Crop Insurance: Opportunities Exist to Improve Program Delivery and Reduce Costs
Released: 2017-08-24T00:00:00

Letter

Background

Farming is an inherently risky enterprise. In conducting their operations, farmers are exposed to financial losses because of production risks— droughts, floods, hurricanes, and other natural disasters—as well as the risk of crop revenue loss resulting from declines in production, price, or both. The federal government has played an active role in helping to mitigate the effects of these risks on farm income by promoting the use of crop insurance.

A&O Subsidies

RMA partners with private insurance companies, which sell and service federal crop insurance policies. Under the Federal Crop Insurance Act, RMA pays these companies A&O subsidies to cover the reasonable expenses of selling and servicing crop insurance policies. Prior to the changes implemented in the 2011 SRA, RMA calculated A&O subsidies by using a fixed percentage of a policy’s premium. This fixed percentage, which is called the A&O subsidy rate, varies by the type of insurance policy. In 2015, these rates ranged from 12 percent to 21.9 percent. The most common type of insurance policy is revenue protection, which has had an A&O subsidy rate of 18.5 percent since 2011. The price of the crop being insured is one of the factors in the premium amount. As a result, A&O subsidies rise and fall over time with changes in crop prices. For example, from 2000 to 2009, insurance companies’ A&O subsidies nearly tripled as a result of increases in crop prices during that time frame. This increase in the A&O subsidies occurred without a proportional increase in the workload for selling and servicing policies as expressed by the number of policies, acres, and the amount of insurance coverage purchased. To address the increases in A&O subsidies, the 2008 farm bill directed RMA to consider alternative methods for determining A&O payment rates as part of the 2011 SRA, stating that changes should take into account current financial conditions of the program and ensure continued availability of the crop insurance program to producers on a nationwide basis.

Besides crop price changes, changes in premium rates cause changes in premium amounts and, in turn, A&O subsidies. RMA sets premium rates, which are a percentage of the insured crop value. Premium rates can change because of changes in a farm’s crop yield history and RMA updates of county premium rates that reflect past loss experience.

Insurance companies’ expenses include overhead (e.g., employee salaries and rent), fees paid to insurance adjusters to verify loss claims, and commissions paid to insurance agents. Insurance agencies’ expenses include salaries and benefits, training, rent and equipment, software to aid farmers’ decisions, and legal services. Insurance agents’ responsibilities can include (1) informing farmers about applicable crop insurance policy provisions and (2) accurately preparing and completing a farmer’s insurance application, certification of production history, acreage reports, and other sales-related documents.

Risk Sharing and Underwriting Gains

The federal government is the primary reinsurer for the private insurance companies that take on the risk of covering, or “underwriting,” losses to insured farmers. The SRA sets the terms of the risk sharing between the participating insurance companies and USDA. The insurance companies retain part of the premiums and associated risk, and USDA holds the remaining premiums and risk. In addition, the 2005 SRA introduced a quota share provision, under which each company cedes to USDA a percentage of its underwriting gains or losses. The 2005 SRA set the quota share at 5 percent.

Crop Insurance Program Costs to the Government

In accounting for the crop insurance program’s costs to the government, the major categories are the following:

Premium subsidies. Premium subsidies are provided by the government on behalf of farmers. As of January 2017, CBO projected that premium subsidies from 2017 through 2026 would average about $6.2 billion per year.

A&O subsidies. The government pays A&O subsidies to participating insurance companies to cover the companies’ expenses to sell and service crop insurance policies. As of January 2017, CBO projected that A&O subsidies from 2017 through 2026 would average about $1.4 billion per year.

Companies’ underwriting gains/losses. The government pays underwriting gains to participating insurance companies in accordance with the SRA’s gain/loss sharing provisions. The term refers to companies’ retained premiums minus their share of the indemnities paid to farmers followed by adjustments based on the SRA’s gain/loss sharing and quota share provisions. As of January 2017, CBO projected that companies’ underwriting gains from 2017 through 2026 would average about $1.3 billion per year.

Excess losses. Excess losses are total indemnities—payments to farmers for losses—minus total premiums (i.e., premiums paid by farmers plus premium subsidies provided by the government). As of January 2017, CBO projected that excess losses from 2017 through 2026 would average about -$1 billion per year, meaning that indemnities are projected to average about $1 billion less than total premiums per year.

Figure 1 shows an overview of the program.

Figure 2 shows the A&O subsidies and underwriting gains that the government paid to insurance companies for program delivery from 2000 through 2015. In 14 of these 16 years, companies had underwriting gains, with underwriting losses in 2002 and 2012. From 2000 through 2015, companies’ underwriting gains averaged $884 million per year. From 2011 through 2015—the first 5 years in which the 2011 SRA has been in in effect—companies’ underwriting gains averaged $773 million per year. As of March 2017, preliminary RMA information indicates that 2016 underwriting gains will be about $2.6 billion. If 2016 underwriting gains were $2.6 billion, then during the 6 years in which the 2011 SRA has been in effect, companies’ underwriting gains would average about $1.1 billion per year.

As mentioned above, CBO projected that A&O subsidies and companies’ underwriting gains would average about $1.4 billion and $1.3 billion, respectively, per year from 2017 through 2026. Thus, projected federal payments to the companies for delivering the federal crop insurance program would comprise about one-third of projected total program costs, which CBO projected would be about $7.9 billion per year.

A provision in the 2014 farm bill requires that any revised SRA is to be budget neutral with respect to estimates of future underwriting gains for the participating insurance companies, and the estimated total A&O subsidies cannot be less than the amounts that would have been provided under the previous SRA. The 2014 farm bill conference manager’s report states that a renegotiated SRA should not be used as a means of achieving further cuts in the federal crop insurance program. During the farm bill debate, according to a Congressional Research Service report, some Members of Congress argued that such cuts, if any, should be made by Congress so it could claim the budget savings toward either deficit reduction or to offset the cost of any new legislative initiative. In addition, the 2014 farm bill requires that if any SRA savings are realized, they have to be used to increase participating insurance companies’ underwriting gains or A&O payments. The conference report to the 2014 farm bill noted that crop insurance funding had been reduced over the previous 6 years, including in the 2008 farm bill and the 2011 SRA.

