Crop Insurance: Opportunities Exist to Reduce Government Costs for Private-Sector Delivery
Released: 1997-04-17T00:00:00

Letter

Introduction

Federal crop insurance protects participating farmers against crop losses caused by perils such as droughts, floods, hurricanes, and other natural disasters. The federal program—which began on an experimental basis in 1938 after private insurance companies were unable to establish a financially viable crop insurance business—was restructured and greatly expanded by key legislation in 1980 and 1994. A major component of the 1980 legislation was the enlistment, for the first time, of private insurance companies to sell, service, and share the risk on federal crop insurance policies. In 1994, the Congress further broadened the program by offering farmers catastrophic risk insurance. This coverage, established at a minimum level, incorporated elements of the former crop disaster assistance program into crop insurance provided jointly by the U.S. Department of Agriculture (USDA) and private insurance companies.

USDA’s Risk Management Agency administers the federal crop insurance program through the Federal Crop Insurance Corporation (FCIC). FCIC pays the participating companies a fee, called an administrative expense reimbursement, that is intended to reimburse the companies for the reasonable expenses associated with selling and servicing crop insurance to farmers. The reimbursement is calculated as a percentage of the premiums paid, regardless of the expenses incurred by the companies. In addition to this reimbursement, participating insurance companies share with FCIC any gains or losses—known as underwriting gains and underwriting losses—that result from the insurance policies they sell. In 1994, 22 participating insurance companies received $395 million from the program—about $292 million in administrative expense reimbursements plus about $103 million in underwriting gains. In 1995, 19 participating insurance companies received $506 million from the program—about $373 million in administrative expense reimbursements plus about $133 million in underwriting gains. Expense reimbursements and underwriting gains varied by company according to the amount of premiums written, the amount of risk retained, and the management of the risk retained.

How Federal Crop Insurance Works Under the Crop Insurance Reform Act of 1994

Federal crop insurance offers farmers two primary types of insurance coverage—catastrophic and buyup. Both types of coverage are available for most major crops under the changes made by the Congress in the Federal Crop Insurance Reform and Department of Agriculture Reorganization Act of 1994 (P.L. 103-354, Oct. 13, 1994, title I). This act created catastrophic risk insurance as a replacement for expensive crop disaster assistance. Catastrophic insurance provides farmers with protection against extreme crop losses for a small processing fee. Buyup insurance provides protection against more typical and smaller crop losses in exchange for a farmer-paid premium. Participating insurance companies offer both types of insurance, whereas USDA’s Farm Service Agency (FSA), through its local offices, offers only catastrophic insurance. Under the terms of a negotiated agreement, participating insurance companies sell crop insurance and process any claims in exchange for an administrative expense reimbursement and for the opportunity to share in the potential for underwriting gains. The government pays the total premium for catastrophic insurance and a portion of the premium for buyup insurance. FCIC establishes the premiums, terms and conditions for both types of insurance.

Under the 1994 reform act, farmers who had not previously purchased crop insurance were required to purchase at least catastrophic insurance coverage if they signed up for USDA’s annual commodity programs; obtained USDA’s farm ownership, operating, or emergency loans; or contracted to place land in the Conservation Reserve Program. Subsequently, the Federal Agriculture Improvement and Reform Act of 1996 (P.L. 104-127, Apr. 4, 1996) eliminated this mandatory linkage by permitting farmers, effective for crops harvested in 1996, to forgo crop insurance for any given crop without losing eligibility for other programs, provided they waive all rights to any possible crop disaster assistance in connection with the particular crop.

Catastrophic insurance, which protects farmers against extreme losses, is often referred to as minimum coverage because it provides protection at the lowest production and price levels offered. Catastrophic insurance pays farmers only when they experience production losses greater than 50 percent of their normal crop. A normal crop is determined on the basis of a farmer’s production history as reported to USDA’s local office or to the insurance agent. For production losses greater than 50 percent, farmers are paid 60 percent of FCIC’s projected market price for the crop.

Farmers desiring protection above the minimum price or production levels provided by catastrophic insurance can purchase buyup insurance. Unlike farmers who purchase catastrophic insurance, farmers purchasing buyup insurance must choose both the coverage level (the proportion of the crop to be insured) and the unit price (e.g., per bushel) at which any loss is calculated. With respect to the coverage level, farmers can choose to insure as much as 75 percent of normal production (25-percent deductible) or as little as 50 percent of normal production (50-percent deductible) at different price levels. With respect to unit price, farmers choose whether to value their insured production at FCIC’s full projected market price or at a percentage of the full price. FCIC adjusts farmers’ premiums according to the production and price levels selected.

The following example illustrates how a claim payment is determined under catastrophic insurance, which insures 50 percent of production and 60 percent of the price. A farmer whose normal crop production averages 100 bushels of corn per acre and who chooses catastrophic insurance will be guaranteed 50 percent of 100 bushels, or 50 bushels per acre. Assuming that FCIC had estimated the market price for corn at $3 per bushel, the farmer will be guaranteed a price of 60 percent of $3, or $1.80 per bushel. The farmer’s total coverage per acre will be $90 (50 bushels x $1.80 per bushel). This total amount will be paid in the event of a complete crop failure. Should an event like drought cut the farmer’s actual harvest from 100 to 60 bushels, the farmer will not receive a payment because, in this example, catastrophic insurance only pays if the yield drops below 50 bushels per acre. If a more severe problem caused the yield to fall to 25 bushels per acre, the farmer will be paid for the loss of 25 bushels per acre—the difference between the insured production level of 50 bushels and the actual production of 25 bushels. In this case, catastrophic insurance will pay the farmer’s claim at $1.80 x 25 bushels, or $45 per acre.

If this same farmer chooses buyup insurance at the 75-percent coverage level, the farmer will be guaranteed 75 percent of 100 bushels, or 75 bushels per acre. Assuming that the farmer had chosen the maximum price coverage of 100 percent, and that FCIC had estimated the market price for corn at $3 per bushel, the farmer’s price coverage will be $3 per bushel. Accordingly, the farmer will have coverage in the event of a total crop loss of $225 per acre (75 bushels x $3 per bushel). Should drought or other perils cut the farmer’s actual harvest to 60 bushels, the farmer will be paid for the loss of 15 bushels per acre—the difference between the insured production level of 75 bushels and the actual production of 60 bushels. In this case, buyup insurance will pay the farmer’s claim at $3 x 15 bushels, or $45 per acre. In the event of a more severe loss that reduced production to a level of 25 bushels per acre, the farmer will be paid for the loss of 50 bushels per acre—the difference between the insured production level of 75 bushels and the actual production of 25 bushels. In this case, buyup insurance will pay the farmer’s claim at $3 x 50 bushels, or $150 per acre.

The Insurance Companies’ Role in Crop Insurance Delivery

According to a written agreement between FCIC and participating insurance companies—called the standard reinsurance agreement—FCIC pays the participating companies a uniform reimbursement for administrative expenses at a preestablished percentage of total premiums to deliver—sell and service—catastrophic and buyup insurance. This base rate can be, and has been, supplemented to provide additional funding in years when administrative costs were high because of excess losses or when other factors require the companies to conduct additional work. Beginning in 1994, as part of the agreement, FCIC required each participating company to report its delivery expenses to FCIC for the prior year to help determine the long-term adequacy of the reimbursement rate. In addition to providing an administrative expense reimbursement, this agreement governs the participating companies’ share of any underwriting gains or losses resulting from the policies they sell.

FCIC does not directly reimburse the participating companies for their actual costs of administering the program. Instead, FCIC pays all participating companies a uniform administrative expense reimbursement at a preestablished percentage of total premiums (including the farmer-paid premium, government premium subsidy for buyup insurance, and the imputed premium for catastrophic insurance). FCIC pays participating companies an administrative expense reimbursement that is intended to reimburse them for the expenses that can be reasonably associated with the sale and service of federal crop insurance, including the expenses associated with adjusting claims. Because the reimbursement is not tied to specific expenses, the companies are not obligated to spend the payment they receive on selling or servicing crop insurance policies; the payments can be used in any way the companies choose. Since 1980, in fact, the reimbursement rate has evolved as a result of negotiations between FCIC and the participating companies and budget concerns and has not been based on a systematic evaluation of companies’ expenses.

