Program Changes Improving the Actuarial USDA. Soundness of the Federal Crop Insurance Program

SUMMARY: The Omnibus Budget Reconciliation Act of 1993 (OBRA) directed

the Federal Crop Insurance Corporation (FCIC) to make program changes

as necessary to improve actuarial soundness of the Federal crop

insurance program and to achieve, by the fiscal year beginning October

1, 1995, a projected overall loss ratio not to exceed 1.10 (110

percent) (section 1501(a)). Section 1501(c)(2) further directed the

Department to issue for public comment a comprehensive plan or

``blueprint'' that identifies, among other things:

Steps FCIC intends to take to achieve a projected overall

loss ratio of no greater than 1.10 on and after October 1, 1995.

Additional steps if further action is required, based upon

actual program experience or unforeseen external circumstances.

Modifications to be considered if initial actions to

improve actuarial soundness work better than anticipated.

Projections, assumptions, and analyses which underlie the

FCIC conclusions that the above actions will achieve the required loss

ratio within the stated deadline while maintaining fairness and

effective coverage to agricultural producers, and which thereby

demonstrate FCIC's compliance with the performance standard identified

in section 1501(a).

The following notice outlines such a plan. Readers are requested to

identify additional issues other than those outlined herein that they

believe are relevant and important in assisting FCIC in its actions to

manage the program to achieve the target loss ratio. This notice

encourages comment and participation from the affected public. Comments

and inquiries should be sent to the address listed below.

FOR FURTHER INFORMATION CONTACT:

Mari Dunleavy, Regulatory and Procedural Development Staff, Federal

Crop Insurance Corporation, Washington, DC 20250, telephone (202) 254-

8314.

NOTICE: The Federal Crop Insurance Corporation's ``Blueprint for

Financial Soundness'' reads as follows:

Blueprint for Financial Soundness

Scope and Purpose

Actions identified herein result from internal analysis by FCIC and

information previously provided to FCIC by numerous interested parties.

These include the Commission for the Improvement of Crop Insurance (a

Congressionally established work group in 1989 and 1990), various crop

insurance industry organizations, members of Congress, agricultural

producers, crop insurance agents and insurance companies, the General

Accounting Office, and others. Information was not solicited

specifically for this draft but was compiled from previous

recommendations. Not all of the specific recommendations made by any or

all of these groups are included herein. This document establishes

initiatives to achieve the above actions.

Estimates of the financial impact of an action, based on available

data and professional judgment, are provided whenever possible. Readers

should recognize that these estimates are fluid due to the nature of

the data and the ever-changing program. In particular, since FCIC does

not have a single aggregate mathematical or statistical model that

describes its programs, estimates of financial impact are based on

partial analysis which considers the effect of one particular action in

the absence of any other action or initiative. Also, the exact steps to

be taken under this Blueprint depend in part upon the public comment

and recommendations received before investing resources in detailed

studies of potential impacts. Readers are encouraged to provide

information, rationale, and where possible, estimates of costs or

potential savings.

In some cases the financial impact of an action may not be

quantified. This does not mean the action is not important or that it

cannot contribute to achievement of the goal. For example, enhanced

management reporting systems do not produce a measurable financial

impact. However, such systems can enhance FCIC's ability to estimate

the potential impacts of program changes and assure that ongoing

management decisions recognize the impact of the decision on future

actions.

This document is divided into four main sections, which describe:

(1) Crop insurance program to provide context and background;

(2) Actions FCIC proposes as part of this plan to achieve the

target loss ratio;

(3) Additional actions that FCIC may take if those described in

section II are not effective or that cannot be implemented due to

unforeseen circumstances; and

(4) Changes FCIC will consider once the projected loss ratio

achieves the targeted level of 1.10.

I. Background of the Crop Insurance Program

A. Overview of Program Operations

Crop insurance is delivered primarily by commercial insurance

companies that have entered into a cooperative financial arrangement

[the Standard Reinsurance Agreement (SRA)] with FCIC. Under this

arrangement, the company agrees to deliver an FCIC designed and priced

product to eligible buyers. The company is responsible for all aspects

of customer service, and guarantees payment of the insured person's

share of the premium to FCIC. In return, FCIC reimburses the company

for administrative expenses and requires the company (on a state basis)

to share in insurance experience whether favorable or unfavorable. FCIC

also provides stop loss reinsurance that limits the maximum loss the

company can sustain.

A small and decreasing portion of the total sales is managed

directly by FCIC through sales and service contractors. These

contractors agree to sell an FCIC designed and priced product and to

perform certain servicing functions related to the sale (such as

determining the average yields). FCIC reimburses the contractor for

administrative expenses associated with selling and servicing the

product; however, FCIC is directly responsible for premium collection,

loss adjustment, and payment of losses. These latter functions are the

responsibility of the reinsured company under that delivery system.

FCIC intends to eliminate direct sales after the 1994 crop year because

this system now delivers less than 10 percent of the total business,

and maintaining a nationwide capability for delivery at an acceptable

cost is difficult.

The crop insurance plan for most crops indemnifies insured persons

for losses in yield exceeding a predetermined threshold amount. To

establish this threshold an average yield is determined based on the

individual's production history. The first portion of the loss

(deductible of the insurance), equal to 25, 35, 50, or 65 percent of

the average yield, must be sustained by the insured person. These are

the choices of deductibles now offered by FCIC, and typically are

described by the maximum loss in yield covered by the insurance; e.g.,

75 percent coverage, 65 percent, etc. The 50 and 75 percent coverage

levels are required by the Act to be available to all persons. The

level of coverage is chosen by the insured individual.