The Federal Government’s Monitoring of the Program

In part to improve the government’s ability to ensure the integrity of the federal crop insurance program, Congress passed the Agricultural Risk Protection Act of 2000. The act provided RMA with new tools for monitoring and controlling program abuses. Among other things, the act required the Secretary of Agriculture to use data mining—a technique for extracting knowledge from large volumes of data that was made possible by advances in computing—to administer and enforce the crop insurance program. RMA uses data mining to detect potential cases of fraud, waste, or abuse. For example, RMA and the insurance companies use data mining results to conduct reviews of policies with anomalous loss claim payments. According to RMA documents, RMA’s data mining efforts have improved program monitoring. RMA estimates that from 2001 through 2014, its data mining to identify anomalous policies resulted in $1.1 billion in cumulative cost avoidance—or, reduction in the amount of indemnities claimed (i.e., losses claimed by farmers).

The 2011 SRA’s Cap on A&O Expense Subsidies Has Stabilized Overall Costs, but Subsidies Have Fluctuated Widely by Crop, State, and County

The 2011 SRA’s cap on A&O expense subsidies—payments to insurance companies to cover the cost of selling and servicing crop insurance policies—stabilized the program’s overall costs, but subsidies have fluctuated widely by crop, state, and county. When negotiating the 2011 SRA, RMA adjusted the A&O subsidy calculation method by applying a national cap on the overall annual A&O subsidies. The cap was successful in stabilizing the overall subsidy amount. However, the revised calculation method has allowed changes in crop prices to result in substantial fluctuations in the subsidies for many crops as well as states and counties. For example, the average A&O subsidy per policy in California decreased by 32 percent from 2010 to 2011, when the subsidy declined for two of the state’s leading insured crops, almonds and grapes. The average A&O subsidy per policy in California increased by 66 percent from 2013 to 2014, when the subsidy for almonds and grapes and other crops produced in California increased.

RMA Adjusted the A&O Subsidy Calculation Method by Applying a National Subsidy Cap

In developing the 2011 SRA, RMA sought to stabilize A&O subsidies to help make the program more sustainable over time. To control government costs and stabilize fluctuations in A&O subsidies from year to year, RMA considered revisions to the A&O subsidy calculation method when negotiating the 2011 SRA and ultimately chose to apply a national A&O subsidy cap. Specifically, through a revised subsidy calculation method, RMA capped annual A&O subsidies for the most commonly used types of policies and set a minimum annual subsidy for these policy types. The cap controls government costs when crop prices rise, and the minimum protects companies against low market prices. Because A&O subsidies remain linked to crop prices under the revised calculation method, initial A&O subsidy calculations may exceed the cap during years when crop prices are high. Under such circumstances, RMA has applied an “adjustment factor” to bring down overall annual A&O subsidy expenses to within the capped amount. For a given year, the adjustment factor is equal to the capped A&O subsidy amount divided by the total dollar amount of unadjusted A&O subsidies for all policies. RMA applies this adjustment factor to each policy by multiplying it by the policy’s unadjusted A&O subsidy amount. For example, in 2011 the total amount of unadjusted A&O subsidies was $2.12 billion, and the cap was $1.22 billion, or 58 percent of the unadjusted amount. Thus, the adjustment factor was 0.58.

As a result of the revised calculation method, overall A&O subsidies have become more stable since 2010, staying at about $1.4 billion per year from 2011 through 2015. Figure 3 shows the average A&O subsidy per policy for 2000 through 2015. The average A&O subsidy per policy increased from $418 in 2000 to $834 in 2006. Then, as a result of higher prices for major crops, such as corn, soybeans, and wheat, the average subsidy increased sharply, reaching $1,756 in 2008. Crop price declines brought down the average A&O subsidy per policy to $1,200 by 2010. Although the prices of corn, soybeans, and wheat increased again in 2011, the 2011 SRA’s cap on total A&O subsidies for the most common types of policies prevented the average A&O subsidy per policy from increasing, holding it at $1,178. From 2011 through 2015, the overall average A&O subsidy per policy was relatively stable, ranging from $1,139 to $1,189.

A&O Subsidies Have Fluctuated Substantially for Many Crops

Based on our analysis of RMA data, we found that for many crops the average A&O subsidy per policy fluctuated substantially between 2010 and 2015. Changes in crop prices and the A&O subsidy adjustment factor affected the extent of these fluctuations. The average A&O subsidy per policy for each of the three leading crops—corn, soybeans, and wheat— fluctuated modestly during this period. The fluctuations were larger for many of the other crops. Figure 4 shows the annual percentage changes for corn, soybeans, and wheat, and figure 5 shows the changes for almonds, apples, and grapes. For corn, the largest change was a 7 percent increase in 2015. For soybeans, the largest change was a 6 percent decrease in 2013. For wheat, the largest change was an 11 percent decrease in 2014. In contrast, as shown in figure 5, the fluctuations for almonds, apples, and grapes were larger. For example, the changes for almonds exceeded 29 percent in each year except 2013, including an increase of 75 percent in 2014. In addition to almonds, apples, and grapes, many other crops had large changes. For example, the average A&O subsidy for cotton increased 36 percent in 2011, and for peanuts increased 49 percent in 2013. Appendix II shows the annual percentage changes in the average A&O subsidy per policy for all crops that were insured under the federal crop insurance program during 2011 through 2015.

Fluctuations in A&O Subsidies Varied among States and Counties

Based on our analysis of RMA data, we found that the level of fluctuation in A&O subsidies varied among states and counties. Figure 6 shows the annual percentage change in the A&O subsidy per policy nationwide and for California, Iowa, and Texas since 2010; we selected these three states to review more closely because they have substantial crop insurance program participation, and they are located in different regions of the country. The 2011 SRA’s cap on nationwide A&O subsidies stabilized the changes in the nationwide average A&O subsidy per policy in a relatively narrow range, as shown in the figure.