For buyup insurance, the administrative expense reimbursement base rate under the standard reinsurance agreement has declined from a high of 34 percent of total premiums between 1988 and 1991 to 31 percent between 1994 and 1996. In 1995, the administrative expense reimbursement for buyup insurance totaled 32.6 percent of buyup premiums. This reimbursement rate included a base administrative expense reimbursement of 31.0 percent of premiums and a supplemental reimbursement of 1.6 percent of premiums associated with extra adjustments for crop losses in 1995. The 1994 reform act requires FCIC to limit the reimbursement rate for selling and servicing buyup insurance to no more than 29 percent of total premiums in 1997, no more than 28 percent in 1998, and no more than 27.5 percent by 1999. While this reduction in reimbursement rate was mandated by the act, the established rates were not based on a systematic evaluation of the costs associated with selling and servicing crop insurance.

For catastrophic insurance, companies were paid a lower base reimbursement rate—13.8 percent of the imputed premiums—for delivering catastrophic insurance and were allowed to keep most of the $50 processing fee paid by farmers. In 1995, compensation for catastrophic insurance totaled 24.0 percent of catastrophic premiums, including (1) a base administrative expense reimbursement of 13.8 percent of premiums;(2) a retained farmer-paid processing fee of $50, equating to 9.3 percent of premiums; and (3) a supplemental reimbursement of 0.9 percent of premiums associated with extra adjustments for crop losses in 1995.

Beginning in 1994, FCIC began to require companies to submit a detailed expense report in a consistent format following standard industry guidelines for the prior calendar year—1993. However, not all companies complied with the new requirement until 1995 when they reported 1994 expense data. This expense reporting has to comply with a number of guidelines, such as those that the National Association of Insurance Commissioners issues on allocating expenses among lines of business. These expense reports do not directly affect the amount paid to the companies but rather provide support and serve as an indicator for establishing future reimbursement rates for administrative expenses. Included in the expenses reported are loss adjustment costs, sales commissions paid to local insurance agents, and the general administrative expenses associated with operating the insurance companies, such as payroll, equipment, travel, training, and rent. Currently, FCIC is developing a new standard reinsurance agreement, including new expense reimbursement rates, that will be completed with the participating companies in June 1997.

In addition to receiving an administrative expense reimbursement, the participating companies share any underwriting gains or losses with FCIC that result from the policies the companies sell. Underwriting gains occur if the premiums exceed the claims paid on the policies. In the same manner, underwriting losses occur when the claims paid exceed the premiums. The participating companies are able to vary the extent to which they share in the risk. In general, the companies choose to retain more of the risk on the historically lower-loss producers and share more of the risk with FCIC for those producers who have a history of more frequent or more severe loss experience. In addition, to protect participating companies against high underwriting losses in years with extreme crop losses, FCIC limits the total loss that participating companies must share.

The number of companies selling and servicing crop insurance for FCIC has decreased from 27 in 1990 to 16 in 1996 because of business acquisitions and changing business relations. Insurance premiums written by participating companies during this same period increased from $747 million in 1990 to $1.6 billion in 1996. As shown in table 1.1, FCIC paid participating companies significantly larger administrative expense reimbursements than the companies earned in underwriting gains between 1990 and 1996. This reflects the fact that the reimbursement is a fixed fee based on premiums written, whereas the underwriting gain varies depending on crop loss experiences.

Recent Federal Crop Insurance Sales

Between 1994 and 1995, federal crop insurance sales increased from $918 million to over $1.5 billion. In 1995, catastrophic insurance accounted for $456 million in premiums, and buyup insurance accounted for an additional $1.1 billion in premiums. Before catastrophic insurance was available, the program had been generating average premiums of about $700 million a year. As shown in table 1.2, participating companies sold a larger portion of federal crop insurance than USDA.

In 1996, federal catastrophic crop insurance sales decreased slightly to $424 million, while federal buyup insurance increased to almost $1.4 billion.

Government Costs Have Increased in Recent Years

Under the expanded federal crop insurance program created by the 1994 reform act, program costs increased from over $700 million in the early 1990s to about $1.6 billion in 1996. As shown in table 1.3, federal crop insurance costs paid by the government totaled about $7.2 billion from 1990 through 1996 and were made up of claims paid in excess of premiums ($1.6 billion), premium subsidy ($2.8 billion), administrative expense reimbursements ($2.2 billion), and other administrative costs ($611 million).

Objectives, Scope, and Methodology

Concerned about the cost-effective delivery of federal crop insurance and recognizing the important role the private insurance industry plays in delivering federal crop insurance, the Congress, in section 118 of the Federal Crop Insurance Reform and Department of Agriculture Reorganization Act of 1994, directed GAO and FCIC to jointly evaluate the financial arrangements between FCIC and participating insurance companies for delivering the crop insurance program to qualified producers and to address several specific issues. Separately, USDA’s Risk Management Agency will report on the adequacy of return on capital to insurance companies and alternative reinsurance arrangements between the government and the companies. Our review focused on the following two issues:

The adequacy and reasonableness of the current administrative reimbursement rate for expenses of participating companies; and

The cost to the government of private-sector delivery compared with USDA delivery of catastrophic insurance.

As required by the act, we also reviewed and reported on (1) the advantages and disadvantages of alternatives to the current arrangement for reimbursing administrative expenses, and (2) FCIC’s actions to simplify procedural and administrative requirements. The results of our work for these two topics are reported in chapter 4 and appendix I, respectively.

To assess the adequacy of the current reimbursement rate for administrative expenses, we compared participating companies’ reported expenses for selling and servicing buyup insurance with reimbursements they received from FCIC for 1994 and 1995. Not all participating companies reported these expenses to FCIC in a consistent format until 1994; furthermore, 1996 expenses for selling and servicing crop insurance were not complete at the time of our review. We assessed expense data for crop insurance at nine participating companies that represented about 80 and 85 percent of the crop insurance premiums in 1994 and 1995, respectively. To gain an understanding of crop insurance expenditures, we interviewed representatives from participating companies and obtained an explanation of all reported expenses. In addition, to evaluate the reasonableness of reported expenses, we used as guidance FCIC’s listing of allowable expenses, the National Association of Insurance Commissioners’ guidelines, generally accepted accounting principles, federal acquisition regulations, and the Internal Revenue Code.

Within the framework of these standards and guidelines, we made judgments about what we considered to be reasonably associated expenses for selling, processing, and adjusting crop insurance policies for the federal government and discussed these judgments with the FCIC officials responsible for administering the program. Generally, we considered as reasonable those expenses associated with (1) interacting with farmers, (2) reviewing insured property, (3) processing policy and claims paperwork, and (4) related overhead and indirect costs, including the training and travel of staff. As part of our review, we examined participating companies’ complete list of reported expenses. For a judgmental sample of these reported expenses, we traced the expenses to source documents. Our results reflect only the findings at the companies we reviewed and do not necessarily reflect the conditions for other companies selling federal crop insurance. We did not specifically validate companies’ accounting systems, but we did review each company’s audited financial statements to ensure ourselves that the financial data provided were reasonable. Appendix II provides a list of the participating companies we visited.

To examine the cost differences to the government between USDA and private-sector delivery of catastrophic insurance, we analyzed the government’s costs to use participating companies in comparison with the costs of using USDA. To perform our analysis, we obtained 1995 data on the costs to deliver catastrophic insurance through USDA, including costs for USDA’s headquarters in Washington D.C.; its main field offices in Kansas City, Missouri; and its state, regional service, district, and local offices. We reduced the costs for USDA’s delivery system by the amount of processing fees the Department collected from farmers for catastrophic insurance. We made the reduction because USDA uses these fees to reduce other government expenditures. To identify the government’s costs to use participating companies to deliver catastrophic insurance, we obtained data from FCIC on administrative expense reimbursements as well as underwriting gains paid to companies that participated in the catastrophic insurance program in 1995.

To identify alternative methods for expense reimbursements, we interviewed officials of selected participating companies, trade associations, and USDA. We then narrowed the compilation down to four distinct alternatives and analyzed them against the 1995 crop insurance experience, where reasonable, to measure their impact as if they had been in place for that year. We also determined qualitative factors associated with each of the methods through discussions with industry and FCIC officials.

To determine the status of procedural and administrative simplification, we reviewed FCIC’s summary of completed and in-progress simplification and paperwork reduction actions; and we reviewed potential simplification actions proposed by FCIC and by representatives of the crop insurance industry. We discussed the potential cost and benefit of these proposed actions with crop insurance company and FCIC officials. The information we developed is presented in appendix I.