The insured person also must choose a price at which the yield is

valued for the purposes of computing the amount of premium and any

applicable amount of loss; this variable is called the price election.

FCIC must offer a price election that is not less than the anticipated

market price at time of harvest. This determination is made well before

the possibility of loss is known during the crop year. Otherwise,

insured persons would choose low price elections if no loss is

sustained (minimizes premium payments) the highest possible price

election if a loss occurs (maximizes indemnities).

FCIC establishes premium rates for the various coverage levels,

yields, crop types and farming practices (e.g., irrigated) for each

county. All planted acres of the crop are covered by the insurance

policy unless for some reason the acreage is uninsurable. The premium

owed by the insured person is determined by multiplying the average

yield per acre by the coverage level, multiplied by the number of acres

planted, the price election, and the premium rate. For example, if the

average yield is 100 bushels per acre, the coverage level is 65

percent, planted acres are 50, the price election is $2.25, and the

premium rate is 5.2 percent, the premium is equal to 100 x 0.65 x

50 x $2.25 x 0.052, or $380.25. The potential indemnity in the

event of a total loss is $7,312.50 (determined by multiplying the

average yield, coverage level, planted acres, and price election).

A portion of the total premium is subsidized to encourage

participation in the program. The subsidy is 30 percent of the total

premium for coverage levels up to and including the 65 percent level.

The subsidy for 75 percent level of coverage is equal to the dollar

amount that would be paid at the 65 percent level of coverage. The

premium subsidy for the above example would be $114.08; thus, the

insured person would pay $266.17. The same $114.08 subsidy would be

paid if the insured person chose the 75 percent coverage level.

In the event of a loss, the amount of production that was

harvested, or that was determined should have been harvested, is

measured by the insurer. An indemnity payment is made if the determined

production is less than the total guarantee for the acreage (yield

multiplied by coverage level and acres planted). For example, if the

insured person harvests 1,000 bushels from 25 acres and does not

harvest a potential yield of 10 bushels per acre from the remaining 25

acres, the total of the production to count is 1,250 bushels (1,000

bushels harvested plus 25 acres multiplied by 10 bushels). This is

subtracted from the total bushel guarantee for the acreage (100 x

0.65 x 50, or 3,250 bushels), resulting in a loss of 2,000 bushels.

The indemnity is equal to the number of lost bushels multiplied by the

price election. For this example, the indemnity would be 2,000 bushels

x $2.25, or $4,500.

Crop insurance does not guarantee revenue. As the above example

illustrates, it provides an insurance indemnity only if production is

less than the established guarantee. No protection is provided if the

market price is less than the price election.

B. Legislative Background and Issues

Federal crop insurance was established as a pilot program in the

1930's. Prior to 1980, crop insurance was available only on major crops

in major producing areas. The coverage level often was limited to 60

percent or less of a long-term average yield for an area. Congress

amended the Act in 1980 to expand the scope and coverage of the program

with the intent that it be the sole means of providing public disaster

assistance to U.S. farmers. Participation in the program increased

after the 1980 amendments, but remains below levels deemed necessary to

be regarded as the principal vehicle for disaster assistance. Insured

acreage peaked at about 40-45 percent of the total acreage planted to

insurable crops in 1988-89, but more commonly has been in the 30-35

percent range. Losses also increased with the expansion of the program.

The loss ratio has exceeded the break-even amount of 1.00 in every year

since 1980. Cumulative losses for the years 1980-1992 were

approximately $2.9 billion, with a cumulative loss ratio of about 1.45

for the 13 years.

Program participation is an issue influencing the Federal crop

insurance program. Full participation (i.e., 100 percent of eligible

acres insured) is the measure of program success that is accepted (at

least implicitly) by some persons. This measure may not be the most

appropriate. A rational decision to buy insurance of any kind must be

based on the magnitude of the financial difficulties that accompany a

loss. For example, buying collision coverage on a 15-year old

automobile makes little financial sense. Similarly, buying insurance on

a crop that contributes only a small portion of the expected income of

the insured person may not make financial sense. Full participation in

the crop insurance program may not represent an efficient use of the

taxpayer's resources. However, participation must be high enough to

minimize or eliminate perceived needs to legislate disaster assistance

funded under dire emergency provisions of the Budget Enforcement Act.

The level of participation in the crop insurance program that maximizes

returns to the public is not known, and is an area needing further

definition.

Many losses paid in the 1980's and early 1990's were due to

widespread disasters, the adverse financial effects of which Congress

intended to mitigate under the Act. However, continuing loss ratios

exceeding 100 percent, enactment of disaster assistance in nearly every

year since 1988, and lower than desirable participation indicate that

the public policy goals of the program have not been fully realized.

The Secretary of Agriculture has proposed a reform of the crop

insurance program to:

Achieve actuarial soundness.

Increase participation to levels that render ad hoc

disaster legislation.

Eliminate incentives to enact ad hoc disaster assistance

legislation.

The proposals contained in this Blueprint focus on these three

areas that directly relate to the goal of achieving the targeted loss

ratio. They are:

(1) Actuarial matters such as premium rates and yield guarantees,

(2) Underwriting matters such as terms and conditions of insurance

policies, and

(3) Management issues such as compliance and risk-sharing

arrangements with commercial insurers.

II. Management Actions To Achieve a Loss Ratio of 1.10

A. Develop More Accurate Insurance Yields

The insurance yield may be the single most important factor in

determining the success or failure of the crop insurance program. A

yield that is too high compared to the productive potential of the

person or land will increase the number of years that a loss is paid.

An excessively high yield also increases the amount paid when a loss

occurs. A yield that is too low will not effectively protect farmers

from loss and, because it is regarded as insufficient, will not induce

desired levels of participation.

