Insurance Lecture 24

1. Insurance Lecture 24 • Lecture 24 Insurance.xlsx

2. Principal of Insurance • Insurance is a risk management tool • Buy insurance to cover a specific risk of a loss to the business • Low yield due to fire, hail, drought, flood, etc. • Low prices • Low revenue due to low production of price • Health, auto, and home insurance most popular • Liability insurance • Insurance transfers a part of the risk to a third party

3. Terms for an Insurance Policy • States the risk to protect against • Conditions for a loss • Amount of loss that must occur for a payment • States the premium to be paid • States indemnity payment conditions • Amount of the deductible (losses not paid) • Formula for calculating a payment

4. Insurance Premiums • Premiums are set to cover the expected loss plus a risk premium and a profit for the insurance company • Premium = E(losses) + RP + Profit • Calculate the E(Losses) with simulation • Simulate the type of loss and use the losses in the formula for calculating the premium • Calculate the average loss over a given time period, usually a year • Profit is a set fraction by the company • RP covers risk not fully captured in PDF for risk

5. Insurance for Agriculture • Crop Yield insurance • Low yields insured against hail, fire, insects, drought, flood • Revenue insurance • Protects crop farmers from low revenues relative to historical averages

6. Agriculture Insurance Presents Unique Problems • Agricultural risks widespread due to weather affecting large regions when drought of occur • If an insurance company covered all the risk they would be wiped out • Solution was for the federal government to back up these companies • USDA-Risk Management Agency (RMA) write insurance policies and set premiums and terms • Private cos. sell these policies • Sell most policies to RMA, keep the lower risk policies as an investment

7. US Drought: Current Conditions

8. Texas is actually looking pretty good relative to 2011 … September 13, 2011 February 3, 2015 … but parts of Texas are still in an exceptional, multi-year drought …

9. Brief History of Federal Crop Insurance • 1930’s USDA offered yield insurance in the Great Plains for wheat • Experimental project • Expanded to other crops gradually • 1971 Farm program offered Disaster Program • Paid farmers for low yield and prevented plantings • Replaced with FCIC insurance in 1983 • In ‘83 FCIC yield insurance expanded to all crops in all counties

10. FCIC Yield Insurance (YP) • Production guarantee = APH * coverage level percentage elected • APH = 10 year yield history on the farm unit • Based on actual yields for the farm unit • Premium set by RMA based on announced price guarantee, APH, and coverage level percentage • Indemnity = Max[0, (Actual Yield – Production Guarantee) * Projected Price * Acreage Covered]

11. FCIC Yield Insurance • 50 acres of corn, RMA projected price of $3.50/bu, APH yield 145 bu/acre, 85% coverage level • Production guarantee = 0.85 * 145 = 123.3 • If actual yield = 115 so lost yield is 123.3-115 • Indemnity = (123.3-115) * 2.25 * 50

12. Revenue Insurance • Crop Revenue Coverage (CRC) • Producers buy a fraction of the historical revenue • 65% to 85% in 5% fractions • Insure with a projected price or the harvest price • Indemnity = Max[0, (Guaranteed Revenue – Actual Revenue) * Acres ] • Actual Revenue = actual yield * (RMA projected price OR harvest time price)

13. Revenue Insurance • 50 acres of corn, RMA projected price of $3.50/bu, APH yield 145 bu/acre, 85% coverage level • Revenue guarantee = 50 * 145 * 0.85 * 3.50 • Actual yield = 100 • Indemnity = Max[0, (revenue guarantee – 50 * 100 * 3.50 or actual harvest time price)] • Electing the RMA projected price is referred to “Harvest Price Exclusion” and is cheaper

14. Analyzing Insurance Options • Simple simulation problem • Simulate yield and price • Compare yield or revenue to alternative (insured) coverage levels, calculate indemnities and premiums • Pay premiums every year • Collect indemnities only when there is a loss • Pick insurance policy which is best at reducing risk and increasing net income, NPV, or cash flows

15. RMA Insurance Policies • Insurance policies must be purchased prior to planting to reduce: • Moral hazard -- buying insurance when farmers know the crop will fail • xxx • General Policies and Provisions • Actual Revenue History (ARH) Pilot Endorsement (14-arh). • Area Risk Protection Insurance (14-ARPI) • Commodity Exchange Price Provisions (CEPP) • Catastrophic Risk Protection Footnote 5. • Ineligibility Amendment (15-Ineligibility) Footnote 1. • Farm Bill Amendment (15-ARPI-Farm-Bill) Footnote 6. • Catastrophic Risk Protection Endorsement (15-cat). Footnote 3. • Common Crop Insurance Policy, Basic Provisions (11-br) • Commodity Exchange Price Provisions (CEPP) • Contract Price Addendum (CPA) • Ineligibility Amendment (15-Ineligibility) Footnote 1. • Farm Bill Amendment (15-CCIP-Farm-Bill) Footnote 2. • Other Information • Supplemental Coverage Option (SCO-15) • High-Risk Alternate Coverage Endorsement (HR-ACE)(13-HR-ACE) • High-Risk Alternate Coverage Endorsement Standards Handbook • High-Risk Alternate Coverage Endorsement Frequently Asked Questions • Livestock • Quarantine Endorsement Pilot (11-qe). • Rainfall and Vegetation Indices Pilot • Whole-Farm Revenue Protection (WFRP) Pilot Policy