We conducted our review from March 1996 through March 1997 in accordance with generally accepted government auditing standards. Although we did not independently assess the accuracy and reliability of USDA’s computerized databases, we used the same files USDA uses to manage the crop insurance program and its local county offices.

In December 1996, we provided USDA officials and representatives of National Crop Insurance Services, Inc., the American Association of Crop Insurers, the Crop Insurance Research Bureau, Inc., and several individual companies with a detailed briefing on the results of our review. In March 1997, we provided a copy of our draft report to USDA and to the crop insurance industry organizations for their review and comment. The Department’s and industry’s comments are addressed at the end of each chapter. In addition, the industry’s written comments are reproduced in appendixes VIII and IX.

USDA and Crop Insurance Industry Comments

USDA’s Risk Management Agency found no fault with our methodology. However, the industry associations that received copies of our draft report stated that our review did not fully respond to the Congress’ mandate in the 1994 reform act because we focused on delivery costs and did not address other requirements of the act. We focused on delivery costs because, in researching the legislative history of this mandate, we found that in the context of funding this program in a deficit reduction environment, the paramount congressional interest was in controlling the costs of reimbursing crop insurers. Furthermore, we confirmed our interpretation of the mandate in a commitment letter sent to the Chairmen and Ranking Minority Members of the Senate Committee on Agriculture, Nutrition, and Forestry and the House Committee on Agriculture. This letter set forth our approach for meeting this mandate including our scope and methodology. Consequently, we focused on costs incurred by insurers that are reimbursed by the government in order to provide the information most useful to congressional decisionmakers. Therefore, we believe that the report fulfills the Congress’ mandate.

Administrative Expense Reimbursements Paid by the Government Exceed Private Companies’ Expenses

In 1994 and 1995, FCIC’s reimbursement payments to the nine participating companies in our review were higher than the expenses that can be reasonably associated with the sale and service of federal crop insurance. For the 2-year period, the companies we reviewed reported $542.3 million in expenses, compared with a reimbursement of $580.2 million—a difference of about $38 million. In addition, our review of the companies’ reported expenses showed that about $43 million did not appear to be reasonably associated with the sale and service of federal crop insurance to farmers and thus, should not be considered in determining future administrative reimbursement rates. These expenses included payments to compensate company executives for refraining from joining or starting competing companies, fees paid to other insurance companies to protect against underwriting loss, bonuses tied to company profitability, management fees paid to parent companies with no identifiable benefit to subsidiary crop insurance companies, and lobbying expenses.

We further identified a number of expenses reported by the companies that, while in categories that can be reasonably associated with the sale and service of crop insurance, seemed to be excessive for a taxpayer-supported program. These expenses included above-average commissions paid to agents by one large company, corporate aircraft and excessive automobile charges, country club memberships, and various entertainment activities for agents and employees, such as stadium sky box rentals at professional sporting events and company-sponsored fishing trips. Although nothing in the current agreement between FCIC and the insurance companies precludes the companies from spending on these items, we believe that these types of expenses suggest that opportunities exist for the government to reduce its future reimbursement rate. Furthermore, a variety of emerging factors, including higher crop prices and higher premium rates in 1996 and 1997, and program simplification, have increased companies’ revenues or may decrease companies’ expenses.

Reimbursements Exceed Expenses

For 1994 and 1995, companies collectively reported expenses that were less than the administrative expense reimbursement they received from FCIC. For 1994, the reimbursement was equal to the expenses reported, and for 1995, reported expenses were about $38 million less than the reimbursement. After examining the companies’ expense reports, however, we determined that a number of the reported expenses did not appear to be reasonably associated with the sale and service of crop insurance to farmers and thus, should not be considered in determining an appropriate future reimbursement rate for administrative expenses. After adjusting the expense reports to delete these items, we found that the expenses reasonably associated with crop insurance delivery were about $43 million less than those reported.

Companies Received Higher Reimbursements Than Their Expenses Over 2-Year Period

In total for 1994 and 1995, the nine companies we reviewed reported expenses for buyup and catastrophic crop insurance sales and service that were somewhat less than the administrative expense reimbursement FCIC paid them. FCIC administrative expense reimbursements paid to participating companies in 1994 and 1995 were 31 and 31.4 percent of total premiums, respectively. This represented $236.5 million in 1994 and $343.6 million in 1995. For these same years, the companies reported expenses of 31 percent, or $236.8 million, and 27.9 percent, or $305.5 million, respectively. Collectively, reported expenses were $38 million less than the reimbursements the companies received.

As shown in figure 2.1, the largest component of the expenses reported by the companies went to pay sales commissions to local insurance agents.

The average commission reported for 1995 was less than in 1994—14.5 percent of total premiums compared with 17.2 percent of total premiums in 1994. The 1995 average commission was lower because in that year companies combined catastrophic expenses, which have lower agent commissions, with buyup expenses. With respect to loss-adjusting expenses, although insurance claims were higher in 1995 than in 1994, the company reports that showed average loss-adjusting expenses as a percent of premium actually dropped slightly in 1995.

Some Reported Expenses Do Not Appear to Be Reasonably Associated With Crop Insurance Delivery

Our review of the nine companies’ reported expenses showed that about $43 million did not appear to be reasonably associated with the sale and service of federal crop insurance to farmers and thus should not be considered in determining an appropriate future reimbursement rate for administrative expenses. Expenses reported by the companies that did not appear to contribute to the sale and service of crop insurance were expenses related to acquiring competitors’ businesses, protecting companies from underwriting losses, sharing profits through bonuses or management fees, reporting errors and omissions.

Each of these types of expenses is discussed below.

Expenses Related to Acquisition of Competitors’ Businesses

Among the reported costs that did not appear to be reasonably associated with the sale and service of crop insurance to farmers were those related to costs the companies incurred when they acquired competitors’ business. These costs potentially aided the companies in vying for market share and meant that one larger company, rather than several smaller companies, was delivering crop insurance to farmers. However, this consolidation was not required for the sale and service of crop insurance to farmers, provided no net value to the crop insurance program, and according to FCIC, was not an expense that FCIC expected its reimbursement to cover.

We identified costs in this general category totaling $12 million—$8.3 million in 1994 and $3.7 million in 1995. For example, one company took over the business of a competing company under a lease arrangement. The lease payment totaled $3 million in both 1994 and 1995. About $400,000 of this payment could be attributed to actual physical assets the company was leasing and we recognized this amount as a reasonable expense. However, the remaining $2.6 million—which the company was paying each year for access to the former competitor’s policyholder base—provided no benefit to the farmer and added no net value to the program. Likewise, we saw no apparent benefit to the crop insurance program from the $1.5 million the company paid executives of the acquired company over the 2-year period as compensation for not competing in the industry.

In a related instance, the company reported a $3.9 million expense to write down the value of an acquired company because of liabilities identified after acquiring that company’s business. These liabilities arose from crop insurance claims in dispute, crop insurance claims paid in error, premium adjustments, legal actions, and bad debts relating to the acquired company’s operations in prior years. This expense reflected a cost that the company incurred to increase its market share and provided no net benefit to the program. Although FCIC did not explicitly refer to this type of expense in its last standard reinsurance agreement with companies, we discussed this type of expense with FCIC. It agreed that this expense cannot be reasonably associated with the sale and service of crop insurance and thus should not be considered in determining a future reimbursement rate for administrative expenses.

Expenses Related to Protecting the Companies From Underwriting Losses

We also found that two companies included payments to commercial reinsurers among their reported delivery expenses for crop insurance. These are payments the companies made to other insurance companies to expand their protection against potential underwriting losses. This commercial reinsurance allows companies to expand the amount of insurance they are permitted to sell under insurance regulations while limiting their underwriting losses. The cost of reinsurance relates to companies’ decisions to manage underwriting risks rather than to the sale and service of crop insurance to farmers. Although FCIC did not explicitly refer to this type of expense in its last standard reinsurance agreement with companies, we discussed this type of expense with FCIC. It agreed that this expense should be paid from company underwriting results and thus should not be considered in determining a future reimbursement rate for administrative expenses. For the two companies that reported reinsurance costs as an administrative expense, these expenses totaled $10.7 million over the 2 years—$5.4 million in 1994 and $5.3 million in 1995.

