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One Last Chance for Congress to Fix the Absurd Economics of Crop Insurance

After passage of separate House and Senate versions of the 2018 farm bill earlier this year, negotiators will meet this week to hash out their differences in a conference committee. One of the thorniest issues the conferees will face is what to do about crop insurance.

Insurance plays an essential role in any market economy. By spreading losses among members of a group with similar exposure, insurance encourages people to take prudent risks while protecting them from financial ruin in case they are the unlucky ones. But not all insurance is equal. Crop insurance, a multi-billion-dollar government subsidy that lies at the heart of federal farm policy, is nothing like the kind of insurance we buy for our cars and homes.

Let’s take a look at the absurd economics of crop insurance, and at what could be done to fix this program.

Crop losses are not an insurable risk

The problems of crop “insurance” begin with the fact that crop losses are not really an insurable risk. Over time, insurers have developed rules that identify which risks are insurable and which are not. Crop insurance violates three of the most important.

First, to be insurable, losses should be fortuitous — the result of events that are outside the control of insured party. Some crop losses, for example, damage from hail or tornados, fit this definition. They strike randomly, no one knows where. However, many other risks depend on the choice of farming practices, which, in turn, are influenced by the presence of insurance.

The tendency for people who are protected from loss by insurance to take greater risks is known as moral hazard. Commercial insurers guard against moral hazard as best they can by encouraging practices that reduce losses. For example, you can get a discount on your home insurance if you have a smoke alarm and burglar alarm. However, as the National Resources Defense Council explains in a recent report, rules of the federal crop insurance program encourage risky practices, such as planting crops on land that is marginally suited for them. At the same time, rather than encouraging loss mitigation practices such as diversification and planting cover crops, crop insurance discourages them. When crops are planted that are likely to fail, resources are wasted and program costs soar.

Second, insurance is normally limited to situations in which people face a pure risk, that is, a risk of loss that is not offset by a hope of gain. For example, if I insure my house against fire, I either experience a fire, in which case I suffer a loss, or I do not, in which case I have neither a loss nor a gain. In contrast, speculative risks carry a chance of gain as well as loss. If I plant a field of corn, I may suffer a loss if the weather is bad or prices are low, but if the harvest and market conditions are good, I expect to make a profit. Insurers have traditionally been unwilling to cover speculative risks. Other financial mechanisms, such as futures and options markets, are more suited to that job.

Third, in order for a risk to be insurable, it must be possible to establish a premium that is affordable to the party seeking coverage, yet high enough to cover claims and the administrative expenses of the insurer. That is not possible for crop insurance. Due to the prevalence of moral hazard and the speculative nature of the risks, an actuarially fair premium for crop insurance would be unaffordable.

Together, moral hazard, speculative risks, and lack of affordability make crop “insurance” a sham. It is able to exist only because the government subsidizes more than 60 percent of the cost of the program. It is the subsidy, not the insurance, that makes the program so popular with farmers.

Benefits are skewed toward the largest farms

It is no wonder that farmers like crop insurance, but why do the vast majority of the non-farm population tolerate such generosity toward a small group of their fellow citizens? One reason appears to be a widespread perception that the principal beneficiaries of these programs are small family farms that would face a high risk of failure without government protection. However, the numbers, as reported for 2016 by the USDA, do not support that view.

Some of the confusion arises from the notion that “family farms,” which account for 99 percent of all farms, are the same as “small farms.” However, the USDA applies that term broadly to “any farm where the majority of the business is owned by the principal operator — the person most responsible for running the farm — and individuals related to the principal operator.” In practice, most of the big “family farms,” that produce the lion’s share of output are really limited liability corporations or partnerships.

The smallest family farms, those that produce less than $50,000 of income, are the ones that the highest financial risks, yet they receive very little of the benefit of crop losses — just 17 percent of all insurance payouts. Midsize farms, with an average income of $120,000 and more moderate financial risks, receive another 32 percent of crop insurance payouts.

The 2.9 percent of family farms that are classified as large or very large exist in a different world. Large farms have more than a million dollars per farm in sales and average $357,000 in annual household income. Those that are very large have more than $5 million in sales and average $1,675,000 in household income. The USDA classifies more than half of large farms and more than 40 percent of very large farms fall in are classified as facing low financial risks. Yet together, these high-income, low-risk “family” farms received 46 percent of all crop insurance payouts. If we add in non-family corporate farms, which are also very large, on average, we find that just 4.3 percent of all farms receive more than half of all crop insurance payouts.

Finally, it is worth noting that crop insurance benefits are not only skewed toward the largest farms, but are also skewed toward just a few crops. In principle, insurance is available for over 100 different crops, but according to data from the Congressional Research Service, as of 2014, corn, wheat, and soybeans accounted for 77 percent of actual benefits. Adding cotton, rice, and peanuts brought the total to 94 percent. Yet these six crops accounted for just 28 percent of total farm output in that year. The millions of farmers, large and small, who produce the milk, beef, eggs, tomatoes, lettuce, and other things you eat receive little or no support from crop insurance.

In short, the great majority of American farm output is produced by farmers who are, or should be, willing accept the responsibility of any business to protect against financial risk without special subsidies from the federal government.

What can be done?

The obvious thing would be to phase out the federal crop insurance program altogether, giving farmers reasonable time to adjust their mix of crops, farming practices, and financial arrangements. Short of that, critics of crop insurance offer a number of reforms that would make the program less costly to taxpayers and less disruptive to markets.

Strict caps that limit subsidies paid to the wealthiest farms would be a good place to start. The old farm bill made an effort to impose caps, but left many loopholes. One of the largest loopholes was the ability of large farms to form “pass through entities” that allowed them to split total farm income among family members. Far from fixing this, the House version of the 2018 bill would widen the loophole by adding nephews, nieces, and cousins to the siblings and adult children who can already share farm income. Tightening the caps, instead of relaxing them, would be a big step forward.

Furthermore, if the government is to offer any protection against farming risk, it should focus on risks to crop yields from droughts, tornadoes, pests, and other natural hazards. That would mean eliminating programs like Agricultural Risk Coverage, which protects farms not just from natural disasters, but also from low prices. When crop insurance offers protection against normal price fluctuations it stops being a safety net and becomes a simple income guarantee of a type Congress would not dream of granting to any other business.

The bottom line: Crop “insurance” is not true insurance. It is sham insurance that could not exist without government subsidies. Although the iconic small family farm is often invoked in its defense, the primary beneficiaries of the program are, in practice, the largest and wealthiest farms — huge limited liability corporations and other tax-advantaged pass-through entities that are “family farms” only in name.

Outside the favored sectors of corn, wheat, and soybeans, the vast majority of American farmers and ranchers manage deal with the risks of farming without subsidized insurance. Neither the House nor the Senate versions of the 2018 farm bill are much better than the old one, but there is one last chance to fix things in the conference committee. Congress should seize that chance!

For additional data and sources, see a longer version of this post at Niskanen.com

Written by

Economist, Senior Fellow at Niskanen Center, Yale Ph.D. Interests include environment, health care policy, social safety net, economic freedom.

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