, the Sumaria Systems contract study addressed two essential questions about the Volatility Factor

Methodology used in computing the premium associated with the price risk portion of MPCI Crop Insurance.

1. Is the Black‐Scholes methodology legitimate and do the volatility factors measure the price risk?

2. Is there a more valid and transparent methodology available?

The fundamental results of the Sumaria study were as follows:

1. While the conclusion is that the Black‐Scholes method is a legitimate one, there fails to be correlation between the

price volatility and magnitude of the actual price change. As a result the approach may not provide an adequate

measure of price risk within a given year for MPCI crop insurance.

2. Unable to identify or recommend any meaningful improved or acceptable alternatives.

As previously mentioned, Sumaria’s comprehensive analysis is understood and their thorough documentation is

appreciated.

However, because the implications of the study conclusions have not been addressed, we hope that RMA and Sumaria

Systems will recognize and appreciate our recommendation for their further involvement to address the following

outstanding matters.

Specifically, the Volatility Factor Methodology is admittedly unable to address the price risk embedded in the MPCI Crop

Insurance program. The implication is an understanding that years exhibiting low volatility factors may have (or even

observe) significant price change and that premiums associated with the price risk will be inadequate.

We would request that RMA consider addressing the issue in two ways.

A. Consider a floor in the volatility factor calculation.
 

The floor would, in low volatility years, serve as a means to ensure a reasonable but not excessive price‐risk premium is
 

generated to directly recognize that significant price risk may not be unlikely to occur (i.e. it may be more than just a tail
 

probability).
 

It is our estimate that low vol factors in the presence of volatile market conditions will exist more frequently than high

vol factors in the presence of significant market stabilization. Thus, the logical framework for an upside LR bias is

developed and the discussion/solution involving a floor should be the more immediate concern.

B. Consider risk management alternatives within the confines of the existing SRA Risk Share formulas in order to mitigate

the leveraged damage resulting from observed price volatility in the presence of low volatility factors (inadequate

premiums).
                                 

                                              

                                

                                

                                

                                   

                              

                                

                                       

                                  

                     

                                 

   

                                 

               

                                   

         

   

     

         

The underlying motivation is a result of the general acknowledgement that price risk cannot be appropriately measured

and experience is likely to exhibit an upward LR bias. As a result, it is logical to implement stop loss relief when price

reduction/increase exceeds a specific value. This value may be determined by specified percentiles associated with the

price curve implied by the volatility factor. Our recommendation is to address one of two ways:

i. to implement an RMA stop loss at 200% gross LR for these outlying losses or

ii. create harvest price bands around a base volatility factor. As the volatility factor/measurement changes from year to

year, the price bands would expand/contract appropriately with loss cessions outside of those harvest price ranges.

In recent years, companies have generally observed Gross Indemnities exceed Gross Premiums on a regular basis. The

majority of the coverage risk in the program can be classified as a Low Deductible Revenue Product (i.e. high coverage

level). In the meantime 2 recent and significant MPCI Program Development concerns of TA option and APH

modernization provide vehicles to increase a farmers “effective coverage level”.

Our view and expectation is that further pricing and risk management problems will arise given the program

development trend.

As such, we also recommend RMA and RMA Contractor’s begin to incorporate stakeholders in the crop insurance

program in advance of finalizing contract project scope.

We appreciate RMA’s efforts to understand industry concerns, and would like to thank RMA for the opportunity to

comment on this important issue.

Sincerely,

Brian Gugat

V.P. Research & Development

Rain & Hail / ACE