Expenses Resulting From Sharing Profits Through Bonuses or Management Fees

Among their reported administrative expenses for crop insurance, some companies included expenses resulting from decisions to share profits with (1) company executives and employees through bonuses or (2) parent companies through management fees. We found that expenditures in this general category totaled $12.2 million—$5 million in 1994 and $7.2 million in 1995. We do not believe that bonuses associated with profit sharing are appropriate for inclusion in a long-term reimbursement rate. In contrast, we believe that bonuses given to recognize employee performance, as well as bonuses paid to agents, are reasonable expenses associated with the sale and service of crop insurance, and we included them as reasonable expenses.

Profit-sharing bonuses—bonuses linked to overall company profitability for each year—were a significant component of total salary expenses at one company, equaling 49 percent of basic salaries in 1994 and 63 percent in 1995, and totaling $9 million for the 2 years. Total employee salaries at this company, as a percent of premium, were somewhat less than at other companies. However, when the profit-sharing bonuses—paid out of profits after all necessary program expenses were paid—were added to salaries, overall employee salaries at this company were 35-percent higher than the nine-company average. While company profit sharing may benefit a company in competing with another company for employees, the profit-sharing bonuses, which in this particular case seemed excessive, do not contribute to the overall sale and service of crop insurance or serve to enhance program objectives. Additionally, we identified profit-sharing bonuses totaling $2.1 million reported as expenses at three other companies for 1994 and 1995. FCIC agrees that this type of expense goes beyond the reasonable expenses associated with the sale and service of crop insurance.

Similarly, we noted that two companies reported expenditures for management fees paid to parent companies as administrative expenses for crop insurance. Company representatives provided few examples of tangible benefits received in return for their payment of the management fee. We recognized management fees as a reasonable program expense to the extent that companies could identify tangible benefits received from parent companies. Otherwise, we considered payment of management fees to be a method of sharing income with the parent company and paid in the form of a before-profit expense item rather than as a dividend. These expenses totaled $1.1 million for 1994 and 1995.

Although FCIC did not explicitly refer to these types of expenses in its last standard reinsurance agreement with companies, we discussed these expenses with FCIC. It agreed that to the extent the expenses exceed tangible benefits to the companies, they cannot be reasonably associated with the sale and service of crop insurance and thus should not be considered in determining an appropriate future reimbursement rate for administrative expenses.

Lobbying and Related Expenses

FCIC’s standard reinsurance agreement with the companies precludes them from reporting expenditures for lobbying as crop insurance delivery expenses. Despite this prohibition, we found in our sample of company transactions that the companies included a total of $418,400 for lobbying and related expenses in their expense reporting for 1994 and 1995. The vast majority of these expenses involved lobbying by crop insurance trade associations.

Each company in our review paid membership fees to one or more crop insurance trade associations. Lobbying is one of the services provided to the companies by these associations. In accordance with Internal Revenue Service’s rules, each industry trade association provided information to its members on the extent to which the payments to the association were used to fund lobbying activities. Nevertheless, none of the companies in our review excluded these expenses from their expense reports.

Expenses Reported in Error and Omitted Expenses

We also identified a number of errors and/or omissions in the companies’ expense reporting. In 1994, the net effect of these errors and omissions was to reduce total company expenses by $8.4 million, whereas in 1995, the net effect was to increase total company expenses by $0.6 million.

In our review of companies’ reported expenses, we identified various errors and/or omissions including expenses reported in the wrong year, expenses reported twice, and expenses not reported at all. Also, we found that five companies erred in reporting a total of $1.8 million in state income taxes as an expense of selling and servicing crop insurance in 1994 and 1995. State income taxes are the result of successful crop insurance delivery and are not an administrative expense associated with the sale and service of crop insurance to farmers, whether the taxes are based on underwriting gains or on profits made from the delivery itself. To the extent that the taxes are based on profits from the delivery, they are not associated with the sale and service of crop insurance because, according to FCIC, companies are expected to earn profits from underwriting—not from administrative reimbursements. To the extent that the taxes are based on underwriting gains, they should not be recognized as an expense of delivering crop insurance.

Collectively, as shown in table 2.1, for the nine companies we reviewed, we found that the expenses reasonably associated with the sale and service of buyup and catastrophic crop insurance combined were 27.5 percent of total premiums for 1994 and 26.4 percent for 1995. These rates are considerably lower than the 31 percent and 31.4 percent of total premiums paid by FCIC to reimburse the companies for these sales in those years. In total for 1994 and 1995, FCIC reimbursements exceeded delivery expenses by $81 million. FCIC reviewed and agreed with our analysis and treatment of these expenses.

Appendix III provides a complete listing of those expenses that do not appear to be reasonably associated with the sale and service of federal crop insurance and should not be considered in determining an appropriate future administrative expense reimbursement. Appendix III also includes our rationale for expense adjustments. Appendix IV shows the expenses for selling and servicing federal crop insurance as reported by the nine companies in our review and our presentation of the expenses reasonably associated with the sale and service of federal crop insurance. In addition, for 1995, appendix IV shows adjusted expenses as they relate to buyup and to catastrophic insurance. As shown in the appendix, for 1995, companies’ adjusted expenses related to buyup insurance were 27.1 percent of premiums and expenses related to catastrophic insurance were 22.2 percent of premiums. In comparison, in 1995, companies received an administrative expense reimbursement for buyup insurance of 32.6 percent of buyup premiums and compensation for catastrophic insurance of 24 percent of premiums.

Other Reported Expenses Represent Opportunities to Lower Reimbursement Rates

We also found a number of expenses reported by the nine companies that, while in categories associated with the sale and service of crop insurance, seemed to be excessive in nature for a taxpayer-supported program and offer opportunities for FCIC to reduce future reimbursement rates. Collectively, controlling these expenses should reduce the average cost of selling and servicing crop insurance policies. These expenses included above-average commissions to agents on buyup policies; travel expenses, such as corporate aircraft and excessive automobile charges; and entertainment expenses, such as country club memberships and stadium sky box rentals. Each of these types of expenses is discussed below.

Agent Commissions

In the crop insurance business, participating companies compete with each other for market share through the sales commissions paid to independent insurance agents. To this end, companies offer higher commissions to agents to attract them and their farmer clients from one company to another. When an agent switches from one company to another, the acquiring company increases market share, but there is no net benefit to the crop insurance program. On average, the nine companies in our review paid agents sales commissions of 16 percent of buyup premiums they sold in 1994 and 16.2 percent in 1995. However, one company paid more—about 18.1 percent of buyup premiums sold in 1994 and 17.5 percent in 1995. When this company, which accounted for about 15 percent of all sales in these 2 years, is not included in the companies’ average, commission expenses for the other eight companies averaged 15.6 percent of buyup premiums in 1994 and 15.8 percent in 1995. This company paid its agents about $6 million more than the amount it would have paid had it used the average commission rate paid by the other eight companies. According to FCIC officials, the agency plans to further study the issue of appropriate agent commissions.

Travel-Related Expenses

Employee travel is an essential part of selling and servicing crop insurance. Although FCIC has not provided specific guidance on appropriate expenses for travel, government travel regulations provide guidance as to what type of expenses might be appropriate when conducting business on behalf of the government. In our review of company-reported expenses, at eight of the nine companies we found instances of expenses that seemed to be excessive for conducting a taxpayer-supported program.

For example, we found that one company in our sample for 1994 reported expenses of $8,391 to send six company managers (four accompanied by their spouses) to a 3-day meeting at a resort location. The billing from the resort included rooms at $323 per night, $405 in golf green fees, $139 in charges at a golf pro shop, and numerous restaurant and bar charges. Our sample for 1995 included a $31,483 billing from the same resort for lodging and other costs associated with a company “retreat” costing a total of $46,857. Furthermore, we found in one instance, as part of paying for employees to attend industry meetings at resort locations, a company paid for golf tournament entry fees, tickets to an amusement park, spouse travel, child care, and pet care. The company reported these as delivery expenses for crop insurance.

Moreover, our samples of travel expenditures revealed instances of charges that appeared to involve the purchase of items not related to business. For example, at one company, our sample included charges to the company corporate charge card of $107 at a department store, $175 at a clothing store, $165 at a country club gift shop, $364 at a book and record shop, $41 at an airport gift shop, $209 at a resort gift shop, $208 at a hotel gift shop, and $928 from a cruise line. We found similar examples at five other companies.