From the 1985 through 1993 crop years, insured yields were based on

a program called the Actual Production History (APH) Plan. The goal of

this program was to obtain 10 previous yields to establish the insured

yield for the next crop year. Proxy yields largely based on ASCS farm

program payment yields or county averages were allowed whenever farmers

would not or could not provide 10 years of history. Analysis by FCIC

and others determined the proxy yields were benefiting farmers whose

yields tended to be lower than average and discouraging farmers whose

yields tended to be above average. Consequently, a modified-APH program

that reduced the influence of the proxy yields was introduced beginning

with the 1994 crop year; thus, a ``ladder'' was introduced into the

proxy yields. Only 65 percent credit is given to the proxy yield if no

actual yields are reported, 80 percent credit is given if one actual

yield is reported, 90 percent if two actual yields are reported, and

100 percent if three actual yields are reported. The proxy yields are

not used after four actual yields are available. The insured yield is a

simple average of the 4 years of actual and modified proxy yields for

the first 4 years, and then (after 4 years) is the simple average of

the actual yields reported. Acquiring 10 years of production history

remains the goal of the program. These revised procedures are the core

of the initiatives to comply with the mandate of OBRA 93 to institute

rules to demonstrate actual production histories.

The revised rules are expected to substantially reduce losses of

the Federal crop insurance program. Analysis performed by FCIC

indicates the new rules would reduce losses by 15 percent for corn, 22

percent for soybeans, and 18 percent for wheat. These analyses were

based on simulations of loss histories using the rules for the two

computational methods--the previous APH and the proposed modified-APH

plans. The analyses encompassed nine states each for corn and soybeans

and three states for wheat. These states and crops represented nearly

60 percent of the total premiums earned in 1990. The results indicated

that the modified-APH rules would reduce losses by a weighted average

of 19 percent and are believed to be representative for most crops.

The actual loss ratio for the 1990 crop year was 1.23. If the

modified-APH rules did reduce losses by an average of 19 percent, the

loss ratio would have been 0.996. This would achieve significant

compliance with the loss ratio target of 1.10.

Based on these results, FCIC implemented modified-APH for the 1994

crop year by:

Promulgating regulations for the program during calendar

year 1994.

Measuring the impact of the modifications upon net program

losses by calculating insured yields, premiums, and indemnities of

policyholders under 1993 and 1994 rules.

Where possible, determining whether the modified-APH rules

had the intended effect of providing a more accurate offer for farmers

who previously elected not to purchase crop insurance.

Determining whether the average number of yields reported

for prior years has changed under the modified-APH rules compared with

APH rules for 1990 through 1993.

Implementing a tracking system to assure that insurance

experience remains associated with a person in future years (see item D

below).

Developing reporting processes to assure that the accuracy

of yield determinations is continuously monitored and improved.

Actions requiring analysis of the effects of the modified-

APH rules upon the accuracy of insured yields cannot be completed until

losses from the 1994 crop year are processed. For wheat and other fall

planted crops, such availability will occur by about the fourth

calendar quarter of 1994. For spring planted crops, this does not occur

until about the middle of the first calendar quarter of 1995.

FCIC believes that these actions to implement modified-APH will

reduce the average loss ratio over time by 10-15 percentage points

(e.g., from an average of 1.40 for several years to 1.25 to 1.30). This

estimate is based on a conservative expectation of the actual results

of the simulations described above.

B. Catastrophic Yield Adjustment

FCIC recognizes that the average of a series of observations as

short as 4 years is subject to significant variations due to abnormally

large or small yields during that time. For example, if a major

disaster year such as 1993 is included in the 4 years, the procedure

implicitly states that a similar year will occur once every 4 years.

This is not likely. Thus, FCIC will examine certain adjustments to the

modified-APH rules with a goal to assign more appropriate probabilities

to the individual observations. These adjustments commonly are called

catastrophic yield adjustments. However, just as the yields for 1 year

may be abnormally low, they also may be abnormally high. Capping the

abnormally high years may also be appropriate so that average yields

are not excessively high due solely to a few observations.

FCIC will evaluate alternative methods to recognize catastrophic

and unusually good crop years, and consider implementing appropriate

adjustments to the modified-APH plan effective for the 1995 crop year.

C. Implement Group Risk Plan

FCIC is implementing a program of insurance that is based on the

average yield of an area, not upon individual yield coverage as is

offered under the traditional APH program. The area coverage is called

the Group Risk Plan (GRP) by FCIC. GRP was introduced as a pilot

program for the 1993 crop year for soybeans in 96 counties. It was

expanded for the 1994 crop year to include seven additional crops

encompassing, 1,872 county crop programs (one crop in one county) in 27

states. Crops now included under GRP are barley (three states), corn

(17 states), cotton (seven states), forage (two states), grain sorghum

(four states), peanuts (four states), soybeans (24 states), and wheat

(eight states).

The GRP is intended to protect the insured person against the

financial consequences of a disaster that strikes all or nearly all

farmers in an area. It sets an expected county yield for each year

based on historical yields, adjusted for any trends. Whenever the

actual county average yield for the year is less than the expected

county yield by a predetermined amount, an indemnity is paid. The

principal differences of the GRP compared to traditional individual

coverage area:

Coverage is based on a trend projected yield, which

probably will exceed the average yield of all farmers insured under

individual yield coverage is there is a positive trend in yields for

the area.

Higher coverage levels (deductibles are as low as 10

percent) at affordable premium rates can be sold.

Thus, in the proper circumstances, GRP will offer risk protection

that may be better than the individual coverage, and may do so at a

lower cost.

