New data by agricultural economist Art Barnaby indicates that the Congressional Budget Office may have overstated the cost of federal crop insurance.
Barnaby concludes that price volatility, the amount of uncertainty or risk in the size of the changes of a security’s value, drives premium cost more than market price. If implied volatility (estimated volatility) decreases then the resulting decrease in premiums will create lower premium support costs equaling lower taxpayer costs.
The Risk Management Agency’s rating system uses the market implied volatility for estimating the price risk of insuring the crop. However, higher volatility does not always correspond with higher loss years. In 2012, corn had an implied volatility of 22 percent for the crop that had the largest historical underwriting loss and largest loss ratio since 1993.
In the last four years of winter wheat production the implied volatility has decreased from 33 percent volatility in 2011 to 19 percent volatility for the 2014 crop. If the volatility for both corn and wheat remains about 20 percent, this will keep the premium prices lower indicating a lower federal cost for crop insurance.
If CBO estimated crop insurance for an average 30 percent volatility rate then the budget could be vastly overstated. Barnaby’s numbers are dependent on a reduction of implied volatility, and if true then the CBO estimated crop insurance costs will likely exceed the actual cost.
“My estimates are based on an assumption that we are going to 20 percent volatility if that assumption is wrong than the CBO is probably right,” said Barnaby.
This numerical error could cause major issues in the Farm Bill debate. The conference committee works within a budget cap and if one of the programs costs less than budgeted, the money could be used for other programs.
“The committee has to fit the farm bill under that magic budget number. If the CBO over estimates the cost and the committee doesn’t spend that full amount then what they spent becomes the new baseline. It only impacts the current farm bill debate whether you can make current improvements through the commodity or crop insurance,” Barnaby said.
Ken Wood, a wheat farmer from Chapman, Kan. said he believes his premium will decrease this year but is unsure if the data will impact the farm bill debate.
Crop insurance is an important risk management tool for farmers. As the cost and risk of production agriculture is increasing, many farmers use crop insurance to protect their assets.
“I hope that the public understands that crop insurance is used in a risk management program. Rarely does anyone get enough from a crop insurance claim to equal what they would get from the crop. It’s not a get rich quick thing but it will keep you in business,” said Wood.
Implied volatility is just one of the factors that affect premium costs for farmers. While it is the most influential factor, premium cost is also based on market price, the rate set by the RMA and the individual farmer’s actual production history.
“It comes down to what you assume for implied volatility. The last two years we’ve been in the 20 percent range, and in the estimations that I did, we are going to return to the 20 percent volatility,” said Barnaby.
Does the CBO have a history of overstating farm programs costs? Barnaby said he believes so but has not done the research to back it up. As for crop insurance costing a significant amount for taxpayers, the current loss ratio is under one dollar, meaning that the government has paid out less than it has taken in from premium payments. However, this does not account for the premium support that the government provides to assist the farmer.
Time will only tell if Barnaby’s predictions prove to be true. The next announcement about crop insurance prices and premium costs for Kansas farmers will come with the corn and soybean price discovery periods in Feb. 2014.