As shown in the figure, California’s average A&O subsidy per policy was volatile between 2011 and 2015. California’s average subsidy per policy decreased by 32 percent in 2011 and then increased during the next 4 years, especially in 2014, when it increased 66 percent. The A&O subsidy adjustment factor, which was 58 percent in 2011 and increased to 71 percent in 2014, contributed to California’s 2011 decrease and its 2014 increase. Iowa, where the leading insured crops are corn and soybeans, experienced substantially less fluctuation than California. Texas’s average subsidy per policy increased by 21 percent in 2011. That increase coincided with increases in the prices of cotton and wheat, Texas’s two leading insured crops in 2011. Texas’s average subsidy per policy decreased by 6 percent and 9 percent in 2013 and 2015, respectively.

Appendix III shows the annual percentage changes in the average A&O subsidy per policy for each of the 50 states from 2011 through 2015.

Figure 7 shows the percentage change in the average A&O subsidy per policy by county from 2011 through 2015. As shown in the maps, many counties had substantial fluctuations in their average A&O subsidy per policy.

According to a crop insurance industry organization document, a large decrease in A&O subsidies for a state can disrupt program delivery in that state. In the 2011 SRA, RMA sought to stabilize A&O subsidies, according to an RMA document, which states that “because the A&O subsidy will be less vulnerable to extreme commodity price changes, companies and their agents will enjoy more stable and dependable subsidies in the future to support the cost of delivering the program,” making the program more sustainable over time. Furthermore, according to the RMA document, by providing relatively stable A&O payments and a cap on agent commissions, the new SRA will allow for a more sustainable delivery system in the future, protecting producers, companies, and taxpayers.

RMA had previously considered other A&O subsidy calculation methods to reduce fluctuations in A&O subsidies. For example, in the 1990s, RMA considered a fixed amount per policy plus a percentage of the policy’s premium. More recently, in its first two drafts of the 2011 SRA, RMA proposed the use of reference crop prices—rather than market prices—to calculate A&O subsidies. In general, a reference crop price is a fixed amount that does not change from year to year. Reference crop prices have been used in other farm programs to stabilize farmers’ incomes. Specifically, RMA proposed the use of reference crop prices in calculating A&O subsidies for seven major commodities—corn, soybeans, wheat, grain sorghum, cotton, barley, and rice. The proposed reference prices were based on a 10-year average (1999 through 2008) of each crop’s market price. However, the crop insurance industry expressed concerns about RMA’s reference crop price proposal. For example, according to an RMA document, many companies noted price volatility factors in comments on the draft SRA. This document said that price volatility factors have become significant in the determination of premiums for the increasing number of revenue-based policies and, consequently, the A&O subsidy for those policies. This document also said that using reference prices alone to stabilize the A&O subsidy accounts for levels of high commodity prices, but ignores changes in price volatility. In addition, this RMA document stated that incorporating reference crop prices for the seven major commodities could affect areas of the country differently, depending on the types and mixture of crops in each area. RMA ultimately removed its reference crop price proposal from the 2011 SRA and replaced it with the current calculation method to cap overall A&O subsidies.

Although the current calculation method has resulted in relatively modest fluctuations in A&O subsidies for corn, soybeans, and wheat, it has not done so for other crops or for all states and counties. In some cases, double-digit decreases were followed by double-digit increases. As mentioned earlier, RMA’s intention was to stabilize A&O subsidies. Without stability in A&O subsidies, the sustainability of the program’s delivery system in states and counties that experience large fluctuations may be compromised. For example, according to crop insurance industry organization documents, reductions may adversely affect the services provided to farmers. In addition, fluctuations may make it more difficult for insurance agencies to operate and budget effectively. By considering an adjustment to the A&O expense subsidy calculation method that reduces the effects of changes in premiums caused by changes in crop prices or other factors, when it renegotiates the SRA, RMA could reduce year-to- year fluctuations in the A&O expense subsidies that companies receive at the crop, state, and county levels.

RMA officials acknowledged to us that large fluctuations have occurred for some crops, states, and counties. However, the officials said that an advantage of the current method is its ease of administration and that the crop insurance industry has become familiar with and understands it. While changing the calculation method may add complexity, not changing it will likely result in continued large annual fluctuations for some crops, states, and counties.

The Federal Crop Insurance Program’s Target Rate of Return Does Not Reflect Market Conditions

The federal crop insurance program’s target rate of return—the average annual rate of return that insurance companies are expected to earn— does not reflect market conditions. A 2009 USDA-commissioned study, which RMA used in SRA renegotiations, estimated a reasonable rate of return for crop insurance providers for 1989 through 2008 based on economic factors, such as interest rates, which are subject to changes in market conditions. Interest rates have decreased since 2008, and our analysis that updated the information in the USDA-commissioned study, in which we estimated the reasonable rates of return for 2009 through 2015 (years not included in the study), shows that the market-based (reasonable) rate of return has declined.

The USDA-commissioned 2009 study was based on the premise that government intervention should reflect competitive, market-based outcomes. The 2009 study derived the annual rate of return on equity that insurance companies participating in the federal crop insurance program should be expected to earn. This annual rate of return should produce earnings that are equal to earnings from alternative investment opportunities relative to the risk assumed—a reasonable or market-based rate of return. To determine a reasonable rate of return for companies participating in the federal crop insurance program, the USDA- commissioned study averaged the results obtained from using two generally accepted methodologies: the capital asset pricing model and the discounted cash flow model. We conducted our updated analysis using the two methods that the 2009 study used. Our capital asset pricing model calculations estimate that the average reasonable rate of return from 2009 through 2015 was 9.7 percent. Our discounted cash flow model calculations estimate that the average reasonable rate of return was 9.6 percent. The average of the two methods was 9.6 percent. We also note that the reasonable annual rate of return generally trended downward from 2009 through 2015 and reached a low of 8.8 percent in 2015. Lower interest rates contributed to the decrease in the reasonable rate. For example, from 2008 to 2015, one measure of an average interest rate—U.S. Treasury securities—fell from 3.1 percent to 1.4 percent.