GRP has characteristics that make it unsuitable for managing the

adverse financial consequences of crop loss in certain circumstances. A

farmer's yield each year must change in the same direction and by about

the same amount as the county yield if it is to be fully effective

coverage for the individual. For example, if the county's yield

decreases by 25 percent from the expected yield for that year, the

farmer's yield also should decline by about 25 percent from the yield

he or she would have expected. In financial market terms, the ``beta''

or the farmer's yields and the county yields should be near 1.00.

Adequate data are a limitation to further significant expansion of

GRP. The concept as presently developed uses many years (30 or more) of

county yields. These data are routinely available only for counties in

which the crop has been grown in commercially significant quantities.

Weather data and crop growth models may permit expansion into counties

in which the historical yield data are not available, but research is

needed to develop and test these approaches. Further, acceptance of GRP

by bankers as collateral for loans is yet to be determined.

Significant expansion of GRP is not anticipated until its

contributions to agricultural risk management can be measured. No

estimates of savings can be attributed to GRP because customer

acceptance is not known. Customer acceptance of the soybean GRP for the

1993 crop year was limited. Fewer than 500 policies (of nearly 700,000

total for the crop insurance program) were sold. Even if the plan

improves the actuarial soundness of crop insurance, the present volume

of business is not sufficient to make any noticeable difference in

program results.

D. Implement Data Base of Taxpayer Identification Numbers

Amendments to the Federal Crop Insurance Act enacted in 1990

authorize FCIC to collect and use social security numbers and employer

identification numbers to administer its programs. These regulations

were appropriately approved and were published in the Federal Register

in late 1992. OBRA 93 further directed FCIC to implement a database of

these numbers for certain uses not later than the 1995 crop year.

FCIC implemented the database described above in January 1994,

effective for the 1994 crop year. This database is used to locate

production history that is not reported by a person to assure that

classifications assigned under the nonstandard classification system

(NCS--see paragraph E below) are used for both the individual who

accumulated the adverse history and any person having a significant

beneficial interest in a crop produced by that person, and for other

related purposes. In particular, further efforts will be made to

accumulate information about persons involved in sales and servicing of

crop insurance--agents, loss adjusters, and other insurance providers--

so that their contributions to achieving the target loss ratio can be

measured.

Implementing this database will make both modified-APH and the NCS

more effective by permitting FCIC and reinsured companies to assure

that all appropriate experience and premium rating factors are used.

Incremental improvement in the loss ratio due to modified-APH and NCS

is difficult to quantify. The database will enhance those programs as

well as permit FCIC to systematically measure the performance of

insurance providers for the first time.

FCIC will also use the social security numbers and employer

identification numbers for the implementation of an Ineligible File

Tracking System. This system will be used to restrict (through an

automated environment) producers who have been declared ineligible to

obtain benefits provided by the Federal crop insurance program. The

FCIC expects to implement the Ineligible File Tracking System beginning

with the 1995 fiscal year.

E. Expand the Nonstandard Classification System (NCS)

FCIC instituted the NCS for the 1990 crop year because evidence

indicated that a small percentage of insured persons had losses in

nearly every year. The losses paid to these persons far exceeded paid

premiums. For various reasons, the insured yields for these individuals

exceeded their apparent capabilities, and the premium rates were not

representative of the risks posed by these persons. NCS was intended to

reduce the insurance guarantee and increase the premium rate for such

individuals. Modified-APH eliminates the need to reduce insured yields

because the insured yield will be based solely on actual yields when a

person is selected for NCS. However, NCS will continue to increase the

premium rates as appropriate for those individuals who persistently

have losses.

The Agriculture, Rural Development, Food and Drug, and Related

Agencies Appropriation Act for the 1994 fiscal year prohibited FCIC

from using any funds appropriated to insure crops in certain counties

unless an NCS program had been implemented in those counties. Counties

were affected if the loss ratio, after applying the 1993 premium rates,

was greater than 1.10 more than 70 percent of the years that the crop

had been insured in that county. Approximately 2,100 county crop

programs were affected by this provision.

For the 1994 crop year, NCS has been extended to 11 crops

encompassing over 90 percent of the total value of insurance in force.

Additionally, all of the county crop programs affected by the

Appropriations language have been included under the NCS. Over 25,000

individuals (about 3.6 percent of all active policies for the 1993 crop

year) were included under this program. Not all of these persons had

been insured during the base period. NCS also extends to persons who

participated in growing the crop in some way but who may not have been

insured. These persons also are classified under NCS so that the

acreage cannot simply be insured under a different name to avoid the

NCS classification.

In 1993, FCIC commissioned a study of the NCS to determine its

effectiveness. A draft report of that study indicates that the NCS

reduced the loss ratio by 5 to 10 points. This report is undergoing

final preparation as this Blueprint for Financial Soundness is

finalized.

FCIC will expand the NCS program for the 1995 crop year. All

eligible crops will be included, although greater flexibility in

selections may be authorized whenever program factors that led to poor

experience have been identified. NCS is not suited to certain insured

crops (e.g., Texas citrus trees) that are subject to infrequent losses

of great severity. The additional savings from NCS are likely to be

small in terms of the total business because the crops that constitute

the majority of premiums and losses already are included.

F. Institute Premium Rate Adjustments

Premium rates are essential to the success of the crop insurance

program. Rates that are too low will not produce adequate income and

will lead to persistent losses. High rates will, paradoxically, likely

lead to the same outcome. Excessive premium rates discourage

participation by a broadly based cross-section of the farming

community. Instead, persons who are most likely to collect indemnities

will buy, and it is not likely that rates can be increased as rapidly

as the relative risk of the pool of insured persons increases.

