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Mike's Blog

Insights from the President of ProAg

How It All Flows Through the SRA

by Mike Connealy on 07.27.2012

We have seen many media articles questioning whether the Approved Insurance Providers (AIP) have the financial resources to manage the drought losses that are certain to be realized in the 2012 crop year. Let’s do a bit of simple research on the public documents which outline how all the cash flows on claims and how it affects the stakeholders.

The United States Department of Agriculture (USDA) through the Risk Management Agency (RMA) handles the reinsurance agreement with the AIP crowd. RMA actually uses the Federal Crop Insurance Corporation (FCIC) as their corporate vehicle to accomplish the contract with the AIP. This contract is called the Standard Reinsurance Agreement (SRA) because it is standard – all AIP’s have identical terms with the RMA. Simply said, we all get the same deal with the USDA.

The SRA plus appendices include hundreds of pages of materials that have been developed through the years with the intent of program improvement. You may go to the RMA website and, under reinsurance agreements, download the entire SRA and appendices. For the purposes of this blog, we are going to limit the discussion to two topics:

  1. Escrow
  2. Underwriting loss – commercial fund

There are two tabs on the RMA website that deal with escrow agreements. One is an escrow agreement with an AIP and the other is an escrow agreement with a bank. The AIP and the bank sign fairly simple documents that detail how money will flow for “payment of loss indemnities to insureds” for “crop insurance policies issued by the AIP and reinsured by FCIC” under the terms of the SRA. Back in the 1980’s, the industry worked with FCIC to facilitate timely payments to the insureds without the AIP having to line up $100’s of millions in credit with banks to pay for claims that might be reinsured in whole or in part with FCIC. So, the fact is that the US government fronts nearly all of the indemnity payments and then settles up with each individual AIP on a monthly basis for each crop year using a detailed accounting document called the RO (reporting organization) recap. This document eventually includes A&O, premium collected, CAT fees, loss credits, interest, penalties, UW gain or loss, etc. Indemnity payments to insureds are just one of many items that we account for each month with FCIC, it is after all these years a bit of a complicated process.

So, unless, for some reason, the RMA decides to shut down an AIP, the 2012 claims will be paid on a timely basis after the I’s have been dotted and T’s have been crossed on claims and compliance paperwork. In 2011, ProAg paid $972 million of indemnities on $765 million of base premium. FCIC funded our escrow requests and we did monthly accounting reports and other than occasional questions or coverage disputes, all the stakeholders were satisfied with the process.

The second item of concern is the underwriting losses in the commercial fund resulting from the 2012 drought. The SRA includes provisions which allow for an AIP to earn an underwriting gain or pay an underwriting loss by state depending on the ultimate loss ratio in that state. This blog will not deal with the assigned risk (AR) fund due to space limitations and we don’t wish for excessive boredom to set in for our loyal readers. The RMA website includes a link for the SRA and pages 15-20 or so deal with how the underwriting gains and losses are calculated.

The heart of the 2012 drought includes Illinois (State Group 1) and we will use some simple math to illustrate how the 2012 results will impact an AIP. Let’s start out with the assumption that an AIP has $10 million of commercial fund (retained at 100 after 6.5% FCIC quota share holdback) base premium in Illinois. This figure would include all of that AIP commercial fund business for all crops, plans, CAT revenue, etc. Let’s then assume that drought losses are severe and the AIP ends up with $55 million of losses on this $10 million of premium for a robust 550% loss ratio in Illinois.  The commercial fund break even state loss ratio for an AIP is 100% which means all loss ratios above that number contemplate a loss and all loss ratios below 100% include a gain. The State Group 1 states have the following loss sharing layers:

100% loss ratio to 160% loss ratio – the AIP has 65% of the losses
160% loss ratio to 220% loss ratio – the AIP has 45% of the losses
220% loss ratio to 500% loss ratio – the AIP has 10% of the losses
500% and above, FCIC pay all these losses

In our example, the AIP would pay:

  • $10 million times 60% (160-100) times 65% for the first layer or $3.9 million
  • $10 million times 60% (220-160) times 45% for the second layer or $2.7 million
  • $10 million times 280% (500-220) times 10% for the third layer or $2.8 million
  • Zero for the 4th layer as this is all FCIC

This adds up to an underwriting loss in Illinois of $9.4 million for the AIP with $10 million of base premium. The AIP then goes through all of their states and has a similar accounting process to track gains and losses and if the outcome is positive, then an underwriting gain is earned. If not, we have an AIP with an underwriting loss. At this writing it is too early to speculate on whether any individual AIP will have a positive or negative result for 2012 on their entire book. It seems to me nearly certain that Illinois, Indiana, Missouri and Ohio will be in the loss column.

In 2011, Illinois and Indiana had close to $1.2 billion of commercial fund business. This number will be less in 2012, but could still amount to say $900 million. If both states go to the same loss ratio as outlined in the example, then you would take the $9.4 million example loss times 90 to estimate the potential impact on the industry. Again, this loss would be split between the various AIP’s depending on their market share and individual results and just be part of the multi-state roll up for the AIP. A gain in Florida or California (if any) could reduce the impact of the 2012 drought on an AIP writing a national book of MPCI business. In addition, ProAg and many other AIP’s buy aggregate stop loss protection in the commercial reinsurance marketplace on our retained business to guard against a drought year such as 1988, a flood year such as 1993 and now perhaps another drought event in 2012.

In the opinion of this writer, the SRA state stop loss, commercial reinsurance and base capital position of each individual AIP allow the industry to be fully capable of handling the expected underwriting results from the 2012 drought. In addition, we hope to have illustrated how FCIC actually funds the indemnity payments for the policy holders and cash flow risks on claims payments are kept to a minimum. The public-private sector system is set up to handle a difficult loss situation and the 2012 drought will be managed with minimal noise. My advice to agents in the affected areas is to prepare for high dollar claims reviews which include APH documentation that can be tedious and time consuming. Advance planning and communication will be among the keys to a successful claims season. As always with the blog, questions or comments are welcome.

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