An overview of the results of our updated analysis based on the 2009 study and our summary of RMA data on the actual rates of return on retained premiums of participating insurance companies for the 20 years from 1996 through 2015 is presented in table 1. Appendix V provides more information on the USDA-commissioned study, its results for 1989 through 2008, and our updated analysis for 2009 through 2015.

According to a document from a crop insurance industry organization, participating insurance companies’ financial returns under the 2011 SRA have been lower than expected. The average rate of return on retained premiums for the first 4 years that the 2011 SRA was in effect—2011 through 2014—was less than the 14.5 percent target rate, and companies had underwriting losses in 2012, when a major drought occurred. However, 4 years is a short time for assessing the rate of return. The 2009 study noted that the federal crop insurance program has significant catastrophe exposure. According to the study, with most lines of insurance that have a significant catastrophe exposure, insurers expect to earn significant profits in non-catastrophe years and significant losses in years with catastrophes. As a result, average returns over relatively short sample periods are not necessarily indicative of the long-term pattern of returns.

Participating insurance companies’ actual rate of return can vary significantly from year to year. Table 2 shows the participating insurance companies’ actual rate of return on retained premiums for each year from 1996 through 2015. The average actual rate of return for these 20 years was 18.0 percent. During the 5 years that the 2011 SRA has been in effect—2011 through 2015—the average rate of return on retained premiums was 9.4 percent. A major reason the rate of return during these 5 years was less than the target rate was because the rate dropped to -15.3 percent in 2012. In that year, a major drought caused underwriting losses. Because the 2011 SRA’s target rate of return is 14.5 percent, additional years of experience would, on average, likely result in an increase in the average rate of return under the 2011 SRA. For example, as of March 2017, preliminary RMA information indicates that the 2016 rate of return on retained premiums will be about 35 percent. If the 2016 rate of return on retained premiums were 35 percent, then in the 6 years in which the 2011 SRA has been in effect, companies’ underwriting gains during those 6 years would average about 13.7 percent.

Two Opportunities Exist for the Federal Government to Reduce the Delivery Costs of the Program

We identified two opportunities for the federal government to reduce its delivery costs for the crop insurance program: (1) by reducing the target rate of return or (2) by reducing the portion of premiums that participating insurance companies retain. A reduction of either the target rate of return or the portion of premiums that companies retain would reduce companies’ expected underwriting gains because those gains are equal to the companies’ rate of return multiplied by the premiums that companies retain. (As mentioned earlier, premium subsidies make up the majority of the federal crop insurance program’s costs. Information about our recent reports that identified potential actions that Congress or RMA could take to reduce the cost of the program and achieve budgetary savings is in app. VI.)

Reducing the Target Rate of Return

Given that our analysis shows that the federal crop insurance program’s target rate of return does not reflect market conditions, an opportunity exists for the federal government to reduce the program’s delivery costs. Adjusting the target rate of return to reflect market conditions could produce significant cost savings. For example, if the target rate of return was reduced by 3.5 percentage points, from the current target rate of 14.5 percent to 11.0 percent—the average reasonable rate that we calculated for 1996 through 2015—on the companies’ 2015 retained premiums of $7.42 billion, the companies’ expected underwriting gains would decrease by $259 million. If the target rate of return was reduced by 4.9 percentage points, from the current target rate of 14.5 percent to 9.6 percent—the average reasonable rate that we calculated for 2009 through 2015—on the companies’ 2015 retained premiums of $7.42 billion, the companies’ expected underwriting gains would decrease by $364 million. With such a cost savings for a single year, the savings for the program would be significant over time with either reduction. As we reported in January 2017, absent policy changes, the federal government’s fiscal path is unsustainable, and to change the long-term fiscal path, policymakers will need to consider policy changes to the entire range of federal activities and spending. We have also reported that Congress and executive branch agencies can act to improve the efficiency and effectiveness of government programs and activities.

However, any savings that the federal government could achieve through the SRA by reducing companies’ expected future underwriting gains as a result of reducing the target rate of return cannot be implemented without congressional action to repeal a provision in the 2014 farm bill. This provision requires that any revised SRA be budget neutral with respect to estimates of future underwriting gains for the companies participating in the crop insurance program. In addition, the 2014 farm bill requires that if any SRA savings are realized, they have to be used to increase underwriting gains or A&O subsidies. If Congress directs RMA to adjust the participating insurance companies’ target rate of return to reflect market conditions, the underwriting gains that insurance companies can expect to receive would decrease. Such a reduction would not affect the premiums that farmers pay, but such an adjustment would reduce the cost of the crop insurance program and achieve budgetary savings for the federal government.

Reducing the Portion of Premiums that Companies Retain

In addition to the rate of return, participating insurance companies’ underwriting gains are affected by the portion of premiums that they retain. Even if the target rate of return remained unchanged, reducing companies’ portion of retained premiums would reduce their expected underwriting gains because they would earn their rate of return on a smaller premium base. The companies would have a smaller underwriting stake, retaining a smaller portion of underwriting gains or losses. The extent of sharing in premiums—and the associated opportunities for gains and risk of losses—between the federal government and the companies has long been a subject of debate. For example, according to a report by a former USDA official, the degree of this sharing has been controversial since the beginning of the public-private partnership created by the Federal Crop Insurance Act of 1980. According to this report, part of the justification for the companies to share in the program’s underwriting losses was that it would encourage the companies to more carefully adjust farmers’ loss claims. According to a crop insurance industry organization document, the structure of the program is such that companies have dollars at risk on every policy and are thus financially incentivized to reduce fraudulent loss claims.