FCIC has increased premium rates for all crops in a systematic

fashion beginning with the 1991 crop year. Rates have increased as much

as 70 percent for some crops in some counties from the 1991 to the 1994

crop years. Decreases of up to 20 percent have been made for some crops

in counties with histories of low losses. By an amendment to the Act in

1990, Congress limited general premium rate increases to 20 percent

annually.

The above statistics indicate the amounts that FCIC has increased

the base premium rates. The average premium rate actually earned

(actual premium paid divided by actual liability) may not have

increased by the same magnitude for various reasons. Most importantly,

insured persons may choose a lower coverage level when the rate

increases. By doing so, they accept a lesser degree of protection but

also pay a lower premium rate.

FCIC proposes to continue premium rate increases as needed to help

achieve the required loss ratio. The rate increases made during 1991-

1994 have done much to enhance the actuarial soundness of the program.

However, the premium rates for some crops and areas of the country

remain below the levels needed to achieve the overall 1.10 loss ratio

target.

The impact of premium rate adjustments has been evaluated by using

data for the 20 years from 1973-1992. The effectiveness of the

adjustments was measured by applying the current 1993 premium rate

levels to the historical period from 1973 and all subsequent years. The

loss ratios were recalculated by using the revised premium amounts.

This method does not include any change in sales that may occur due

to a higher or lower cost of insurance. It assumes the 20-year base

period is adequate to measure actuarial performance, an assumption that

may not be the most appropriate definition of actuarial soundness.

Events such as a 1993 Midwestern flood may or may not be appropriate to

include in the 20-year base period for a particular area of the

country.

In 1993, seven crops (barley, corn, cotton, grain sorghum, oats,

soybeans, and wheat) constituted 75 percent of total premiums. The loss

ratio for 1980-1992 for these seven crops was 1.45, identical to the

loss ratio for all insured crops for this same period. Thus, changes in

premium rates for these crops should be representative of the changes

that have been made for all crops in recent years. The premium rate

changes for the seven crops through the 1994 crop year are estimated to

have been adequate to reduce the 1980-1992 loss ratio from 1.45 to

1.08. This aggregate result meets the 1.10 standard required by OBRA

93, but only two of the seven crops individually meet this standard.

Within each of these crops, many parts of the country will meet the

standard but others will not. Hence, additional rate changes in 1995

and later years are appropriate.

FCIC recognizes that premium rate increases are an important

component of a viable crop insurance program. It is also recognized

that increasing premium rates to the levels suggested by the most

recent 20 year experience may not be good public policy. Extremely high

premium rates will preclude realization of the social benefits and

public policy goals of the program because participation will be

discouraged. If this happens, experience indicates that ad hoc disaster

assistance will be enacted. Such assistance is less likely to satisfy

social objectives with regard to maintaining rural communities and

adequate supplies of food and fiber because it is uncertain for any

particular year or region of the country. Thus, a catastrophic

adjustment process may be needed to temper the influence of a year such

as 1993. If the weather of 1993 truly is a 1 in 100 year event (or, as

some have suggested, a 1 in 500 year event), its influence should be

tempered in terms of the premium rates charged to insured persons.

In addition to changing premium rates as needed, FCIC proposes to

take a number of additional actions to enhance the accuracy and

adequacy of its actuarial activities. These include:

Develop computer software and other tools to enhance the

quality of the data used to establish premium rates and perform

actuarial analyses (``STATPLAN'' database, due for completion in

October 1994).

Plans to contract with a major actuarial consulting firm

to review all aspects of FCIC's actuarial methods.

Enhance staff skills by additional training in analytical

methods for existing personnel and more emphasis on recruitment of

actuarial trainees (ongoing) for appropriate functional units.

Continue to contract with external specialists such as the

Economic Research Service, land grant universities, the Cooperative

Extension Service, and others (ongoing).

Develop models to measure sources of change in premium

volumes and track the effects of premium rate changes as isolated from

changes induced by factors such as price elections, coverage level

choices, insured crops, and other factors that are not controllable by

the rate-making function (development to begin immediately).

G. Improve Underwriting of Crop Insurance Contracts.

Underwriting begins by establishing the basic terms and conditions

of the coverage. These include defining conditions that result in a

covered loss, measuring the amount of that loss, and defining the

responsibilities of the insured and the insurer. Underwriting continues

with proper classification of an insured risk. For example, planting

crop B the year after crop A was grown on the same acreage may be

riskier that if other crops were grown the previous year. Some land,

such as flood plains, is more prone to losses. Quality of management

also is important. A farmer who is organized, plans, performs

preventive maintenance on equipment, and performs field operations in a

timely manner may minimize losses.

A comprehensive underwriting system requires effective risk

management strategies and goals, standards, and documentation.

Initiatives to improve underwriting that began in the early 1990's will

be continued as part of the strategy detailed in this Blueprint. The

following specific actions will be pursued:

Fully automate the actuarial documents to facilitate more

comprehensive underwriting at the point of sale and to verify the

classification of risk in an automated environment (completed by the

1996 crop year).

Develop standards and classification systems to assess and

classify individual risk, including completion of research intended to

develop a ``scoring model'' for risk that is based on measurable

attributes of a person or situation similar to a credit rating model

(for implementation by crop year 1996 if this model is feasible).

Continue to rewrite crop insurance policies to better

describe the insurance coverage and limitations and to reduce

vulnerabilities to actuarial soundness that exist due to imprecise,

unclear, or omitted terms and conditions (ongoing, with major crops

scheduled for the 1995 crop year).

