Cutting the Fat

It Won’t Kill Crop Insurance

December 3, 2015

Cutting the Fat: Rate of Return with Lower Cost Inflation

It is instructive to calculate what the costs of delivering crop insurance would have been in 2013 had they increased only as fast as total civilian compensation, and what impact this lower rate would have had on the rate of return in the industry from 2001 to 2013.

Suppose that work-adjusted costs in each of the three cost categories for crop insurance had increased by 3.7 percent per year from 2001 to 2013, which is how fast total civilian compensation rose. The 3.7 percent rate of increase is higher than the rate at which wages and salaries actually increased in the rest of the insurance industry.

Table 3 shows what work-adjusted costs for each category would have been at a 3.7 percent rate of increase, what total costs would have been, and what costs actually were. Total crop insurance delivery costs at this inflation rate would have been $1.32 billion in 2013 rather than $2.09 billion, a difference of $767 million. Costs would have been 37 percent lower in 2013 than they actually were if they had increased similarly to the rest of the economy.

Table 3. Crop Insurance Costs Assuming Lower Inflation

Year Agent Commission Loss Adjustment Other Total Difference from Actual
 
$ million
2001 465 110 240 815 0
2002 468 162 241 871 42
2003 478 136 247 861 -35
2004 491 120 253 865 -157
2005 493 98 255 846 -145
2006 493 130 254 878 -253
2007 507 115 262 883 -685
2008 531 220 274 1,024 -1,104
2009 562 129 290 980 -1,114
2010 566 104 292 963 -912
2011 585 223 302 1,110 -841
2012 627 291 324 1,242 -570
2013 678 293 350 1,321 -767

Table 4 shows what pre-tax profits and the rate of return to the crop insurance industry would have been over the same period had cost inflation been held to 3.7 percent per year. The average rate of return from 2001 to 2013 calculated by the accounting firm Grant Thornton LLP was 11.3 percent. If costs had risen at 3.7 percent per year the average rate of return would have been 19.0 percent.

The results in Tables 3 and 4 present an economic puzzle. It seems odd that crop insurance costs could increase so rapidly compared to the rest of the economy and the rest of the insurance industry. One would expect that new companies with lower cost structures would enter the market and out-compete the high-cost companies.

Table 4 shows that a low-cost competitor would have been able to earn a much higher rate of return than the industry average. Once more efficient companies enter a business, competition should lower the rates of return to competitive levels. Existing high-cost companies have to cut costs or they go out of business. The fact that costs rose much faster in crop insurance than the industry average is evidence that normal competitive forces are not at work. Understanding why competition has not led to cost control explains why the budget agreement’s reduction in subsidies to crop insurance companies will not affect either their ability or willingness to deliver crop insurance to farmers.

Table 4. Impact on Rate of Return of Lower Cost Inflation

Year Net Incomea Alternative Net Incomeb Retained Premiuma Actual Rate of Returna Alternative Rate of Returnc
 
$ million
   
2001 166 166 2,372 7% 7%
2002 -248 -290 2,295 -11% -13%
2003 214 248 2,607 8% 10%
2004 558 715 3,145 18% 23%
2005 756 900 2,893 26% 31%
2006 641 894 3,502 18% 26%
2007 1,364 2,049 4,899 28% 42%
2008 944 2,048 7,744 12% 26%
2009 1,750 2,864 6,627 26% 43%
2010 1,389 2,301 6,053 23% 38%
2011 1,131 1,972 9,531 12% 21%
2012 -1,747 -1,177 8,640 -20% -14%
2013 -62 705 9,230 -1% 8%

a From Exhibit 1, Grant Thornton LLP.
b Net Income minus last column from Table 3.
c Alternative Net Income divided by Retained Premium