The Agricultural Risk Protection Act of 2000, however, improved RMA’s ability to monitor farmers’ loss claims and companies’ adjustment of these loss claims by enhancing the agency’s data mining capabilities. Since 2001, RMA has used its enhanced data mining capabilities to identify policies with anomalous loss claims as compared to similar policies in a geographic region. For example, RMA and the companies review these policies with anomalous loss claims. As a result of its enhanced data mining capabilities, RMA’s ability to monitor companies’ adjustment of loss claims has improved. Furthermore, with more recent technological advances, such as the inclusion of satellite data in data mining methods, RMA’s data mining ability has continued to improve. According to RMA documents, the agency’s data mining efforts have improved program monitoring. RMA estimated its data mining resulted in $1.1 billion in cumulative cost avoidance—reduction in the amount of indemnities claimed—from 2001 through 2014.

Moreover, the 2005 SRA reduced the companies’ share of the premiums and their potential underwriting gains or losses through a quota share provision. A quota share is a type of reinsurance contract in which the insurer—in this case, the insurance companies participating in the crop insurance program—and the reinsurer—in this case, the federal government—share premiums, gains, and losses according to a fixed percentage. The quota share concept was introduced in the 2005 SRA as a way to transfer underwriting gains from the companies to the government in order to generate a reduction in program costs, according to RMA officials. Under quota share provisions in the 2005 SRA and 2011 SRA, each company ceded to USDA a percentage of its premiums and potential underwriting gains or losses. The 2005 SRA’s quota share was 5 percent, and the 2011 SRA’s quota share was 6.5 percent. For example, in 2010, the quota share reduced companies’ retained premiums by $319 million (5 percent) from $6,382 million to $6,063 million and reduced companies’ underwriting gains by $101 million (5 percent) from $2,017 million to $1,916 million. Thus, the quota share increased the government’s underwriting gains by $101 million and reduced program delivery costs by that amount.

Although RMA’s program monitoring has improved since 2000 and even with the implementation of a quota share, there has been little change in the level at which companies are allowed to retain premiums and share in program underwriting gains or losses—which provides companies with financial incentive to carefully adjust farmers’ loss claims. In 2000, insurance companies retained $1,895 million (75 percent) of the program’s $2,538 million in total premiums. In 2004, the insurance companies retained $3,140 million (75 percent) of the program’s $4,186 million in total premiums. In 2015, 14 years after RMA implemented the Agricultural Risk Protection Act of 2000’s data mining activities and 10 years after RMA implemented a quota share, the insurance companies retained $7,422 million (76 percent) of the program’s $9,744 million in total premiums. Thus, during the period that RMA was improving its program monitoring, the portion of premiums that companies retained stayed about the same, the crop insurance program grew, and the potential amount of companies’ underwriting gains increased. The last time RMA had an opportunity to assess and change the level of sharing in program gains or losses was in 2010 when it completed renegotiating the SRA.

Reducing the portion of premiums that companies retain by, for example, 5 percentage points, could save the government tens of millions of dollars per year by increasing the government’s share of the insurance coverage, thereby giving the government more opportunity to reduce its cost by achieving underwriting gains. For example, in 2009, the SRA’s quota share provision, which reduced the premiums that companies retained by 5 percentage points, resulted in program cost savings of $121 million for that year. An additional adjustment in the portion of premiums that companies retain could result in comparable savings.

As mentioned earlier, we reported in January 2017 that, absent policy changes, the federal government’s fiscal path is unsustainable. However, any savings that could be achieved through the SRA by reducing insurance companies’ expected future underwriting gains as a result of reducing the portion of premiums that participating companies may retain would require congressional action to repeal a provision in the 2014 farm bill. This provision requires that any revised SRA be budget neutral with respect to estimates of future underwriting gains for the companies. In addition, the 2014 farm bill requires that if any SRA savings are realized, they have to be used to increase underwriting gains. Given fiscal pressures and the improvement in RMA’s program monitoring, an assessment and possible adjustment in the portion of premiums that participating insurance companies retain may be warranted.

Conclusions

Federally subsidized crop insurance, which helps farmers manage the risk inherent in farming, is one of the most important programs in the farm safety net. USDA and private insurance companies share in the risk of loss and the opportunity for gain associated with crop insurance policies. The 2009 USDA-commissioned study estimates an annual rate of return that would allow insurance companies participating in the crop insurance program to have expected earnings that are equal to earnings from alternative investment opportunities relative to the risk assumed—a reasonable or market-based rate of return. However, the reasonable rate of return has declined since the 2011 SRA. This decline indicates that the current target rate of return for the federal crop insurance program exceeds the reasonable rate of return. If Congress were to direct RMA to adjust the participating insurance companies’ target rate of return to reflect market conditions, the underwriting gains that insurance companies receive would potentially be reduced, and any such reduction would not affect the premiums that farmers pay. Such an adjustment would, however, reduce the expected cost of the crop insurance program and achieve expected budgetary savings for the federal government, which could be used for deficit reduction or other purposes, such as other farm programs or enhancements of crop insurance products available to farmers. However, any savings that could be achieved through the SRA by reducing companies’ expected future underwriting gains as a result of reducing the target rate of return would require congressional action to repeal a provision in the 2014 farm bill because this provision requires that any revised SRA is to be budget neutral with respect to estimates of future underwriting gains for the companies.

In addition, the portion of program premiums that participating insurance companies retain—which provides the companies with financial incentive to accurately adjust farmers’ loss claims—has changed little since 2000. The last time RMA had an opportunity to assess and change the level of portion of premiums retained was in 2010 when it completed renegotiating the SRA. Given the improvement in RMA’s ability to monitor the program, an additional assessment and possible adjustment in the portion of premiums retained by participating insurance companies may be appropriate. Such an adjustment could generate significant cost savings for the program. However, because a provision in the 2014 farm bill requires that any revised SRA is to be budget neutral with respect to estimates of future underwriting gains for the companies, any savings that could be achieved through the SRA by reducing companies’ expected future underwriting gains as a result of reducing the portion of premiums retained by participating insurance companies are not allowed under current law and would also require congressional action to repeal this provision in the 2014 farm bill.

