Inside P&C Research
We look at crop insurance in detail later in this note.
For readers new to this, crop insurance is not correlated with the broader insurance cycle. It is a short-tail insurance offering by approved insurance providers for farmers on behalf of the government.
These providers then turn around and enter into a reinsurance arrangement with the government. Crop insurers also enter into reinsurance arrangements with private reinsurers to further limit their downside.
Upside and downside are rangebound in an average crop year. It’s mostly a play on scale and ease of doing business as the bigger differentiators from one provider to the other. The concept of loss development is also not applicable because accounts are squared away, and a new contract is entered into at the expiration of every year.
Since it’s a scale play, there is material concentration on the top end due to consolidation or exits from the smaller players with a higher expense base.
Here, we take a closer look at how crop insurance works, commodity futures pricing, and the latest USDA crop progress report to estimate the impact on the market.
Firstly, crop coverage is attractive for carriers once scale is attained.
Crop insurance is available through the federal crop insurance program (also known as multiple peril crop) and through private coverage (crop-hail insurance). It covers over 80% of crop acres in the US, with multi-peril crop making up nearly $11bn of the $12bn in premiums.
While this premium is less than 2% of the total P&C market insurance premium in the US, the coverage has been concentrated in a small number of carriers. The top five carriers cover nearly 70% of industry premiums.
Writing crop insurance requires approval from the USDA, as the government serves as a reinsurer for the premiums written.
The number of players has been declining due to consolidation. Following Sompo’s 2020 acquisition of Diversified Crop Insurance and ProAg’s 2019 acquisition of Technology Insurance, the number of companies providing crop insurance has declined to 13.
Because the government sets the premiums and backstops the program if heavy crop losses occur, less informed politicians view insurers as unequal participants with not enough skin in the game on the downside while benefiting from the upside. (Biden’s 2022 budget did not include any cuts to the program).
Due to this, overall returns have declined from historic highs even reaching 20% to a more respectable double-digit number in a normal year. This is a good outcome where a worst-case outcome is close to breakeven - or a modest loss – due to the federal backstop. The median combined ratio over the past 10 years is 92%.
Hence crop can provide near-double digit returns uncorrelated with the broader insurance cycle.
For companies with the proper platform (agents, technology, etc.), writing crop coverage can provide for a differentiating earnings contribution once they build scale.
Secondly, how do the basics of crop insurance work?
If you as a farmer have a parcel of land you are worried about two things: Is my field going to yield enough? And will I get a good price for it? You can choose to protect either.
About three-quarters of crop insurance policies are revenue-based, with the remainder yield-based. Like it sounds, yield protection covers the farmer growing less than anticipated due to natural causes (drought, excessive moisture, hail, wind, frost, insects, and disease), and revenue protection covers a combination of yield losses and revenue losses.
Let’s take it to the next step with an example.
The farmer provides an actual production history (AHP) yield. This is the average yield obtained on the insured unit for the last 4-10 consecutive crop years and serves as the baseline that the actual yield will be compared to.
Let's say the farmer has an APH of 150 bushels. Their deductible is 30%. The February average corn/maize price for the December 2021 contract is $4.58 for a $481 revenue guarantee per acre. There are four loss scenarios.
In the first scenario, the harvest price was higher than the projected price ($5.75 vs. $4.58). Revenue protection provides the higher of the harvest or projected price. This means the farmer would be covered for the higher price. After a deductible, this translated to a guarantee of $604 (150 x $5.75 *.70). The actual yield was lower than the APH (100 vs. 150) so the farmer would only be able to get $575 (100 x $5.75) for the crop. The farmer would look to insurance to cover the $29/acre loss.
Thirdly, can we look at the future crop prices and project which way the crop insurance market could go?
When the crop insurance policy is written, you need a starting point when projecting the price for a crop. This projected price for corn and soybean (AKA the discovery price) is based on the average trading price for February and the harvested price will be based on October averages.
With corn (December 2021 future) trading at ~$5.40 and soybean (November 2021 future) trading at ~$13.05, harvested prices are likely to be higher than projected prices.
