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Crop Insurance

A Lottery That’s a Sure Bet

Moving From Lottery To Risk Management

February 10, 2016

Crop Insurance: Moving From Lottery To Risk Management

Designing crop insurance to produce high rates of return to farmers based on the premiums they pay dramatically increases the cost of the program and encourages farmers to choose policies as if they’re playing a lottery rather than actually managing risk. Many studies have shown that farmers buy crop insurance only because it is heavily subsidized. If the subsidies were reduced, many farmers would find more cost effective ways of managing risk. They would purchase far lower amounts of insurance, which would transfer much less risk to the government. The unintended but serious problems caused by excessive risk transfers to the taxpayers would be avoided.

The excessive risk transfer creates incentives to plant on marginal and environmentally sensitive lands that would otherwise be too risky to farm. It also puts upward pressure on land rents, because the claims payouts make it easier for growers to afford higher rents.

Supporters of the status quo argue that the high rates of return are needed to bring a large proportion of farmers into the program and avoid the problem of adverse selection – when only farmers with a high likelihood of making a claim would buy insurance. It also makes it easier for Congress to avoid the trouble and uncertainty of funding ad hoc disaster aid for agriculture.

However, an alternative policy design that decouples premium subsidies from coverage decisions would avoid both adverse selection and ad hoc disaster payments while encouraging farmers to buy only the levels of insurance that meet their risk management needs. A decoupled subsidy would mean that farmers could not alter the size of the subsidy by strategically choosing policies with different coverage levels and different subsidy rates.

Decoupling farm program payments from production decisions in the 1996 farm bill dramatically reduced the incentive for farmers to plant for the program rather than the market. The result was an expansion in soybean acreage and drops in cotton, wheat and rice acreage. Farmers received fixed subsidies but planted for the market.

Decoupled premium subsidies would work much the same way. Farmers would stay in the crop insurance program in order to receive a subsidy, but they would make their insurance decisions based on risk management needs rather than on a subsidized lottery. Just as farmers try to apply fertilizer just to the point where the cost of applying another pound equals the return they get from that extra pound, farmers would buy insurance until the last dollar they spend on it just equaled the risk management benefit they receive. Most farmers would respond by lowering their coverage levels and buying more whole-farm insurance that would only pay off if the revenue from all their crops fell below a critical level.

Decoupling premium subsidies could be accomplished in several ways. For example, a fixed per-acre premium subsidy could be made available to all farmers for all their crop acres. They would receive the subsidies as a fixed amount of credit that would be applied toward their crop insurance premium. Or subsidies could be set at the value, in dollars per acre, equivalent to the subsidy a farmer receives when he or she buys a policy at a 65 percent coverage.

A fixed per-acre premium subsidy would be equitable across crops and regions. Setting the premium subsidy at the rate that a 65 percent policy is subsidized would provide more per-acre support to crops with high prices and regions with high risk. Either option would move farmers toward using crop insurance as a risk management tool, rather than as a subsidized lottery ticket. The critical feature is that no farmer could influence the size of the subsidy by changing how much insurance to buy.

Decoupling premium subsidies would also save taxpayers billions of dollars a year. The subsidies averaged about $26 per crop acre in 2014. Fixing the premium subsidy at $13 per acre – half that amount – would save almost $3 billion a year. Because subsidies paid to crop insurance companies and agents increase with the level of insurance farmers buy, shifting to lower coverage levels would also reduce the cost of running the program. The subsidies paid to crop insurance companies and agents have averaged about $2 billion a year over the last 10 years. If farmers reduced their premium costs by 50 percent, decoupling premium subsidies would save another $1 billion a year.