Moreover, RMA sought to make A&O expense subsidies more stable and dependable when it negotiated the 2011 SRA, and the current calculation method has resulted in relatively modest fluctuations in A&O expense subsidies for corn, soybeans, and wheat, the program’s three leading crops. However, our analysis shows the SRA’s calculation method also resulted in substantial subsidy fluctuations for many crops, states, and counties with double-digit decreases followed by double-digit increases in some cases. Because large decreases in A&O expense subsidies can disrupt program delivery, and the sustainability of the program’s delivery system in states and counties that experience large fluctuations can be compromised, an adjustment to the A&O expense subsidy calculation method that reduces the effects of changes in premiums caused by changes in crop prices or other factors when RMA renegotiates the SRA, could help RMA reduce year-to-year fluctuations in the A&O expense subsidies that companies receive at the crop, state, and county levels.

Matter for Congressional Consideration

To reduce the cost of delivering the crop insurance program, Congress should consider repealing the 2014 farm bill requirement that any revision to the standard reinsurance agreement not reduce insurance companies’ expected underwriting gains, and directing the Risk Management Agency to, during the next renegotiation of the agreement, (1) adjust the participating insurance companies’ target rate of return to reflect market conditions and (2) assess the portion of premiums that participating insurance companies retain and, if warranted, adjust it.

Recommendation for Executive Action

To reduce year-to-year fluctuations in the administrative and operating expense subsidies that companies receive at the crop, state, and county levels, we recommend that the Secretary of Agriculture direct the Administrator of the Risk Management Agency to consider adjusting the administrative and operating expense subsidy calculation method in a way that reduces the effects of changes in premiums caused by changes in crop prices or other factors when it renegotiates the standard reinsurance agreement.

Agency Comments and Our Evaluation

We provided USDA with a draft of this report for review and comment. RMA, responding on behalf of USDA, stated in its written comments (see app. VIII) that it had no comment on the matter for congressional consideration. RMA also stated that, consistent with our recommendation, it will examine with insurance companies the potential to reduce variations in A&O expense subsidies the next time the SRA is renegotiated.

RMA stated that the 2011 SRA produced substantial savings for taxpayers of approximately $4.5 billion, which was accomplished with no significant disruption of service. RMA also stated that our report omits the SRA’s success. We agree that the 2011 SRA produced successful results, and we discuss some of them in our report. For example, the report states that the Office of Management and Budget estimated the 2011 SRA’s 10-year budgetary savings would be about $6 billion and that the national cap on annual A&O expense subsidies controls government costs when crop prices rise. In addition, the report states that the 2011 SRA’s national cap on annual A&O subsidies was successful in stabilizing the overall subsidy amount. In addition, we noted that for the three leading crops—corn, soybeans, and wheat—A&O subsidy fluctuations were relatively modest and linked these modest fluctuations to the 2011 SRA’s A&O subsidy calculation method. However, as we state in the report, our analysis also found substantial subsidy fluctuations for many crops, states, and counties.

Further, RMA stated that our report gives the impression that the cap on A&O expense subsidies negatively impacted service to farmers and that stabilizing A&O subsidies would not lead to any discernible difference in service to farmers. However, crop insurance industry organization documents suggest that reductions in A&O subsidies could have negative effects. As we state in the report, according to crop insurance industry organization documents, reductions in A&O subsidies may adversely affect the services provided to farmers. Furthermore, in the 2011 SRA, RMA sought to stabilize A&O subsidies, according to an RMA document, which states that “because the A&O subsidy will be less vulnerable to extreme commodity price changes, companies and their agents will enjoy more stable and dependable subsidies in the future to support the cost of delivering the program,” making the program more sustainable over time. According to this RMA document, by providing relatively stable A&O payments and a cap on agent commissions, the new SRA will allow for a more sustainable delivery system in the future, protecting producers, companies, and taxpayers.

As agreed with your office, unless you publicly announce the contents of this report earlier, we plan no further distribution until 30 days from the report date. At that time, we will send copies of this report to the appropriate congressional committees; the Secretary of Agriculture; the Director, Office of Management and Budget; and other interested parties. In addition, this report will be available at no charge on the GAO website at http://www.gao.gov.

If you or your staff members have any questions about this report, please contact me at (202) 512-3841 or morriss@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. Key contributors to this report are listed in appendix IX.

Appendix I: Objectives, Scope, and Methodology

Our objectives were to examine (1) the changes, if any, in the distribution of administrative and operating (A&O) expense subsidies due to the implementation of the 2011 standard reinsurance agreement’s (SRA) national cap on subsidies, (2) the extent to which the federal crop insurance program’s target rate of return reflects market conditions and (3) opportunities, if any, for the federal government to reduce its delivery costs for the program.

To address these objectives, we reviewed, among other things, sections of 2011 SRA drafts and the final 2011 SRA; Risk Management Agency (RMA) documents on the development and implementation of the 2011 SRA; crop insurance industry documents; provisions of the Food, Conservation, and Energy Act of 2008 (2008 farm bill), the Agricultural Act of 2014 (2014 farm bill), the Agricultural Risk Protection Act of 2000; prior GAO reports; and standards for internal control in the federal government. We also interviewed RMA officials to discuss the development and implementation of the 2011 SRA.

To examine the changes, if any, in the distribution of A&O expense subsidies due to the implementation of the 2011 SRA’s national cap on subsidies, we reviewed and analyzed RMA crop insurance data by state, county, and crop for 2010 through 2015. We chose this time frame to examine changes associated with the implementation of the 2011 SRA because it contained the most recent data available at the time of our review. We analyzed changes in A&O subsidies per policy by state, county, and crop to identify and summarize trends during 2011 through 2015. We used A&O subsidies per policy because RMA used this benchmark in its development of the 2011 SRA. The RMA data we used provided unadjusted A&O subsidy amounts (i.e., the amounts before adjustment in accordance with the 2011 SRA’s cap on total A&O subsidies for policy types that are subject to this cap). Based on the 2011 SRA’s provisions and information from RMA officials, we performed calculations to convert these amounts to adjusted A&O subsidy amounts. We compared our adjusted A&O subsidy amounts with other RMA data— such as state and national totals—to confirm that our adjustments were accurate.

