Insurance Basics: Value Matters04/19/2016
Here’s a hypothetical situation to ponder:
In 2010, you purchased a brand-new car for $30,000. Since then, you’ve driven 100,000 miles, worn out a couple of sets of tires, and accumulated an impressive collection of dents, scrapes, and pings. Now, that five-year-old vehicle is worth $10,000. Unfortunately, you’re in a wreck and total the car. Does your insurance provider send you a check for $30,000 or $10,000?
Obviously, your auto insurance covers the value of the property at the time of the accident, not the time of purchase. Otherwise, there would be a whole lot of folks wrecking old cars to recoup the value of a depreciating asset.
Of course, the flip side is true, too. Here’s another hypothetical:
In 1975 you purchase a nice home for $50,000. Throughout the years, the surrounding area is developed. You remodel your kitchen and bathrooms and even finish out the basement with an extra bedroom, an entertainment area, and a full bath. Today, the building alone is worth $300,000. Unfortunately, it burns to the ground. Does your homeowner’s policy just cover the original purchase price of $50,000 or the full market value of $300,000?
Luckily for the homeowner, it’s the latter. And it makes sense. You will have to replace the appreciating asset at today’s market value.
Not to mention, the insurance premiums you paid throughout the years reflected the changing value of the home – premiums for a home worth $300,000 are more expensive than premiums on a $50,000 home.
These same common-sense principles apply to crop insurance, and are too often overlooked when discussing the Harvest Price Option available to farmers. Let’s consider one more hypothetical:
A farmer plants a corn crop in May that is valued at $250,000. The farmer forward contracts to sell his crop at that amount – in other words, he agrees to sell it at a locked-in price to a buyer after harvest in October. But a drought strikes that summer and most of the corn withers, leaving the farmer with little to harvest. Since this farmer isn’t the only one experiencing drought, overall corn supplies fall driving up prices nationally. Now, the value of the crop that the farmer lost is worth $350,000. What does the insurance pay?
In the hypothetical above, if the farmer paid an extra premium for Harvest Price Option coverage, the insurance would pay the value of the crop at the time of loss, or $350,000, minus the farmer’s deductible.
The farmer paid more to get that extra protection because under the forward contract, the farmer is obligated to deliver corn to the buyer at the set price, even if the farmer’s crop fails. That means the farmer must purchase enough corn on the open market at the current market rate, to satisfy the contractual obligation. In other words, the farmer must pay $350,000 to buy corn that will then be resold for $250,000.
That’s not a great deal for the farmer. Yet, agriculture’s political opponents try to spin the Harvest Price Option as some free giveaway. Such critics are being intentionally misleading.
Harvest Price Option is a policy that farmers pay more for out of their own pockets, while still absorbing the deductible. And, it’s the only meaningful risk management tool farmers have to replace the lost bushels needed to fulfill their forward marketing obligations or to feed their livestock in the event of wide-spread crop failure.
Source: National Crop Insurance Services