Estimation and attenuation of reinsurance risk in the crop insurance market

Abstract

Because of the high level of systemic risk in farming, crop insurance has failed to be provided by the market without government involvement. Currently, in addition to subsidy support the Federal government aids the crop insurance industry by providing reinsurance services to crop insurance companies. This means that the government will reimburse insurers for a large portion of their losses in years when indemnities to farmers are high. In exchange, portions of firms' profits are paid to the government when indemnities are below premiums;This study measures the level of risk accepted by the government in its role as reinsurer for the crop insurance market. This is accomplished by means of a Monte Carlo simulation in which random correlated draws are made for county and farm yields. These are then used to calculate indemnity levels for the crop year. Government share of the industry profit or loss can then be calculated based on the government's contract with the industry, the Standard Reinsurance Agreement. The simulation also permits the estimation of the expected net cost for the government. This value is the average net transfer from the government to the insurers and represents the fair market value of the Standard Reinsurance Agreement;In addition to this, the risk reducing potential for the reinsurer of commodity yield and price contracts is investigated. Offsetting positions are determined by linear regression of government net cost on yields and prices. It is shown that use of market contracts reduces measures of risk by more than fifty percent.