Some companies incurred expenses associated with maintaining their own travel fleet. For example, one company owned a corporate jet and another leased an aircraft. Both employed full-time pilots. Subsequent to the years involved in our review, both companies decided it would be more cost-effective to rely more heavily on commercial flights instead of owned or leased aircraft. The companies we reviewed varied widely with respect to furnishing automobiles—from providing only a few pool automobiles, to providing automobiles for a few officials, to providing automobiles for up to 45 percent of company employees. The types of vehicles also varied from luxury and sport utility to standard and economy.

FCIC’s guidelines do not tell companies how they must spend their administrative expense reimbursement. However, in our opinion, if the current reimbursement provides companies with the opportunities to travel as described above, FCIC may be able to reduce its reimbursement rate and still reimburse companies for the reasonable expenses of selling and servicing crop insurance to farmers.

Entertainment Expenses

Recruiting new employees and maintaining employee morale is a reasonable business expense. However, our review of company expenses showed that some companies’ entertainment expenditures appeared excessive for selling and servicing crop insurance to farmers. For example, one company spent about $44,000 in 1994 for Canadian fishing trips for a group of company employees and agents. It also spent about $18,000 to rent and furnish a sky box at a baseball stadium. Company officials said the expenditures were necessary to attract agents to the company. These expenditures were reported as travel expenses in 1994 and as advertising expenses in 1995. Moreover, the company’s 1995 travel expenses included $22,000 for a trip to Las Vegas for several company employees and agents. Similarly, our sample of company expenditures disclosed payment for season tickets to various professional sports events at two other companies; and six companies paid for country club memberships and related charges for various company officials and reported these as expenses to sell and service crop insurance.

Companies also purchased promotional items as gifts for agents and employees. For example, our 1994 sample of expenditures at one company included $17,514 paid for 1,375 boxes of chocolates and $8,242 paid to purchase 2,000 cookbooks as gifts to agents and employees.

While a number of the companies believe the type of expenses described above are important to maintaining an effective sales force and supporting their companies’ mission, we believe that most of these expenses appear to be excessive for a taxpayer-supported program. These entertainment expenses may be helpful in competing for agents, but it is not clear how these types of expenses directly benefit either the farmer or the government in the delivery of crop insurance to farmers. We did not exclude the above items from our determination of necessary delivery expenses because they were in categories that appear to be associated with crop insurance delivery. But FCIC agreed that these types of expenses may be excessive for a government-sponsored program like federal crop insurance.

Emerging Factors Have Increased Companies’ Revenues

Several emerging factors affecting the crop insurance program have increased companies’ revenues or may decrease companies’ expenses. These factors include the following: higher crop prices and higher premium rates in 1996 and 1997 that resulted in higher premium income; expanded use of new types of revenue guarantee coverage (such as crop revenue coverage) that, for a higher premium, protects farmers against price drops between planting and harvest; and continuing simplification of program administrative requirements, potentially resulting in reduced company expenses.

Higher crop prices and higher premium rates could enable FCIC to reduce the administrative expense reimbursement by about 3 percent of buyup premiums below the adjusted expense level determined in our analysis of companies’ 1994-95 expenses without diminishing service to farmers. New types of revenue guarantee coverage as well as simplification actions could serve to increase companies’ revenues or decrease companies’ expenses even further in the future. Each of these factors is discussed below.

Higher Crop Prices and Premium Rates

Two factors affecting the premiums paid by farmers have improved the income potential of crop insurance companies over the levels achieved in 1994 and 1995. These two factors are the (1) FCIC-projected market price of the commodity to be insured and (2) premium rate established by FCIC. When projected market prices and premium rates increase, the premiums that farmers pay increase. When the premiums that farmers pay increase, reimbursements to companies—which are currently paid on the basis of a percentage of premiums—increase proportionately without a proportionate increase in workload for the companies.

As shown in table 2.2, the projected market price FCIC used in establishing crop insurance premiums for six major crops increased 9.2 percent from 1995 to 1997, after the 1994-95 period we reviewed.

Furthermore, to improve the actuarial soundness of the program, FCIC has increased the basic premium rates that are the other principal component of the crop insurance premiums. From 1995 to 1996, basic premium rates for buyup insurance increased 3.6 percent, on average. FCIC projects premium rates to further increase in 1997. The increase in premium rates combined with the increase in crop prices resulted in an overall increase in premiums of about 13 percent. This increase occurred after the period we studied.

As a result of this increase in premiums, companies will receive a proportionate increase in their administrative expense reimbursement, about 3 percent of premiums, unless FCIC reduces the reimbursement rate. The additional 3 percent of premiums—the 13-percent increase in premiums multiplied by the 27.1 percent of premiums that we determined represents companies’ expenses reasonably associated with the sale and service of buyup crop insurance in 1995—is in effect an unanticipated bonus to the companies and does not represent additional work for them.

This means that FCIC, at current crop price and premium rates, could reduce the administrative reimbursement for buyup insurance by about 3 percentage points and still reimburse companies for the reasonable expenses associated with selling and servicing crop insurance. Conversely, if premiums decline, the companies would receive a proportionate decrease in their expense reimbursement.

The increase in the companies’ reimbursement resulting from the higher premiums that have occurred since 1995 will not be accompanied by a proportionate increase in the companies’ workload. Company administrative work processes remain essentially the same regardless of the premium charged. For example, the cost of data entry and transmission is a function of the number of documents and data elements processed and transmitted, not the premiums those documents represent. Similarly, the cost of loss adjustment is a function of the frequency and nature of crop loss, not the premiums charged on the damaged crops. Thus, as premiums increase, the companies receive windfall increases in their income unless the reimbursement percentage is reduced.

Expanded Use of Revenue Guarantee Coverage

A second factor that may improve the companies’ income potential is the introduction of a more expensive form of crop insurance. In 1996, FCIC approved a privately developed revenue guarantee crop insurance policy on a pilot basis in seven states. In January 1997, FCIC’s board of directors authorized the expansion of this program to additional crops and states. The revenue guarantee policy protects producers against a decline in the value of the insured crop. The decline in value could occur because of crop loss, as with traditional crop insurance policies, or it could result from decline in commodity prices, or some combination of the two. Because of the increased risk borne by the revenue guarantee program, premiums are considerably higher than those charged for conventional crop insurance. Thus, because the companies’ reimbursement is based on a percentage of total premiums, they will receive higher reimbursements without a commensurate increase in workload. A recent FCIC proposal addresses the potentially high administrative reimbursement associated with this product by limiting the administrative reimbursement for the price-risk aspect of the program.

Program Simplification Efforts

A third emerging factor affecting the crop insurance program may aid the companies in reducing their administrative expenses. As part of implementing the 1994 crop insurance reform act, FCIC and the crop insurance industry jointly studied potential procedural changes that could result in simplifying or streamlining program delivery processes. As of January 1997, FCIC had completed action on 26 simplification projects identified by the study group and was continuing to study 11 additional potential changes. Simplification projects FCIC has implemented include restructuring actuarial documents, thereby reducing printed pages by providing actuarial documents electronically; simplifying processing of small claims; authorizing companies to correct obvious and incidental errors directly; integrating various options and endorsements into crop insurance policies; and implementing a single insurance policy format for most crops.

Neither FCIC nor the companies could precisely quantify the amount of savings that can be expected from these changes, but they agreed that the changes were necessary and collectively may reduce costs somewhat. Industry representatives emphasized that FCIC should continue to emphasize simplifying the delivery procedures. FCIC officials agreed but noted that any changes must be carefully analyzed on the basis of their impact on the actuarial soundness of the crop insurance program. Appendix I provides a more detailed discussion of these changes and their potential effects.

Conclusions

On the basis of our review of companies’ reported expenses and emerging factors in the crop insurance industry, we believe that the current expense reimbursement rate paid to participating companies exceeds the reasonable expenses associated with selling and servicing crop insurance. Our review showed that for 1994 and 1995, the actual expenses reasonably associated with the sale and service of buyup crop insurance for the nine companies in our review were about 27 percent of premiums—4 percentage points below the 31-percent base reimbursement rate paid to companies—and that FCIC could reduce rates another 3 percent of premiums because of higher crop prices and increased premiums in 1996 and 1997 that provided companies with higher reimbursements without any additional work. This would still provide participating companies with adequate reimbursement for the reasonable expenses associated with selling and servicing crop insurance. The 1994 reform act directs FCIC to reduce the overall reimbursement for buyup insurance to no more than 27.5 percent of total premiums in 1999.