Encourage development of supplemental or alternative

insurance coverages authorized by section 508(b) of the Act so that

coverage may be improved with most of the risk remaining in the

commercial sector.

Improved underwriting will improve program performance. However,

meaningful measures to quantify possible benefits are not readily

available. For this reason, FCIC cannot attribute a specific dollar

amount to the benefits of improved actuarial systems and crop insurance

policies.

H. Emphasize Program Compliance

The FCIC Compliance function is designed to confirm that the

Federal crop insurance program is operated and delivered as intended.

Through internal reviews based on generally accepted auditing

principles, it assures that program controls are in place against

excess losses due to waste, fraud and abuse. Compliance emphasis will

focus on:

1. Program Delivery

Beginning in 1987, the Compliance staff conducted reviews of

program delivery to assess compliance with regulations, policy, and

procedure. That year, according to GAO and OIG audits, errors in claims

payment represented an estimated 15 percent of all losses paid equaling

$55 million of taxpayer dollars. Since that time, Compliance efforts

have reduced these errors to approximately 5 percent of indemnities but

still need continued improvement. Losses due to claim payment errors

are not included in underwriting calculations of risk, so this

reduction in excess losses has a direct and immediate impact of

lowering the program loss ratio without increasing program cost or

premium rates.

To further reduce claims overpayment the Compliance Staff will

review the entire operations of each delivery company in coordinated

nationwide reviews. The review methodology was recently revised to

reflect generally accepted auditing principles and statistically

projectable sampling techniques.

Beginning with the 1995 crop year, Compliance requirements will be

expanded to define specific quality control and performance measurement

processes for each delivery company. Policy service error rates will be

monitored. The performance of each company will then be compared to an

established national standard.

2. Program Performance

Compliance reviews for several years have shown that a proportion

of the excess losses are attributable to features in program

construction that produce unintended results. The Compliance Staff will

conduct program performance reviews that assess regulations, policies

and procedures designed to prevent waste, fraud, and abuse and that the

program, policies, and procedures perform as intended.

As an example, in 1989 GAO claims that construction of policy

language in the California Safflower program alone resulted in

approximately $20 million in excess losses. It is not possible to

determine how much of FCIC losses may be attributable to unintended

features of program construction. However, recent program performance

pilot reviews of the peanut program and regional irrigated practices

resulted in an estimated 4 to 10 percent reduction in losses for those

areas that may otherwise have gone undetected.

For the past several years Compliance has conducted ad hoc program

reviews on topical issues. These reviews will be expanded to identify

and target reviews for crop insurance programs with the greatest

potential vulnerability.

3. Fraud Prevention

The risk of fraud is particularly acute in the insurance industry.

Estimates for property-casualty insurance indicate insurance fraud may

represent as much as 15 percent of all losses paid. Recent efforts at

crop insurance fraud detection and subsequent prosecution have been

increasingly successful. However, after-the-fact controls on program

abuse are not fully effective. Compliance will work with the delivery

companies to focus on practical, cost efficient fraud prevention.

Compliance operations, program performance, and complaint reviews will

emphasize identifying systemic vulnerabilities and assessing program

safeguards. Discrepancies noted in review findings will be evaluated to

determine the underlying causes.

Emphasis also will be placed on measures to control program abuse

that include strict contract enforcement and pro-active policy analyses

that identifies potential abuse and targets additional claims review.

These measures will be coupled with the aggressive implementation of

civil sanctions, agent/loss adjuster debarment, and designating

producer ineligibility in finding related to program abuse.

I. Assure that Adequate Risk is Borne by the Commercial Insurance

Industry

Amendments to the Act in 1990 directed FCIC to assure that adequate

risk is borne by the commercial insurance companies reinsured by FCIC,

consistent with their ability to bear risk and the availability of

commercial reinsurance. For the 1992 reinsurance year (a 12 month

period that began on July 1, 1991 and ended on June 30, 1992), FCIC

substantially modified its Standard Reinsurance Agreement (SRA) with

the commercial insurers which participate in the program. Both the

amount and the probability of losses on the part of the commercial

insurers were increased in this agreement. Additional incremental

changes in the amount of potential gains and losses were made for both

the 1993 and 1994 SRA's.

The GAO suggests in a report entitled Crop Insurance Program Has

Not Fostered Significant Risk Sharing by Insurance Companies (GAO/RCED

92-25, January 13, 1992) that the changes in the 1992 SRA are not

significant enough in the area of risk bearing by the commercial

insurance companies. Still, the 1992 SRA fundamentally changed the

manner in which gains and losses are calculated, a subtle but effective

measure to increase risk. The amount of potential loss increased, but

the change in the formula increased the chances that the company would

lose in years of poor experience. As a comparison, the commercial

industry lost approximately $8 million in 1988 when the crop insurance

program sustained a loss ratio of 2.45 primarily due to drought in the

Midwest. If that experience is restated to the larger 1993 premium

amounts, the loss still would have amounted to only about $10-$15

million. Results from the 1993 crop year are not yet complete, but

current estimates indicate that commercial insurers will sustain losses

of $80-$85 million although the loss ratio will be less than in 1988.

The difference is caused by the SRA changes.

Some will argue that industry-wide losses of $80-$85 million are

not significant compared to overall program losses that may be near

$900 million in 1993. Two factors bear on this issue:

(1) The ability of the insurance companies to earn reserves under

the SRA, and

(2) The effect of losses upon an insurance company's operations in

future years.

