Revisiting the Drought of 2012

The 2011/2012 winter and spring weather set the stage for U.S. agriculture’s destructive summer of 2012. The winter featured above-average temperatures for much of the nation and was the fourth warmest winter on record. The spring was the warmest on record, with 34 states having record-high temperatures. Along with the warmth, spring precipitation was slightly below average for the nation, which eroded soil moisture reserves. Ironically, the warm and dry winter and spring conditions were highly favorable for spring planting. The weather enabled farmers to plant their crops ahead of schedule and encouraged rapid plant development. At the time, the United States Department of Agriculture was calling for above-average production per acre for the 2012 harvest.

The optimism soon turned sour, however, as the summer of 2012 brought continued warmer-than-average and dry weather for much of the country. The U.S. average temperature for June-August made for the second-warmest summer on record. The warm temperatures and lack of precipitation resulted in a drought that NOAA described as similar to those in the 1950s. The pace of the drought’s progress was so rapid that it was termed a “flash drought.” In mid-May, the U.S. drought monitor indicated that only a small part of the Midwest was abnormally dry. At its July peak, however, 62 percent of the continental U.S. was in at least moderate drought.

The Damage

The drought covered from the Rocky Mountains through the Great Plains and into the Midwest. The toll was heaviest on corn, but pastures and other crops suffered as well. Corn, the leading crop in value of U.S. production and insured liability, accounts for nearly one-third of U.S. acreage planted to crops. The U.S. corn yield turned out to be 123.4 bushels per harvested acre, 26 percent below USDA’s initial forecast and on par with the declines suffered in 1983 and 1988, making the drought the worst in 25 years for corn. Corn production totaled 10.8 billion bushels, down 13 percent from 2011, as a large increase in planted acres helped cushion the drop in yield per acre. Corn prices reached record highs. Soybeans fared better, with production down three percent, as August rains and record-high yields in the South and Southeast helped offset the Midwest’s losses.

Hay production was down nine percent from 2011, a drought-affected year, and off by 18 percent from 2010, resulting in the lowest level since 1964. The combination of sharply reduced feed and forage supplies created soaring costs for livestock producers and forced a sharp cutback in ethanol production.

Scope of Insurance Losses

Fortunately for the nation’s farmers, crop insurance is widely available and purchased. Nearly 1.2 million policies were sold for 2012 with a record-high insured liability of $117 billion. Over 282 million acres were insured, also a record, accounting for a high proportion of the 326 million total acres planted to crops. Total premiums, at $11.1 billion, were the second-highest ever. Indemnities and units indemnified also set record highs.

With most claims settled, the crop insurance program loss ratio as of May 1 (gross indemnities divided by gross premium) for the 2012 crop year was 1.55. This loss ratio is far above those observed in the past nine years and is the highest since the devastating flood year of 1993. Illinois had the highest loss ratio at 4.45, followed by Kentucky at 3.32.

Total indemnities are estimated at $17.2 billion, providing essential relief to producers in the hardest-hit areas, enabling them to pay creditors, remain in business, and rebound with what is expected to be very high acreage planted to principal crops in 2013. Illinois producers received $3.4 billion in indemnities, followed by producers in Iowa at $2 billion, Nebraska at $1.5 billion, and Texas and Kansas each with about $1.4 billion. The crop hail business had its largest premium in program history in 2012, $957 million, and paid out $701 million in losses, the second-highest in the last nine years, after 2011.

Reflecting the drought’s intensity in the Midwest, corn ranked first among crops in indemnities paid at $11.7 billion, accounting for 68 percent of total claims paid. Soybeans ranked second with $2.1 billion, followed by cotton with $1.1 billion and wheat with $750 million. These four crops accounted for 91 percent of indemnities and 84 percent of total premium.

Impacts on Crop Insurance

A little background helps in understanding the consequences for the crop insurance industry of the enormous indemnities paid in 2012.

The Federal Crop Insurance Program is considered a public-private partnership where some 18,000 licensed private agents and certified crop loss adjusters sell and adjust policies purchased by farmers. In 2012, 16 private companies were approved to sell crop insurance. They employ the agents and adjusters; collect premiums and remit them to the federal government; provide IT and other services to deliver the program to producers; and share in underwriting gains and losses with the federal government.

The federal government, operating through the Federal Crop Insurance Corporation (FCIC) and USDA’s Risk Management Agency, makes an administration and operating expense payment to the companies to deliver the program; sets premium rates and underwriting standards; shares in the premium cost with the producers; and shares in underwriting gains and losses with the companies. A company must sell a policy to any producer who wants one in any state in which the company operates.

Underwriting gains and losses are divided between the companies and FCIC using the following approach. First, a company may place policies sold into one of two reinsurance funds: the Assigned Risk Fund or the Commercial Fund. Second, under a proportional risk-sharing arrangement for each fund, a company is permitted to cede a portion of premiums, and their associated gains or losses, to FCIC. Third, under a non-proportional arrangement, gains and losses on a company’s retained premium are shared with FCIC as determined by formulas based on the loss ratio by fund and by state.

For residual risk exposure after FCIC reinsurance, the companies generally purchase additional coverage in the private reinsurance market. In 2012, gross underwriting losses—total indemnities less total premiums—were $6.1 billion. As of mid-April, the companies’ share of the underwriting losses stood at $1.2 billion but is expected to finish in a range of $1.2 billion to 1.4 billion, which goes toward paying claims. This loss amounts to a pre-tax rate of return on retained premium of about minus 14 percent.

The underwriting loss in 2012 was the first for the industry since 2002 and the sixth since the modern program began in 1981. While the record-high indemnities have been widely trumpeted in the press, it is important to understand that indemnities are not the taxpayer cost of the program. The underwriting losses of the companies and $4.1 billion paid by producers as their share of the government-set premiums will offset a substantial part of the indemnity costs. The negative double-digit rate of return the companies will experience in 2012, as well as the underwriting losses incurred by the FCIC on its reinsurance operations, will offset a considerable portion of the underwriting gains earned by the companies and the government in recent years that had better weather.

Fortunately, underwriting gains in recent years have provided financial strength to the crop insurance industry and its reinsurers. The industry was on sound financial footing prior to the drought and remains so today. Similarly, U.S. farmers and ranchers have had high farm income in recent years and, with the help of crop insurance, have avoided financial disruption, despite the worst Midwest drought in 25 years. Total planted acreage and crop insurance business in 2013 is expected to be similar to 2012, and, barring another unusual weather disaster, U.S. farmers will produce ample crops for U.S. and foreign energy, feed, fiber, and food consumers.