16. Insurance and Farm Policy • 2014 Farm Bill is relying more on insurance and less on direct or indirect subsidies • Agricultural Risk Coverage (ARC) • Supplemental Crop Optionm(SCO)

17. Agriculture Risk Coverage (ARC-CO) • Payments when actual revenue for the covered commodity < ARC revenue guarantee, where: • Actual County Revenue = Actual county yield per planted acre * Max of {National Marketing Year Price or Marketing Loan Rate} • ARC Revenue Benchmark = (5 Year U.S. Olympic average marketing year price) * (5 Year Olympic average county) • If any of the 5 years of prices are lower than Reference Price then replace with the Reference Price. • If the actual county yield is < 70% of T-yield replace with the T-yield. • ARC Revenue Guarantee = 0.86 * ARC Revenue Benchmark • ARC Payment = Minimum of [(ARC Revenue Guarantee – Actual County Revenue) OR 10% of the ARC Revenue Benchmark] * Base Acres * 0.85 • No yield risk in year one’s calculation but that does not last • Olympic average starts with 2009-2013, but then moves to 2010-2014, 2011-2015, 2012-2016, 2013-2017 with more and more risky yields in the Olympic Average each year of the farm program

18. Illustration of Government Support for Grains Under ARC-County Revenue per cwt or bu Revenue Benchmark 86% of Revenue Guarantee 86% 76% [paid on base acres x .65 (individual) or .85 (county)] Loan Rate MLG Market Price Market Receipts Crop insurance coverage

19. Supplemental Coverage Option (SCO) • Gap insurance: payments for losses from 86% of APH or CRC coverage level down to the underlying insurance coverage level

20. Illustration of Government Support for Rice Under SCO Revenue per cwt 86% of Revenue Guarantee Supplemental Coverage Option Crop insurance coverage

21. Insurance Job Opportunities • Sales representative for the large companies • Insurance actuary • Adjusters • Seasonal employment that pays well • Work during growing season only • Visit damaged fields and prepare estimates of the damages • Experience with crop production and economics • Insurance companies complain there never enough adjusters

22. Insurance Use in Texas for Cotton

23. Insurance Use in Texas for Corn

24. Simulating a Learning Curve to Represent theDemand Cycle • A new business may need a few months or years to grow sales to their potential • May take months or years to learn how to reach potential for a prod function • In either case, assume a stochastic growth function and simulate it, if nothing else is available, use a Uniform distribution • Example of a growth function for 8 years

25. Learning Curve or Demand Cycle

26. Life Cycle Costing • A new concept in project feasibility analysis • Explicitly consider externalities • Such as cleanup costs at end of business • Strip mining reclamation • Removal of underground fuel tanks • Removal of above ground assets • Restoration of site • Prevention of future environmental hazards • Removal of waste materials • 100 year liners for ponds

27. Life Cycle Costing • Steps to Life Cycle Costing Analysis • Identify the potential externalities • Determine costs of these externalities • Assign probabilities to the chance of experiencing each potential cost • Assume distributions with GRKS or Bernoulli • Simulate costs given the probabilities • Incorporate costs of cleanup and prevention into the project feasibility • These terminal costs may have big Black Swans so prepare the investor

28. Life Cycle Costing • Bottom line is that LCC will increase the costs of a project and reduce its feasibility • Affects the downside risk on returns • Does nothing to increase the positive returns • Need to consider the FULL costs of a proposed project to make the correct decision • J. Emblemsvag – Life Cycle-Costing: Using Activity-Based Costing and Monte Carlo Simulation to manage Future Costs and RisksJohn Wiley & Sons Inc. 2003

29. Life Cycle Analysis • LCA is a tool for determining the impact of a new process or project on the environment and climate change • LCAs are concerned with quantifying • Energy Use and CO2 Balance • Green House Gases (GHGs) • Water use and indirect Land use • Nutrient (N,P,K) use and other factors • Thus far these are deterministic analyses – This will soon change

30. Life Cycle Analysis • For those interested in a good example of LCA see MS thesis in our Department by Chris Rutland Analyzed the carbon footprint for crop and dairy farms in principal production regions in the US