To examine the extent to which the federal crop insurance program’s target rate of return reflects market conditions, our work included reviewing a 2009 study commissioned by the U.S. Department of Agriculture (USDA), the Rate of Return Update - 2008: Reasonable Rate of Return Section 3.1. This study derived, for the 20 years from 1989 through 2008, the annual rate of return on equity that companies participating in the federal crop insurance program should be expected to earn. We identified the major factors that the study used to estimate the reasonable rate of return and collected data on these factors from sources of financial information such as Value Line Investment Survey. We then extended the study’s results to estimate the reasonable rate of return on equity for 2009 through 2015, years that were not included in the study. In addition, for the 20 years from 1996 through 2015, we summarized RMA data on the actual rates of return on retained premiums of participating insurance companies. Additional information on our methods for this objective is in appendix V.

To examine opportunities, if any, for the federal government to reduce its delivery costs for the program, we reviewed and summarized RMA data on companies’ underwriting gains and risk sharing as expressed by total program premiums and premiums retained by companies for the 20 years from 1996 through 2015. We also reviewed the 2005 SRA and 2011 SRA sections on risk sharing, as well as crop insurance industry documents, including industry responses to 2011 SRA drafts. Regarding RMA’s program monitoring, we reviewed RMA documents on data mining and other program integrity efforts, USDA Office of the Inspector General reports, and previous GAO reports including our 2005 report on fraud, waste, and abuse, and our 2012 report that examined RMA’s data mining.

To evaluate the reliability of the RMA data, we reviewed an assessment for a previous GAO study, reviewed agency documentation related to the data systems, and obtained updated information on the data systems from knowledgeable officials. We assessed the reliability of the data from the 2009 USDA-commissioned study and the financial information sources by reviewing relevant documentation. In addition, for one of the financial information sources, we reviewed an assessment for a previous GAO study. In each case, we concluded that the data were sufficiently reliable for the purposes of this report.

We conducted this performance audit from April 2015 to July 2017 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence we obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Appendix II: Percentage Change in the Average Administrative and Operating Subsidy, by Crop, 2011-2015

Appendix III: Percentage Change in the Average Administrative and Operating Subsidy, by State, 2011-2015

Appendix IV: Percentage Change in the Average Administrative and Operating Subsidy, by County, 2011-2015

Appendix V: Analysis of Reasonable Rate of Return

A 2009 study commissioned by the U.S. Department of Agriculture (USDA) estimated a reasonable rate of return for crop insurance providers for 1989 through 2008. This study used the opportunity cost of capital as the definition of the reasonable rate of return for crop insurance. In order to determine a reasonable rate of return for companies participating in the federal crop insurance program, the 2009 study averaged the results obtained using two methods: the capital asset pricing model and the discounted cash flow model.

Capital Asset Pricing Model

The capital asset pricing model uses the return on a risk-free asset, usually a U.S. Treasury security, to estimate the additional return an investor should expect as compensation for the additional risk associated with alternative investments. The capital asset pricing model uses the following equation to calculate the cost of capital: K= 𝑟𝑟𝑓𝑓+𝛽𝛽∗ 𝑟𝑟𝑑𝑑 in which 𝑟𝑟𝑓𝑓 is the risk-free rate, 𝛽𝛽 is the beta coefficient, and 𝑟𝑟𝑑𝑑 is the equity risk premium.

Risk-Free Interest Rate in the Capital Asset Pricing Model

According to a 2000 study, movements in the cost of capital for the insurance industry closely follow movements in the risk-free rate of return. The 2009 USDA-commissioned study used the 3-month Treasury bill secondary markets, 5-year constant maturity Treasury bond, and the 20-year constant maturity Treasury bond as the risk-free interest rates to estimate the short-, intermediate-, and long-term costs of capital. The 2009 study used interest rate data from the Federal Reserve for the selected months of April, May, and June to estimate the cost of capital for each year reviewed. We calculated the cost of capital using April, May, and June interest rates in the same way as the USDA-commissioned study. In addition, we calculated the cost of capital using the full 12-month average risk-free rate for each year as a test for the robustness of our results. Although our calculations begin with 2009 data, we note the significant decrease in interest rates from 2008, the last year covered by the USDA-commissioned study, to 2009, the first year for which we updated the analysis included in the study, as context for the downward trend in interest rates from 2009 through 2015. From 2008 to 2009, the average risk-free interest rate—defined as the average of the rates on the 3-month, 5-year, and 20-year Treasury securities—decreased from 3.1 percent to 2.2 percent. Furthermore, from 2009 through 2015, the average risk-free rate generally continued to decrease.

Relative Volatility Measure (Beta Coefficient) in the Capital Asset Pricing Model

The “beta coefficient” (β) is an estimate of the relative volatility of a particular security compared with that of a proxy for the market, normally the S&P 500 index. The USDA-commissioned study gathered estimates of the beta coefficients for a sample of publicly traded property and casualty insurance companies. According to the study, beta coefficients should be adjusted to account for the long-run tendency of beta coefficients to revert to the market mean value of “1”. We calculated the cost of capital with both unadjusted and adjusted beta coefficients for each year. The average unadjusted beta coefficient for property and casualty insurance companies from 2009 through 2015 was 0.94. The average adjusted beta coefficient for property and casualty insurance from 2009 through 2015 was 0.98. These results indicate that the property and casualty insurance industry has generally experienced slightly less volatility, on average, than the market as a whole.

Equity Risk Premium in the Capital Asset Pricing Model

The equity risk premium” (“𝑟𝑟𝑑𝑑”) is the additional return expected by investors for risk. That is, the equity risk premium is the average difference between the return on the risk-free asset and the return on a market portfolio, normally represented by the S&P 500 index. The equity risk premium is an arithmetic mean of this difference for each year beginning in 1926 through the year before which the cost of capital is being estimated. The average equity risk premium fluctuated by no more than 50 basis points from 2009 through 2015.

