Crop Insurance Today November 2011 - (Page 4)

TODAYcrop insurance Systematic Risk Crop Insurance in Retrospect and Prospect By Harun Bulut, Frank Schnapp, and Keith Collins, NCIS Systematic risk has been an appealing concept for justifying government involvement in crop insurance markets. It is also the basis for the design of alternative plans of insurance and farm programs. This article revisits the concept by reviewing the related agricultural economics literature. The review focuses on the period since the Federal Crop Insurance Act of 1994 when the crop insurance program went through major changes such as increased participation, the adoption of biotechnology, rating and data improvements and the introduction of revenue plans in crop insurance and farm programs. In crop insurance literature, the term systematic risk (or catastrophic risk) is typically understood as the common portion of underlying risk when losses among insurance units are positively and spatially correlated.1 Figures 1-3 illustrate no correlation, partial positive correlation and perfect positive correlation between a farmer’s and a county’s yield. Depending on the level and distribution of positive correlation, a relatively large segment of the insured units may be affected by a common cause of loss, such as widespread adverse weather effects of drought, flood and freeze, as opposed to almost mutually independent events seen in other lines of insurance, such as auto accidents (Miranda and Glauber, 1997; Skees and Black, 1997; Duncan and Myers, 2000; and Chambers and Quiggin, 2002). Price risk also contributes to the insurer’s systematic risk due to the high correlation across producers of the same crop. Despite the natural hedge between yield and price movements, in some years, such as 2008, a sharp reduction in price at harvest without major production loss can result in losses on a large number of crop insurance revenue protection policies at the same time. In the next two sections, systematic risk is first considered from the perspective of Approved Insurance Providers (AIPs or insurers) and then from the perspective of farmers. The last section provides concluding comments. Systematic Risk from the Insurers’ Perspective With very few exceptions, the existence of an insurance market is based on the concept of the law of large numbers. If exposures are independent, the law of large numbers implies that the insurer’s risk over its entire book of business is relatively small, with gains on many policies offsetting the losses on a few. On the other hand, if exposures are correlated, then the insurer’s risk can be considerable. Simulations conducted by Miranda and Glauber for the 1993 year estimated that the crop insurance portfolios of the ten largest AIPs were 20 to 50 times riskier relative to a hypothetical portfolio consisting of independent crop insurance losses.2 Facing such a high systematic risk, crop insurance companies would seek reinsurance. The consensus in the literature is that private insurance and reinsurance markets do not provide adequate coverage at a reasonable premium rate for the systematic risk in crop insurance markets. Various proposals have emerged in the literature to address systematic risk in crop insurance markets including: 1) government provided subsidized reinsurance (Duncan and Myers), 2) government provided reinsurance through area insurance (Miranda and Glauber), and 3) options markets, futures markets and forward marketing (Grant, 1985; Chambers and Quiggin). These proposals will be reviewed in the following section. Government Provided Reinsurance through the Standard Reinsurance Agreement (SRA) Based on a theoretical model, Duncan and Myers study the question of whether, in the presence of systematic risk, a private 1 The terms “systematic risk” or “systemic risk” have been interchangeably used in the literature. In recent years, “systemic risk” has commonly been used to refer to events that are so severe that they can potentially devastate the entire economy - such as a financial meltdown in 2008. In referring to non-diversifiable risk, Fabozzi and Modigliani use the term systematic risk, whereas Miranda and Glauber; Mason, Hayes and Lence; Skees and Black use the term “systemic risk.” Duncan and Myers adopt the term “catastrophic risk” instead of the term “systemic risk.” In this article, we choose to use the term “systematic risk.” 2 The analysis was done for the 1993 crop year. The authors made simplifying assumptions such as every farmer chose 65 percent coverage with the yield protection policy. They modeled only the joint distribution of farm-level yields and left out modeling of the joint distribution of price and yield. They combined eight years of farm level data with the county level data which went back 30 years from 1992. The farm level data covered corn, soybeans and wheat farmers who were enrolled in the program in 1993. The sample consisted of 15 percent of the all farmers enrolled in the program in 1993. 4 november 2011

Table of Contents for the Digital Edition of Crop Insurance Today November 2011

Primum Non Nocere
Systematic Risk: Crop Insurance in Retrospect and Prospect
The State of U.S. Livestock Insurance
Crop Insurance in 2020
Dr. Wally Nelson Receives Siehl Prize
High Temperature Effects on Corn: How high is to high?
Educating Adjusters for Over Three Decades
On the Road

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