The commercial industry can bear a greater share of the losses only

if there is corresponding opportunity to achieve comparable earnings in

favorable years. Over the long term, the industry must achieve a

satisfactory rate of return on invested capital, or it would make

economic sense for participants to invest in other endeavors. The SRA

must allow adequate opportunity to earn this satisfactory rate of

return. It also must permit accumulation of reserves to pay losses in

years that disasters strike. Under the present SRA and the conditions

of actuarial soundness of the program, there is no opportunity to

accumulate the reserves needed to bear a large portion of a $900

million loss.

Losses directly impact the capital structure of the companies. An

insurance company leverages its capital (the term ``surplus'' is used

by the industry) to support the volume of business that it writes. As a

general rule, an insurance company is permitted by regulators to bear

the risk associated with $2 to $3 of premium per $1 of surplus. The

ratio of premiums to surplus may be lower for risky lines of insurance

such as multiple peril crop insurance. Thus, whenever an insurance

company loses a portion of its capital, its ability to accept premiums

in future years is reduced by a greater amount, which in turn reduces

its ability to earn profits and reserves. These factors must be

considered when the ability of the industry to bear risk is evaluated,

as is mandated by the Act.

As appropriate, given the factors discussed above, FCIC will

evaluate (1) the need to increase risk sharing with the commercial

insurance industry as the program achieves greater actuarial soundness,

(2) reducing cessions to the assigned risk fund by requiring the

industry to share in losses for loss ratios that exceed 5.00, (3)

changing the stop loss provisions of the SRA, and (4) recruiting

additional commercial insurers to participate in the crop insurance

business. These changes will be made incrementally beginning with the

1995 SRA that takes effect on July 1, 1994.

J. Improve Loss Adjustment

Any actuarial and underwriting system can be affected by errors in

adjustment of losses. These errors include both overpayment and

underpayment of claims. Underpayment would not seem to be a factor

influencing actuarial soundness, but failure to pay a loss when due

will cause insured persons to question the value of the insurance and

potentially reduce participation. The insurance experience also will

not accurately depict the nature of the risk insured, leading to

inaccuracies in future premium rates.

Some problems in loss adjustment are directly related to

deficiencies in underwriting. For example, if the crop insurance policy

is not clear on a particular point, the loss adjuster may find it

necessary to make a determination in favor of the insured person.

FCIC will undertake the following initiatives to assure high

quality of loss adjustment determinations so that results are fair to

insured persons and taxpayers:

Develop uniform loss adjustment standards that clearly

specify the requirements for accurate determinations.

Continue research to improve loss adjustment methods, such

as yield appraisal methods and techniques for unharvested crops, and

measurement techniques for stored production.

Strengthen the quality adjustment provisions of crop

insurance contracts and develop standards to prevent abuse of

production determinations when quality losses are claimed.

The contributions of these factors to achieve the 1.10 target loss

ratio will be measured by a reduction in improper amounts paid on

claims and a reduced error rate. The potential impact of these actions

is difficult to quantify since the initiatives to improve underwriting

also affect this area. These actions are ongoing. Loss adjustment

standards for major crops and changes to the quality adjustment

provisions are targeted for the 1995 crop year.

K. Marketing Crop Insurance

FCIC marketing efforts for 1994 will be directed by a strategic

marketing plan based on information and data received from market

research compiled across the country. The plan's main objectives will

be to inform members of the farming community about changes in the

program and to educate farmers about risk management, emphasizing the

value of crop insurance to farming operations.

FCIC will conduct a year-long media campaign targeted at

publications and broadcast markets with an agricultural audience.

Also, emphasis on outreach to minority farmers, traditionally

under-represented in the program, will be coordinated through a

Minority Outreach Marketing Plan that specifically identifies minority

farmers in each of the 10 FCIC Regional Service Offices.

L. Expand Participation by Introducing New Products

Numerous ideas for products that will enhance the quality and

acceptance of the crop insurance program have been suggested. These

include cost of production coverage (several different concepts),

dollar denominated coverage, revenue insurance, replacement cost

insurance, and others. FCIC currently has contracts with the Economic

Research Service to evaluate several alternatives in the context of

public policy contributions, availability of data to support the

concepts, assessments of producer acceptance, and other factors. FCIC

proposes to continue such research and seeks comments about additional

concepts that may be appropriate. Implementation of a pilot test of the

best alternatives will be pursued.

M. Improve Accuracy of Other Program Variables

This section includes items that impact the program but are not

easily categorized under a previous heading. These are:

Unit division. A unit is a tract of land used to establish

the amount of insurance and any indemnity. For example, the crop

insurance policy defines a unit as all land in a county that is owned

by the farmer or rented for cash and planted to the insured crop. This

unit may be subdivided under certain conditions, including payment of

additional premium. Generally, insured persons favor a program that

gives them great flexibility and freedom for establishing a unit. Some

research indicates that size of a unit may affect losses, i.e., a unit

consisting of 10 acres may have a great loss (in relative terms) than a

unit consisting of 100 acres. This research, if verified, suggests that

a surcharge may be needed for small acreage units regardless of how

these are formed (by dividing larger units or because this is all the

land planted to the crop). FCIC will examine the research and determine

if this surcharge is appropriate, both actuarially and as a public

policy initiative. FCIC also will explore the potential to provide

greater flexibility of unit determinations as a tool to enhance program

acceptance by customers. The pricing needed to support greater

flexibility must be determined before it can be implemented.

Implementation of changes will be targeted for the 1996 crop year.

Program dates. Program dates include sales closing,

acreage reporting, cancellation, and others. Several of these dates may

directly affect the actuarial soundness of the program. For example,

neither the farmer nor the insurer should be able to predict the

potential for loss on the sales closing date. However, a study by one

university indicates that farmers may achieve better than a 50-50

probability of predicting a loss with the current sales closing date of

April 15 in the Midwest. Arguments in favor of having a sales closing

date as late as possible generally focus on the need to maximize sales

opportunities; i.e., that interest in purchasing crop insurance is

greatest as planting time approaches. In a draft report, the GAO has

encouraged FCIC to close sales earlier. FCIC proposes to close sales

for the 1995 crop year by 15-30 days earlier than the present dates.