Our capital asset pricing model calculations estimate that the average cost of capital from 2009 through 2015 was 9.7 percent when calculated using an average of monthly interest rates for April, May, and June of each year. The cost of capital or reasonable rate of return from 2009 through 2015 was 9.6 percent when calculated with a 12-month average of the interest rates for each year.

Discounted Cash Flow Model

According to the 2009 USDA-commissioned study, the discounted cash flow model is perhaps the most widely used method for estimating the cost of capital, particularly in regulated industries, such as public utilities. The discounted cash flow model is constructed on the assumption that the cost of an investment (for instance, a stock) will equal the present value of cash flows (such as future dividend payments or capital gains) resulting from the investment. If the present value of cash flows resulting from the investment does not equal the price, investors will bid on (or against) the investment until the values are equal. The USDA- commissioned study collected data for a sample of publicly traded property and casualty insurance companies from Value Line Investment Survey.

The discounted cash flow model uses the following equation to calculate the cost of capital: K= 𝐷𝐷1𝑃𝑃0 + 𝑔𝑔 The first element, 𝐷𝐷1𝑃𝑃0 , is the dividend yield expected in the first year. The dividend, 𝐷𝐷1, reported by Value Line Investment Survey, is the estimate of the cash dividends payable in the next 12 months. P is the price of the The second element in the discounted cash flow model, 𝑔𝑔 , is an average stock at the beginning of the 12-month period. of the growth forecast method and fundamental analysis. The growth forecast method is an estimate of growth based on an equally weighted average of 10-year historical earnings and dividends, 5-year historical earnings and dividends, and a Value Line analyst’s forecasted dividends and earnings. Sustainable (“fundamental”) growth is the rate at which companies retain and reinvest earnings. Fundamental analysis assumes that retained earnings can be reinvested and used to produce greater earnings in the future—earnings that might produce higher dividends in the future. Alternately, the company may grow by issuing stock above book value, proceeds from which could finance new investments, thereby generating higher dividends in the future.

The discounted cash flow model thus relies on numerous financial metrics such as historical and forecasted earnings and dividends. However, the property and casualty insurance companies that make up the dataset may not report every figure. For instance, a company may not report dividends in a given year. In these places, Value Line Investment Survey may note the missing values. As a result, we performed two sets of discounted cash flow calculations. One set of calculations only included publicly traded property and casualty insurance companies that reported complete historical and forecasted earnings and dividends. However, we also calculated the reasonable rate of return for all publicly traded property and casualty insurance companies covered by Value Line Investment Survey; we imputed zeros for missing values. As a result, we are reporting a range for the discounted cash flow results. Thus, the average reasonable rate of return from 2009 through 2015 was 9.6 percent when calculated including only property and casualty insurance companies that reported complete data and 8.4 percent when calculated including all property and casualty insurance companies (imputing “0” for missing values). However, out of concern that imputing zeroes could skew the rate of return estimate downward, we used the higher rate of return of 9.6 percent based on the companies that reported complete data.

Results

To obtain the reasonable rate of return on equity from 2009 through 2015, we averaged the results of the capital asset pricing model with the results of the discounted cash flow model. According to our calculations, the estimated reasonable rate of return on equity for 2015 was 8.8 percent. The estimated average reasonable rate of return from 2009 through 2015 was 9.6 percent. According to the capital asset pricing model, the average reasonable rate of return from 2009 through 2015 was 9.7 percent. According to the discounted cash flow model, the estimated average reasonable rate of return from 2009 through 2015 was 9.6 percent. The estimated average reasonable rate of return from 1996 through 2015 was 11.0 percent. Estimates of the reasonable rate of return by year for 1989 through 2015 are in table 5.

Appendix VI: Summary of Potential Actions and Estimated Savings for the Crop Insurance Program, 2012 through 2015

From 2012 through 2015, we issued four reports that identified potential actions that could be taken by Congress or the Risk Management Agency to reduce the cost of the crop insurance program and achieve budgetary savings. Table 6 shows the reports, potential government actions we reviewed, and estimated federal dollar savings associated with each potential action, at the time we issued these reports.

Appendix VII: Participating Insurance Companies’ Retained Premiums and Underwriting Gains/Losses, 1996-2015

Table 7 shows, for 1996 through 2015, the premiums on which the participating insurance companies retained risk and these companies’ underwriting gains or losses. It also shows the quota share amounts for 2005 through 2015, the years for which a quota share was in effect, and how the quota share reduced the premiums retained by the companies, thus reducing their underwriting gains or losses. For example, companies’ 2010 underwriting gains before deduction of the quota share were $2.017 billion. This amount was multiplied by the agreed-upon quota share of 5 percent, which resulted in the quota share amount of $101 million. This $101 million was deducted from the $2.017 billion, which resulted in companies’ final underwriting gains of $1.916 billion. In each year beginning with 2005, except 2012, the quota share reduced the government’s program costs by reducing companies’ underwriting gains, thereby increasing the government’s underwriting gains. For example, the quota share reduced companies’ underwriting gains for 2009 by $121 million, thereby increasing the government’s underwriting gains by the same amount. In 2012, a year of major drought, the quota share reduced companies’ underwriting losses by $92 million, increasing the government’s underwriting losses by that amount.

Appendix VIII: Comments from the U.S. Department of Agriculture

Appendix IX: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

In addition to the individual named above, Thomas M. Cook, Assistant Director; Ron Aribo; Kevin S. Bray; Gary Brown; Serena Epstein; Farrah Graham; Michael Kendix; Emei Li; Joshua Parr; Anne Rhodes-Kline; Dan C. Royer; Kiki Theodoropoulos; and Frank Todisco made key contributions to this report. In addition, Martin (Greg) Campbell, Diana C. Goody, Michael Meleady, and Oliver Richard made important contributions to this report.