The Strange Economics of Crop Insurance

REUTERS/John Sommers II

ed dolan, the creator of Ed Dolan’s Econ Blog, is the author of Introduction to Economics.

Published May 9, 2018.

 

Insurance plays an essential role in any market economy. By spreading losses among members of a group with exposure to similar harm, it encourages people to take prudent risks while protecting them from financial ruin in case they are among the unlucky. But not all insurance is equal. Crop insurance, a multibillion-dollar government program that lies at the heart of the farm bill now working its way through Congress, is a case in point. 

Here’s a closer look at the strange economics of crop insurance, how it undermines productivity, who really benefits, and what could be done to fix it.

Crop Losses Are Not an Insurable Risk

The problems begin with the reality that crop losses are not really an insurable risk in the conventional (and appropriate) use of the term. Insurers of everything from office buildings to autos have developed rules that identify which risks are insurable and which are not. Crop insurance violates three of the most important.

First, to be insurable, losses should be due to chance; that is, they should be the result of events that are outside the control of the insured party. Some crop losses, for example, damage from hail or tornadoes, fit this definition. However, many other risks depend on the choice of farming practices — choices that, in turn, are influenced by the availability and price of insurance.

The tendency for people who are protected from loss to take greater risks is known in the lingo of economics as moral hazard. Commercial insurers guard against moral hazard as best they can by encouraging practices that reduce losses. For example, you can get discounts on your home insurance if you install a smoke alarm or a burglar alarm. However, as the National Resources Defense Council (an environmental non-profit) explains in a recent report, the rules of the federal crop insurance program actually encourage risky practices, such as planting crops on land that is marginally suited for them. At the same time, rather than encouraging loss mitigation practices such as diversification and planting cover crops, crop insurance discourages them. Of course, when crops are likely to fail, resources are wasted and program costs soar. 

Second, insurance is normally limited to circumstances in which people face a “pure” risk — that is, a risk of loss not offset by a hope of gain. For example, if I insure my house against fire, I either have a fire, in which case I suffer a loss, or I do not, in which case I have neither a loss nor a gain. 

In contrast, speculative risks carry a chance of gain as well as loss. If I plant a field of corn, I may suffer a loss if the weather is bad or prices are low. But if the harvest and market conditions are good, I expect to make a profit. Commercial insurers have traditionally been unwilling to cover these speculative risks. Other financial mechanisms, like hedging with futures contracts and options markets, are more suited to that job.

Third, in order for a risk to be insurable, it must be possible to charge a premium that is low enough to be affordable, yet high enough to cover claims and the administrative expenses of the insurer. That is not possible for crop insurance as the program is currently designed. Due to the presence of substantial moral hazard and the speculative nature of the risks, an actuarially fair premium for crop insurance would be unaffordable in the sense that few farmers would buy it. 

By these criteria, then, crop “insurance” isn’t true market-based insurance. It is only able to exist because the government covers more than 60 percent of the cost. And it is the subsidy, not the insurance, that makes the program so popular with farmers.

 
Crop “insurance” isn’t true market-based insurance. It is only able to exist because the government covers more than 60 percent of the cost. And it is the subsidy, not the insurance, that makes the program so popular with farmers.
 
Trickle Down

recent public opinion poll found that 80 percent of those questioned had a favorable opinion of farmers. And more than 90 percent thought that it was important for the federal government to spend money to support them. Favorable responses varied hardly at all among Republicans, Democrats and independents.

Why the popularity? One question in the poll gives us a clue: more than two-thirds of those polled disagreed with the statement that

Most of our nation’s food is grown by farming corporations that can easily afford to pay for their own crop insurance premiums without taxpayer money. It is the responsibility of any business to protect itself with insurance, and farmers should not get special treatment that the federal government simply cannot afford.

It thus seems likely that the disagreement reflects a widespread perception that the principal beneficiaries of the program are small family farms that would face a high risk of failure without subsidized crop insurance. However, the numbers, as reported for 2016 by the U.S. Department of Agriculture, do not support that view.

The first source of confusion arises from the notion that “family farms” and “corporate farms” are two different things. It is true that the USDA classifies 99 percent of all farms as “family farms.” However, it applies that term broadly to “any farm where the majority of the business is owned by the principal operator — the person most responsible for running the farm — and individuals related to the principal operator.” In practice, many such farms, including most large family farms, are legally organized as limited liability corporations or partnerships. 

Less than half of all farm output is produced by farms that are organized as traditional sole proprietorships. What’s more, most small farm proprietorships are not the primary source of income for their owners. Some 18 percent of them are operated by people who report themselves to be retired, and another 42 percent report a non-farm occupation as their main source of income.