However, we believe that the administrative reimbursement rate can be reduced to a lower level at the current time—in the range of 24 percent. Our analysis also showed that the compensation for catastrophic insurance exceeded the companies’ expenses that can be reasonably associated with selling and servicing catastrophic insurance, although to a lesser extent.

Recommendations to the Secretary of Agriculture

We recommend that the Secretary of Agriculture direct the Administrator of the Risk Management Agency to determine the administrative expense reimbursement rate that reflects the appropriate and reasonable costs of selling and servicing traditional buyup insurance and include this rate in the new agreement currently being developed with the companies; determine the compensation that reflects the appropriate and reasonable costs of selling and servicing catastrophic crop insurance and include it in the new agreement currently being developed with the companies; explicitly convey to participating insurance companies the type of expenses that the administrative reimbursement is intended to cover; and monitor companies’ expenses to ensure that the established rate is reasonable for the services provided.

USDA and Crop Insurance Industry Comments

Overall, USDA’s Risk Management Agency agreed with the information presented in the draft report and its conclusions and recommendations. In its proposed 1998 standard reinsurance agreement with the private insurance companies, FCIC has included changes to the expense reimbursement rate for delivering both buyup and catastrophic insurance. Additionally, in this proposed agreement, FCIC has clarified the types of expenses that the administrative reimbursement is intended to cover, and it plans to monitor companies’ expenses in the future as a result of our review. USDA’s Risk Management Agency also examined the methodology used to conduct the review and found no fault in it.

In responding to our report, the industry raised questions about the methodology we used in our analysis of companies’ reasonable delivery expenses, including (1) the time period we examined; (2) the standards we used to judge allowability of expenses; and (3) the applicability of emerging factors, such as increased premiums and higher crop prices. In addition, without being specific, the industry stated that a lower reimbursement rate—in the range of 24 percent—would “destabilize” the industry.

With respect to the time period examined, we selected 1994 and 1995 to provide a picture of expenses for delivering crop insurance before and after the implementation of the 1994 reform act. Furthermore, these were the first 2 years that the industry consistently provided the detailed data in a format needed to fully analyze the expenses associated with the selling and servicing of crop insurance. The industry stated that we understated administrative expenses by using 2 years in which crop losses were relatively low. We disagree. Crop losses for buyup coverage in 1995 were equal to or higher than crop loss experiences throughout the 1990s, except for 1993. Furthermore, we found that high crop losses did not significantly increase companies’ loss-adjusting expenses—the delivery cost factor most likely to be affected by high crop losses. For example, for buyup insurance, while companies paid out $1.28 in loss claims for every dollar of premium received in 1995 and $0.58 in loss claims for every dollar of premium received in 1994, their related loss adjusting expenses as a percent of premium for these 2 years were not substantially different. Therefore, although losses were higher in 1995 than in 1994, the companies’ loss adjusting expenses for processing these claims did not increase commensurately. In addition, loss adjusting expenses are not a significant portion of total administrative expenses (about 3.5 percent of premiums on average for the nine companies we reviewed). Furthermore, since the 1980s, the crop insurance companies have received additional reimbursements in years of high crop losses.

Second, the standards we used to identify reasonable costs for delivering crop insurance were developed on the basis of a number of different widely recognized accounting, insurance, and acquisition standards. FCIC agreed that the standards used were appropriate. We recognized all expenses reasonably associated with selling and servicing crop insurance. However, we continue to believe that the government should not be expected to reimburse companies for such expenses as those related to maximizing underwriting gains, acquiring other companies’ business, payments to executives to refrain from joining or starting other companies, payments to parent companies with no measurable benefits to the program, profit-sharing bonuses, and payments to lobbyists. We believe that these expenses should not be included in determining an appropriate future reimbursement rate for administrative expenses.

Third, two factors that have emerged since the 1994-95 time period that we reviewed—higher premium rates and higher crop prices in 1996 and 1997—should be considered in evaluating the appropriate, future reasonable reimbursement rate because these factors did increase companies’ revenues without increasing expenses. Furthermore, USDA projects that crop prices will generally increase through 2005. If crop prices decline, FCIC could reevaluate the reimbursement rate.

Finally, we disagree that a lower reimbursement rate—in the range of 24 percent—would destabilize the industry. Such a rate represents the companies’ current expenses that are reasonably associated with the sale and service of crop insurance and as a result should not diminish service to the farmer nor destabilize the program. Companies will still have the opportunity to realize underwriting profits. In 1994 and 1995, for example, the companies realized underwriting profits of $103 million and $133 million, respectively. (See apps. VIII and IX for the industry’s comments and our detailed response.)

USDA Delivered 1995 Catastrophic Insurance at Lower Cost to Government Than Private Companies

In 1995, farmers without crop insurance were required to purchase catastrophic risk protection insurance to participate in federal farm programs—a requirement that was rescinded in 1996. Farmers could purchase catastrophic insurance either from USDA’s FSA local offices or from an authorized local insurance agent. In 1995, it was more costly for the government to deliver catastrophic insurance through private companies than through USDA. When basic delivery costs were offset by income from farmer-paid processing fees, the costs to the government for selling and servicing catastrophic insurance in 1995 were comparable for both USDA and private companies. However, delivery through private companies was more costly to the government because the companies retained an estimated $45 million underwriting gain. In 1995, FCIC’s long-term target for underwriting gain was 7 percent on the premiums for which the companies retained risk. However, in 1995, the underwriting gain paid by FCIC to the companies was about 37 percent. FCIC is currently studying the issue of an appropriate long-term rate of return for companies participating in the program. Legislation passed in 1996 requires USDA to move delivery of catastrophic insurance solely to private companies, where feasible.

Cost to the Government in 1995 for USDA Delivery Less Because of Underwriting Gain Paid to Companies

In 1995, the total cost to the government to deliver catastrophic insurance was less when provided through USDA than through private companies. The total cost to the government to deliver catastrophic insurance consists of three components: (1) basic sales and service delivery costs, (2) offsetting income from processing fees paid by farmers, and (3) company-earned underwriting gains. When only the first and second components were considered, the costs to the government for both delivery systems were comparable. However, the payment of an underwriting gain to companies, the third component, made the total cost of company delivery more expensive to the government.

With respect to the first component—the costs of basic sales and service delivery—the cost to the government was higher when provided through USDA. The costs of basic sales and service for USDA’s delivery included expenses associated with activities such as selling and processing policies, developing computer software, training adjusters, and adjusting claims. This cost also included indirect or overhead costs such as general administration, rent, and utilities. Included in the 1995 direct and indirect costs for USDA delivery was the Department’s one-time start-up costs for establishing the USDA delivery system. Direct costs for basic delivery through USDA amounted to about $91 per crop policy, and indirect costs amounted to about $42 per crop policy, for a total basic delivery cost to the government of about $133 per crop policy. Appendix V provides more detail on the components of total government costs to deliver catastrophic insurance through USDA and insurance companies.

The basic delivery cost for company delivery consists of the administrative expense reimbursement paid to companies by FCIC and the cost of administrative support provided by USDA. The administrative expense reimbursement amounted to about $73 per crop policy, and USDA’s support costs amounted to about $10 per crop policy, for a total basic delivery cost to the government for company delivery of about $83 per crop policy.

The second component—offsetting income from farmer-paid processing fees—reduced the basic delivery cost to the government for both delivery systems, but had a much larger impact in reducing the cost to the government for the USDA delivery system. In 1995, farmers buying catastrophic insurance were required to pay a $50 processing fee for each crop they insured, up to certain limits. For USDA’s delivery, processing fees paid by farmers reduced the government’s basic delivery cost of about $133 by an average of $53 per crop policy. For company delivery, fees paid by farmers and remitted to the government reduced the government’s basic delivery cost of about $83 by $7 per crop policy. For company delivery, the effect on the cost to the government was relatively small because the 1994 reform act authorized the companies to retain the fees they collected from farmers up to certain limits. Only those fees that exceeded these limits were remitted back to the government. Combining the basic sales and service delivery costs and the offsetting income from farmer-paid processing fees, the government’s costs were comparable for both delivery systems.