FCIC requests comments regarding other actions with regard to program

dates that will facilitate achievement of the targeted 1.10 loss ratio.

Staged guarantees. Staged guarantees reduce the amount of

insurance when a crop is lost before harvest. For example, a farmer who

abandons a crop within 30 days of planting might be paid only 40

percent of the amount of insurance. The concept underlying staged

guarantees is investment costs; the farmer's investment is less than

the total needed to produce and harvest the crop. Some believe this

approach will reduce outlays for indemnities and help achieve actuarial

soundness. However, in the long run its efforts could be to reduce

premium rates from levels otherwise needed. The impact of staged

guarantees upon customer acceptance of crop insurance may be the valid

measure of this concept. FCIC specifically requests comments on this

feature and assessments of its potential contribution to achieving the

targeted 1.10 loss ratio.

De minimis yields. This term denotes a yield below which

any production is disregarded for the purpose of determining the amount

of indemnity. The concept is advanced by interested parties as an

equity issue--that it costs the farmer more to harvest the crop than it

is worth in the market. If allowed by the program, indemnities will

increase compared to the present provisions of the crop policies,

which, in turn, requires higher premium rates to achieve the goal.

Readers are encouraged to comment on the desirability of increasing

premium rates by an amount needed to permit this feature to be included

in crop insurance policies.

Suspension and debarment. Inappropriate determinations and

poor administration of the crop insurance program is alleged about

agents, loss adjusters, and others who are involved with delivery of

crop insurance. The SSN/EIN database is intended to help FCIC monitor

the conduct of these persons. However, monitoring in and of itself is

insufficient if there are no penalties for violations of program rules.

FCIC proposes to develop clear and concise suspension and debarment

procedures for agents, loss adjusters, reinsured companies and others

who fail to observe the highest standards of performance in program

delivery and administration.

Price Elections. The GAO recommended in a 1991 report that

for the major crops, FCIC set its price elections equal to the

forecasts issued by the World Agricultural Outlook Board in its semi-

annual estimates. These estimates correspond to the cycle used to

prepare the annual budget of the United States Government. These

estimates are available only twice each year. Based on a sampling of a

few years, GAO stated that overall losses would be reduced if this

recommendation were adopted. FCIC is committed to offering a price

election that complies fully with the requirements of the law. In

addition, the offer must be meaningful to farmers. FCIC requests

comments regarding this recommendation and assessments by readers of

its likelihood of contributing to reduced loss ratios and improved

participation.

Readers are requested to identify additional issues that they

believe are relevant and important to assist FCIC in its actions to

manage the program to achieve the target loss ratio while maintaining

or increasing participation levels.

III. Management Actions If Section II Are Not Successful

The actions identified in Section II of this document represent a

continuation of current management initiatives that have been and

continue to be important for the effective administration of a public

program. FCIC believes that successful completion of these actions will

meet the objective of achieving actuarial soundness as required by OBRA

93. Several years must elapse before it will be possible to observe

FCIC's achievement of the objective. In the interim, attainment must be

measured by realistic models of risk that adequately represent the crop

insurance program. Flexibility in managing the program to attain the

objective while simultaneously achieving other important policy

objectives must be stressed.

Few options that do not adversely affect participation in a

material manner are available in the event the actions described in

this blueprint are determined to be inadequate. One option is to focus

better on defining the risk that is included in the premium rates

charged to current insureds. Extreme crop disasters (such as the 1993

flooding and cold, wet growing season) tend to be widespread and occur

infrequently. Crop insurance is not actuarially sound in a commercial

sense because the private sector cannot manage the magnitude of these

risks or arrange the financing over the long periods of time needed to

accumulate reserves for a major disaster. This characteristic of crop

disasters argues that actuarial soundness perhaps should be measured on

a basis that separates normally expected conditions from the extreme

disasters. This would serve to more precisely define the risk included

in the premium rates for current insureds, and the risk that should be

amortized over longer time periods.

If the above is not acceptable, another action would be to limit

the liability of crop insurance to specific areas and crops. This

limitation could take the form of complete withdrawal of insurance in

some cases, or limitations on the volume of business that would be

accepted in a year for a crop or area. Commercial insurers use this

process to manage their exposure to avoid concentrations geographically

or by product line. Crop insurance may need the same management of its

exposures rather than accepting any and all risk whenever farmers

decide to enter and exit the program. This extreme action would

indicate that the program was unable to completely fulfill its social

and public policy responsibilities, and must be regarded as an

initiative of last resort.

IV. Management Actions If Actions in Section II Are More Successful

Than Needed

The greatest impediment to increased program participation will be

high premium rates that might result from the actions defined in this

plan. Moderation of premium rate increases will be a priority if more

stringent program administration reduces the loss ratio below the

target. If this occurs, experience should be examined to identify

losses paid that no longer should be expected. Once the impact of those

losses is eliminated from the experience, some improvement in premium

rates would be anticipated. FCIC believes that the remaining management

actions that have improved administration of the program or that have

better defined the coverage provided to U.S. agriculture should not be

relaxed because these generally represent good administration of public

policy.

Done in Washington, DC on April 1, 1994.

Kenneth D. Ackerman,

Manager, Federal Crop Insurance Corporation.

[FR Doc. 94-8244 Filed 4-5-94; 8:45 am]

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