It Won’t Kill Crop Insurance
Cutting the Fat: Competition in the Crop Insurance Industry
In most of the insurance industry, companies compete on the prices they charge for their products, on their product offerings and on their quality of service. Competition prevents profits from getting too high or too low. If profits are too low, premiums tend to rise. If they didn’t, companies would either go out of business or fail to meet the financial reserve requirements set by regulators. If profits are high, premiums tend to fall as companies compete to expand their customer base and new competitors enter the industry.
However, crop insurance companies are not like other insurance companies, because they do not compete on price or on the products they offer, and they have limited ability to compete on quality of service. The large subsidies that the federal crop insurance program provides make it impossible for purely private insurance products to compete. Farmers would have to pay more than double what they currently pay for similar insurance offered by the private sector. Instead, all crop insurance companies sell the same products at the same government-regulated price. 10 Most policies are sold through independent agents, who are by far the most important point of contact farmers have with the crop insurance program. Because the companies are a step removed from their customers, the opportunities to offer improved service are quite limited. In fact, many farmers do not even know which company insures their crop.
But competition does exist in crop insurance. Companies compete for the agents’ business and for specialists such as claims adjusters, insurance underwriters and knowledgeable executives. Agents can deliver their customers to any crop insurance company that does business in the state. And being rational, agents tend to deliver their business to the company that offers them the highest commissions.11
To see how this competition worked before a cap on agent commissions was imposed on July 2010, suppose that an agent in Iowa books of business with $1 million in premiums. The crop insurance companies know how much net revenue to expect from this amount of business. The revenue is generated from the government’s Administrative and Operating (A&O) reimbursements and by the net underwriting gain. The net underwriting gain is the amount by which the $1 million in premium is expected to exceed the claims paid out after accounting for all government-provided reinsurance program details.
Comparing underwriting gains in Iowa with Texas explains why agent commissions in Iowa are higher. Traditionally, Iowa business has generated large net underwriting gains. With an A&O reimbursement rate of 20 percent and net underwriting gains of 15 percent, the $1 million in premiums will generate $300,000 in expected revenue for a crop insurance company. How much will a crop insurance company be willing to pay the agent for this business? The maximum amount that a company will pay will be less than $300,000 because there are extra costs associated with servicing the extra business, the most prominent being loss adjustment costs. All other costs are largely fixed. If expected loss adjustment costs are $30,000, then a company will be willing to pay the agent up to $270,000 for this business. That means the agent’s commission would be 27 percent of premium.
Since the commissions paid to agents represents a real cost to the crop insurance companies, they will try to pay less than $270,000. But, if there is sufficient competition between companies and the agent is a skillful negotiator, the commission in this example should be close to 27 percent.
Now suppose that an agent in Texas also has a $1 million book of business. The expected underwriting gain in Texas is much lower than in Iowa because growing conditions are much more variable in Texas and insurance premiums have not increased enough to reflect this higher variability. To keep it simple, suppose that the expected underwriting gains in Texas are zero and that loss adjustment costs are $60,000, because losses are much more frequent in Texas. Simple arithmetic shows that the maximum amount a company will be willing to pay for the Texas business is $140,000, which represents a commission rate of 14 percent. Because crop insurance in Texas is less profitable than in Iowa, fewer crop insurance companies operate in Texas and there is less competition for an agent’s business. As a result, the Texas agent’s actual commission rate may not approach the theoretical maximum of 14 percent.
Smith, Glauber, and Dismukes12 provide empirical support for a positive relationship between agent commissions and the amount of revenue generated from A&O and underwriting gains. An important implication of this relationship is that when expected revenue from a book of business changes, then so too will agent commissions. What this means is that competition between crop insurance companies will reveal itself on the cost side of the profit equation, rather than on the revenue side, which is fixed by government regulation. That is, if the rate of return by crop insurance companies is too high, competition will raise costs, thereby driving down rates of return to competitive levels. If rates of return are too low, competition will lower costs until rates of return are high enough to keep companies in the business.
This competition for agent business drove commissions so high that USDA’s Risk Management Agency capped commission rates beginning with the 2011 crop year. Agents who had been receiving commission rates above the newly capped levels saw their commissions drop. The new limit on the amount of money that could go to agents meant increased opportunities for excess revenue to flow to other cost categories, which explains why other costs in Table 1 increased by $124 million (31 percent) after commissions were capped. Although commission rates are capped, they are still much higher than they would be if the crop insurance industry faced normal economic competition.
10 USDA’s Risk Management Agency attempted to allow crop insurance companies to compete on price in the mid-2000s by allowing companies to discount premiums to farmers if companies could show that they could deliver crop insurance at a reduced cost. The so-called Premium Reduction Plans gave companies an incentive to cut agent commissions and pass the savings onto farmers. After an intense lobbying effort led by Independent Insurance Agents and Brokers of America, Congress banned these plans beginning in 2007.
11 For a more detailed discussion of competition in the crop insurance industry see Babcock, B.A. 2012. “The Politics and Economics of the U.S. Crop Insurance Program,” pp. 83-112 in Zivin, J.S.G., and J. Perloff, eds. The Intended and Unintended Effects of U.S. Agricultural and Biotechnology Policies, National Bureau of Economic Research, University of Chicago Press.
12 Smith, V.H, J.W. Glauber, and R. Dismukes. “Rent Dispersion in the U.S. Agricultural Insurance Industry.” Montana State University Working Paper. September, 2015.