The third component—underwriting gains paid by FCIC only to the companies—is the element that made delivery through USDA less expensive. The insurance companies can earn underwriting gains in exchange for taking responsibility for any claims resulting from those policies for which the companies retain risk. In 1995, companies earned an underwriting gain of an estimated $45 million, or about a 37-percent return on the catastrophic premiums for which they retained risk. This underwriting gain increased the government’s delivery cost for company delivery by $127 per crop policy. Underwriting gains are, of course, not guaranteed. In years with a high incidence of catastrophic losses, companies could experience net underwriting losses, meaning that they would have to pay out money from their reserves in excess of the premiums paid to them by the government, potentially reducing the government’s total cost of company delivery in such years.

Table 3.1 summarizes the three components of the government’s cost to deliver catastrophic insurance through USDA and companies in dollars per crop policy for 1995.

The table shows that, overall, the government’s cost for delivering catastrophic insurance through USDA was about $124 less per crop policy than the delivery cost through companies in 1995.

The 1995 catastrophic underwriting gain of about 37 percent was the critical component in the difference in comparative costs between USDA and company delivery. This gain was substantially higher than FCIC’s established long-term target of 7 percent for underwriting gains on the catastrophic premiums for which the companies retain risk. According to FCIC’s Senior Actuary, the large underwriting gain in 1995 may have been unusual. However, the program’s experience in 1996 suggests that the large underwriting gain in 1995 may not be that unusual; 1996 underwriting gains were even higher—about $58 million. FCIC is currently studying the issue of an appropriate long-term rate of return for companies participating in the program.

1996 Legislation Directs USDA to Move Toward More Private Company Delivery of Catastrophic Insurance

Beginning with crops harvested in 1997, the Federal Agriculture Improvement and Reform Act of 1996 requires that USDA’s delivery of catastrophic insurance be transferred to private companies in areas where there are sufficient private company providers. In July 1996, the Secretary of Agriculture, after consultation with approved insurance providers, identified 14 states in which USDA would no longer deliver catastrophic policies. Effective for the 1997 crop year, catastrophic policyholders in these 14 states who purchased catastrophic coverage from USDA were either to select a local private company or be assigned by USDA to a local private company. The 14 states are Arizona, Colorado, Illinois, Indiana, Iowa, Kansas, Minnesota, Montana, Nebraska, North Carolina, North Dakota, South Dakota, Washington, and Wyoming.

According to the American Association of Crop Insurers, crop insurance industry executives unanimously support securing the remaining 36 states for private delivery, beginning with crops harvested in 1998. According to the Federal Agriculture Improvement and Reform Act of 1996, the Secretary of Agriculture must make the announcement for any additional states where USDA delivery is to be phased out by April 30 of the year preceding the year in which the applicable crops will be harvested.

Conclusions

If only 1995 is considered, the delivery of catastrophic insurance through USDA is less expensive to the government than through companies because of the underwriting gains companies earned. These gains, 37 percent of catastrophic premiums on which the companies retained risk, were far higher than FCIC’s long-term target gain of 7 percent. Over time, gains and losses may offset each other, and the target gain may be realized. However, if underwriting gains do not become more commensurate with FCIC’s target gain, the potential for high government costs and high company profits will continue. FCIC is aware of this situation and is currently studying the issue of an appropriate long-term rate of return for companies participating in the program. Furthermore, this issue of potentially high costs and high profits takes on added importance because of the requirements of the Federal Agriculture Improvement and Reform Act of 1996. This act requires USDA to transfer its delivery of catastrophic insurance to private companies in areas where there are sufficient private company providers.

Recommendation to the Secretary of Agriculture

We recommend that the Secretary of Agriculture direct the Administrator of the Risk Management Agency to closely monitor the experience of the catastrophic insurance program to ensure that over time the underwriting gains earned on catastrophic insurance by the companies do not routinely exceed FCIC’s long-term target.

USDA and Crop Insurance Industry Comments

FCIC agreed with our conclusions and recommendation and has already changed the proposed 1998 standard reinsurance agreement to ensure that underwriting gains on catastrophic insurance will be more closely in line with its long-term target.

The industry, however, questioned our methodology for comparing the cost to the government of the USDA and company delivery systems. Specifically, it stated that the processing fees paid by farmers and the underwriting gains paid to companies should not be considered in analyzing the costs to the government for catastrophic insurance delivery. It also suggested that restricting our analysis to 1995 provided a distorted picture of underwriting gains because it only represented 1 year’s experience. It further stated that our analysis did not take into account that, in its view, the quality of service provided to farmers by the companies was much higher than that provided by USDA.

We disagree that an analysis of the comparative costs to the government of company- and USDA-delivered catastrophic insurance should exclude the processing fee and underwriting gains components. In computing the overall costs to the government, all revenue and payment components have to be considered. With respect to the industry’s concern about our period of analysis, 1995 was the only year in which a comparative assessment could be made at the time we conducted our review because it was the only year in which both USDA and the companies were delivering catastrophic insurance. Since then, however, we note that underwriting gains paid to the companies in 1996 exceeded those paid in 1995. This would serve to make the cost to the government for company-delivered catastrophic insurance even higher. With respect to the issue of comparative service quality, we did not make this a principal focus of our review. However, during the course of our work, we found little to suggest that the service provided by companies or USDA was less than satisfactory.

The industry’s comments also indicate that it believes our conclusions might mislead public policymakers by implying that delivery of catastrophic insurance by private industry should be reduced. We do not believe that this is the case. We did not conclude or recommend that the industry should have its role in catastrophic insurance delivery reduced. We do hold the view, however, that the level of underwriting gain paid to the companies should be managed so that it more closely follows FCIC’s target.

Alternative Expense Reimbursement Arrangements Offer Potential for Savings

The current method for reimbursing administrative expenses for buyup insurance—whereby FCIC pays private companies a fixed percentage of premiums—has certain advantages, including ease of administration. However, expense reimbursement based on a percentage of premiums does not necessarily reflect the amount of work or cost involved to sell and service crop insurance policies. We identified four alternative reimbursement arrangements that offer the potential to reduce FCIC’s reimbursements and to more closely match reimbursements with expenses. Each has advantages and disadvantages. Industry leaders prefer FCIC’s current reimbursement method because it is relatively simple to administer and because they believe that most alternatives could reduce their reimbursements.

Four Alternatives to the Current Reimbursement Arrangement

Through our discussions with FCIC and crop insurance industry officials, we identified the following four alternatives to the current expense reimbursement method that offer potential cost savings to the government and may more closely match FCIC’s reimbursements with companies’ expenses: place a cap on the amount reimbursed per policy; reimburse companies a flat fee per policy, plus a reduced percentage of reimburse companies according to a schedule of allowable expenses; and reduce reimbursement rates as companies’ total premium volume increases.

Currently, FCIC calculates administrative expense reimbursements by multiplying companies’ total written premiums by a set reimbursement percentage, regardless of the expenses incurred by the company to sell and service crop insurance. Table 4.1 shows the 1995 distribution of premiums and reimbursements for certain buyup policies for all participating companies.

Alternative 1—Place a Cap on Reimbursements Per Policy

Under the current reimbursement arrangement, as policy premiums increase, the companies’ reimbursement from FCIC for administering the policies increases. However, the workload, or cost, associated with administering the policy generally does not increase proportionately. Therefore, for policies with the highest premiums, there may be a large differential between FCIC’s reimbursement and the costs incurred to administer those policies. For example, in 1995, the largest 3 percent of the policies received about one-third of the total reimbursement. In fact, the five largest policies in 1995 had reimbursements ranging from about $118,000 to $472,000. FCIC could reduce its total expense reimbursements to companies by capping, or placing a limit on, the amount it reimburses companies for the sale and service of crop insurance policies.

Alternative 2—Pay a Flat Amount Per Policy Plus a Percentage of Premiums

For each crop insurance policy written, an insurance company must perform some minimum level of work, regardless of the premium. The company, usually through an agent, must obtain, record, and process certain basic policy information. The company performs additional work that varies, generally depending on the size of the farm and value of the crops insured. A larger farm may require more time to measure and inspect the component fields and more contacts with the farmer. This alternative is designed to recognize both the fixed and variable aspects of selling and servicing crop insurance policies. For example, FCIC could reimburse companies a fixed amount (such as $100) for each policy written to pay for the fixed expense associated with each policy. In addition, FCIC could pay a percentage of premiums to compensate companies for the variable expenses associated with the size and value of a policy.