Prices for 2021 are higher than in previous years. The price reflects supply and demand in the market.
The level of supply in the US is based on the amount produced by farmers, as well as built-up supply from previous years. It is also impacted by the available supply from other countries. For example, the delays to the South American harvest have been a benefit to the US crop market.
The higher prices also led to a potentially higher supply, with farmers planting more than last year (2% higher for corn and 5% higher for soybeans).
On the demand side, the demand for a crop is driven by economic factors, as well as global exports. This year there is uncertainty around whether China will maintain the increased demand seen in 2020.
The supply and demand relationship drives the price and as shown in the examples above, the price plays a role in indemnity payments to farmers. It also plays a role in premium calculations.
The volatility in crop prices is another important factor. This year's volatility was 0.23 vs. 2020’s volatility of 0.15. The volatility factors are based on the last five days in February. The higher the volatility in prices, the greater the risk, so the higher the premiums.
The table below shows the projected and harvested price over the last decade, as well as the volatility factor. There is no clear correlation and the values can vary significantly by year.
Fourthly, crop growing conditions haven’t set an alarm off for carriers yet.
An easier way to think of how the yield is looking is by examining the growing conditions.
The USDA publishes a weekly report during the growing season (April to November) summarizing the progress and conditions of selected crops by state.
The USDA’s June 27 crop progress report pointed to corn conditions being incrementally worse than this time last year. With 64% of corn condition rated as “good” or “excellent” vs. 75% last year. For soybeans, 96% emerged by June 27th, higher than the five-year average of 92%.
However, it is still too early to know if crops are in the clear. Getting sufficient rain during the summer months will ultimately determine harvest yields.
Corn is the largest crop in the US. Over 92 million acres are planted for corn in the US for use in animal feed, ethanol, and human consumption, with another 87.6 million for soybeans. The map below shows where more than 90% of corn and soybeans grow in the US.
The current drought conditions have been focused in the western states of California, Nevada, Utah and Arizona, with some impact to Montana, North Dakota, South Dakota, and Iowa as well. This suggests a greater impact on soybean yields than corn yields.
Historically, it took significant weather events (either droughts or flooding) to see a large drop in the amount harvested.
The charts below show the corn and soybean yields compared to the trailing five-year average.
Looking at corn, yields were significantly lower than anticipated in 2002, 2012 and 2019. In 2002, crops were late being planted and experienced severe moisture stress, which led to corn yields being ~4% lower than the five-year average.
In 2012, there were droughts in the Midwest that led to 20% lower corn yields vs. the five-year average (and 26% lower than USDA’s initial forecast). The droughts were particularly impactful as they occurred in states with significant corn and soybean production, including Illinois, Iowa, Nebraska, and Kansas.
The 2019 yields were impacted by excess rain and flooding that delayed/prevented plantings for the season, particularly in Illinois, Indiana and Ohio.
Putting these incidences aside, corn yields have generally increased over the years.
Historical soybean yields are similar to those of corn, also seeing lower than average production in 2002, 2012 and 2019.
Fifthly, crop insurers’ underwriting performance has tracked closely with corn yields.
2007 and 2010 were some of the best years for the industry, driven by favorable crop yields and relatively strong commodity prices.
On the other hand, crop insurers saw the largest underwriting losses in 2002, 2012 and 2019. The 2012 drought was particularly detrimental, leading to the worst corn production in over two decades and the sixth underwriting loss for the industry since the program began in 1981.
Soybean yields were below average in 2003, 2008, 2012 and 2019. While the industry combined ratios were incrementally higher for those years, the corn yields were more significant for carriers’ underwriting results (as seen in the combined ratios below).
In summary, although weather conditions could disappoint and lead to lower crop yields, 2021 is unlikely to be a repeat of the underwriting losses seen in 2012. Corn conditions are somewhat less encouraging when compared to last year, but with the drought concentrated in the West, we are still optimistic crop carriers will see performance for 2021 in line with historical averages.
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