Small family farms — those with gross sales less than $350,000 — are not, on average, very profitable. Even when we exclude the 60 percent run by retirees or people with other principal jobs, the average farm income earned by farm households is less than $50,000. Some 80 percent of such farms have an average operating profit margin — revenue less operating costs — below 10 percent, putting them at high financial risk by USDA standards. Yet, despite the fact that they face the highest financial risk of any farms and would thus seem the best candidates for crop insurance, they receive just 17 percent of all insurance payouts for losses.

Midsize farms, defined as those with revenues between $350,000 and $1 million, generate some $120,000 of income, on average, for the households that own them. Only about 40 percent of them are in the high-risk category with thin operating margins. Another 20 percent face moderate financial risks, with operating profit margins between 10 and 25 percent. Yet these midsize farms, which account for 6 percent of all farms and 21 percent of all acreage, receive 32 percent of crop insurance payouts.

The 2.9 percent of family farms that are classified as large or very large live in a different world. Those classified as “large,” with more than $1 million in sales, generate an average income exceeding $350,000. The “very large” ones (more than $5 million in sales) average $1,675,000 in household income. More than half of large farms and more than 40 percent of very large farms fall in the low-risk category, with operating profit margins of 25 percent or more. Yet, all told, these high-income, low-risk family farms receive 46 percent of crop insurance payouts. If we add in non-family farms (including the generally very large “corporate” farms of legend), we find that just 4.3 percent of all farms receive more than half of all crop insurance payouts.

 
Crop insurance benefits are not only skewed toward the largest farms, but are also skewed toward just a few crops. The millions of farmers, large and small, who produce  milk, meat, eggs, vegetables and fruit receive little or no support from crop insurance.
 

Gilding this poisonous lily, crop insurance benefits are not only skewed toward the largest farms, but are also skewed toward just a few crops. In principle, insurance is available for over 100 different crops, but according to data from the Congressional Research Service, as of 2014, corn, wheat and soybeans accounted for 77 percent of actual benefits. Adding cotton, rice and peanuts brought the total to 94 percent. Yet these six crops accounted for just 28 percent of total farm output (by revenue) in that year. The millions of farmers, large and small, who produce the milk, meat, eggs, vegetables and fruit receive little or no support from crop insurance. 

It’s hard, then, to disagree with the proposition that “Most of our nation’s food is grown by farming corporations that can easily afford to pay for their own crop insurance premiums without taxpayer money.” 

Derailing the Gravy Train

The obvious fix would be to phase out the program altogether, giving farmers reasonable time to adjust their mix of crops, farming practices and financial arrangements to manage risk. Short of that, critics of crop insurance offer a number of reforms that would make the program less costly to taxpayers and less of a drain on ag productivity. Here are just a few ideas from some of the most prominent liberal and conservative critics.

Eliminate yield exclusion. Premiums for crop insurance are adjusted according to each farm’s past yields. The idea is reasonable — farmers who have a record of consistently good yields and less frequent crop failures should pay lower rates for insurance than those with consistently poor yields and high losses. However, in calculating average yields, the government allows farmers to exclude as many as 15 low-yielding years from the average. The exclusions exaggerate past performance, artificially lower premiums, encourage farmers to plant risky crops and increase payouts. 

Stricter caps on subsidies. The 2014 farm bill, which the new version will replace, included a cap on the subsidies that could go to the largest farms. However, it left many loopholes. One of the largest was the ability of large farms to form “pass through entities” that allowed them to split total farm income among family members. Far from fixing this, the 2018 bill would widen the loophole by adding nephews, nieces and cousins to the siblings and adult children who can already share farm income. 

Limit protection to yields, not revenue. If the government is to offer any protection against farming risk, it should focus on risks to crop yields from droughts, tornadoes, pests and other natural hazards. That would mean eliminating programs like Agricultural Risk Coverage, which protects farms from even modest losses in revenue. As the Heritage Foundation (no enemy of business) concludes, “any myth that commodity programs are supposed to be a safety net as opposed to an income guarantee gets quickly dispelled by this program.” 

Eliminate the Harvest Price Option. Under standard insurance, a farmer would be compensated for crop losses at the price prevailing at the time of planting. Presumably, if that price were not high enough to offer a profit, the farmer would not plant — or would plant something else. Under the Harvest Price Option included in subsidized policies under the current farm bill, compensation is based on the higher of the price at the time of planting and the price at the time of harvest. That is not only costly to the government, but it duplicates protection that could be obtained through futures and options markets without government assistance.

•••

Many farmers see themselves as heroes of the free market, working hard to feed America and much of the rest of the world as well. They see themselves, and others see them, as more independent than the millions who toil for wages in offices and factories, not to mention those who live on government handouts. Yet, at least since the Great Depression, that has not been remotely realistic. What is especially galling is the way that, in an era in which social spending is tightly squeezed, farmers lobby so successfully for programs that shower benefits on the wealthiest among them. Perhaps we should not be surprised that the 2018 farm bill, as passed out of committee, does little to change the skewed pattern or benefits or to make farms more efficient. But we certainly should be disappointed.

main topic: Agriculture
related topics: Policy