Alternative 3—Tie Reimbursements to Schedule of Allowable Expenses

Administrative expense reimbursements could be tied to the cost of performing specific services that benefit the crop insurance program. For example, most government contractors are paid on the basis of the Federal Acquisition Regulation (FAR), which establishes a schedule of allowable expenses. Using the FAR, a contractor providing goods and services to the federal government submits a bill that is audited against a schedule of allowable expenses, and subsequently, the government pays an adjusted amount to the contractor, if appropriate. Using this approach, the amount paid would include only reimbursement for allowed expenses. FCIC could limit the overall reimbursement rate and limit the reimbursement rate for specific components, such as commissions, data processing, and travel. Companies could also be required to follow federal guidelines to reimburse employees or contractors for any travel.

Alternative 4—Reduce Reimbursement Rates as Premium Volumes Increase

Assuming companies can realize some economies of scale for certain cost items, FCIC could reduce the reimbursement rates for individual companies as their written premium volumes increase. For example, some expenses, such as underwriting and overhead, are based on fixed expenses, such as investments in equipment and facilities, annual training, and state licenses and fees. These types of fixed expenses decrease as a percent of total premiums written as premium volume increases. Currently, FCIC pays the same percent of written premiums to participating companies regardless of the companies’ size of operation or premium amount written. Under this alternative, FCIC would reimburse companies on a sliding scale based on premium volume.

Each Alternative Has Potential Advantages and Disadvantages

We found that all four alternatives have the potential to reduce FCIC’s reimbursement for administrative expenses. Each alternative, however, has advantages and disadvantages compared with the current reimbursement arrangement. For example, some alternatives have the advantage of possibly encouraging smaller companies to participate in the program. On the other hand, some alternatives have the potential disadvantage of increasing the administrative burden on FCIC or decreasing incentives for participating companies to deliver crop insurance. The potential advantages and disadvantages of each alternative are discussed below.

Place a Cap on Reimbursements Per Policy

Under this alternative, FCIC could realize the largest amount of administrative reimbursement savings while only affecting a relatively small percentage of policies. This alternative would eliminate high reimbursement payments for large or high-premium policies. To illustrate, to calculate potential cost savings using this alternative, we capped the administrative expense reimbursements on individual policies at three different levels—$1,550, $3,100, and $6,200—affecting about 9, 3, and 1 percent, respectively, of policies in 1995. Potential savings generated from this alternative would depend at what level the cap was established, as shown in table 4.2.

As shown in the table, a $3,100 cap would have created a $40.3 million savings while reimbursing companies at the 31-percent reimbursement level for more than 95 percent of the policies written in 1995. Only about 3 percent of all policies written would have been affected by using a $3,100 cap on reimbursements. Decreasing the cap to $1,550 would have provided savings to the government of about $74 million while limiting reimbursements on less than 10 percent of the policies written in 1995.

Although offering the potential for significant cost savings, this alternative has the disadvantage of possibly discouraging some companies from aggressively marketing larger crop insurance policies for FCIC.

Paying a Flat Amount Per Policy Plus a Percentage of Premiums

This alternative offers a potential for cost savings that is somewhat less than capping reimbursements at $1,550 per policy, but it may encourage companies to sell small-premium policies. To illustrate the potential for cost savings, we selected three different reimbursement combinations. As shown in table 4.3, if FCIC reimbursed companies a fixed $100 reimbursement per policy plus 17.5 percent of the premiums, the overall average reimbursement rate would be 22.8 percent. Compared with the 1995 reimbursement method, this approach would produce a savings of 8.2 percent of premiums, or about $67 million, from the 31 percent reimbursement rate. Table 4.3 also illustrates other reimbursement combinations.

Because one component of the reimbursement would be a flat fee regardless of premium size, reimbursements for small, or low-premium, policies under this alternative may exceed reimbursements for these kinds of policies under the current system. This may encourage sales and service to smaller farmers, a goal advanced by some crop insurance observers.

This alternative has the further advantage of more closely matching FCIC’s reimbursement to the administrative workload of the companies and their agents. Finally, unlike the previous alternative that capped reimbursements, reimbursements under this alternative would still be linked in part to premiums. Therefore, companies will continue to have an incentive to sell higher coverage.

This alternative has the disadvantage of requiring FCIC to more closely monitor companies to ensure they do not generate additional policies solely to increase their revenue.

Tying Reimbursements to Schedule of Allowable Expenses

This alternative would offer FCIC the opportunity to better control the expenses to be reimbursed by paying participating companies according to a schedule of allowable expenses for performing specific services, such as selling and writing a policy, processing a policy, and adjusting claims. Companies could be required to reimburse employees or contractors for any travel according to federal reimbursement guidelines for travel. Using the FAR, a contractor providing goods and services to the federal government submits a bill that is audited against a schedule of allowable expenses, and subsequently, the government pays an adjusted amount to the contractor, if appropriate. Savings under this alternative would depend upon the rates agreed to by FCIC and the companies. In addition, this alternative could provide participating companies with additional protection during years with high crop losses by reimbursing them for the actual loss-adjusting expenses they incur.

A major disadvantage of this alternative is that FCIC would need to increase its oversight of participating companies’ financial operations. FCIC would need to draft and approve additional regulations, audit expense vouchers against a schedule of allowable expenses, and require participating companies to follow additional regulations.

Reducing Reimbursement Rates as Premium Volumes Increase

This alternative offers the advantage of potential cost savings and may encourage smaller companies’ participation in the program. Some industry observers have expressed concern at the decline in the number of participating companies—from 49 in 1985 to 19 in 1995. For this reimbursement alternative, companies could be reimbursed at a higher rate for their first level of business and at a reduced rate at higher premium levels. To illustrate, we calculated results using declining reimbursement rates for premium levels of $20 million and below; over $20 to $50 million; over $50 to $100 million; and over $100 million. Table 4.4 shows the results of our analysis.

At the indicated premium levels, in 1995, this alternative had the potential to save the government about $20.4 million in administrative expense reimbursements while having minimal or no impact on participating companies. Of the 19 participating companies, 10 wrote total premiums of $20 million or less, and therefore this alternative would have had no effect on the amount of reimbursements paid to these 10 companies. Only 3 of the 19 companies wrote premiums in excess of $100 million.

Compared with the current system, this alternative would have the effect of favoring smaller companies over larger companies. To the extent that smaller or nonparticipating companies perceive that larger companies do not have a competitive advantage based on the size of operations, they may see increased opportunities to stay in or enter the industry. This outcome would be viewed as an advantage by those who want to see an increase in the number of participating firms.

A disadvantage of this alternative is that it could discourage some larger companies from aggressively delivering crop insurance for FCIC. Furthermore, to the extent that selling and servicing crop insurance policies are subject to economies of scale, such economies may not be achieved if companies do not expand their operations.

Participating Companies Generally Prefer Current Reimbursement Arrangement

According to crop insurance industry officials, participating companies generally prefer the current reimbursement arrangement because they believe that most alternatives would reduce their reimbursements and increase their administrative workload. Officials at some participating companies also said that alternative arrangements would reduce their incentives to deliver federal crop insurance if their overall revenues from reimbursements were reduced. Several company officials also stated that any reduced administrative reimbursements would increase the need for FCIC to provide additional opportunities for underwriting gains. In addition to continuing the current reimbursement arrangement, participating companies want FCIC to simplify administrative requirements. They believe some of the existing requirements are needlessly costly and unnecessary to ensure the integrity of the program. Appendix I provides more information about FCIC’s efforts to simplify crop insurance program administration.

USDA and Crop Insurance Industry Comments

USDA’s Risk Management Agency concurred with our draft report’s treatment of alternative reimbursement arrangements. In its 1998 standard reinsurance agreement, FCIC has proposed using the second alternative—having the government pay a flat amount per policy and a percentage of premiums.

The crop insurance industry stated that we made recommendations to make major changes to the reimbursement system and that these changes would most likely, among other things, greatly undermine agents’ compensation. We did not recommend one alternative over another or over the current system but instead described the arguments for and against the major alternatives that we identified. In so doing, we were complying with the 1994 mandate.

Furthermore, throughout our report and in this chapter, we focused on the effects on companies, not on the agents. Companies may compensate their agents in ways that they consider appropriate, regardless of the companies’ arrangement with the government. (See apps. VIII and IX.)