Crop Dust

Hit with what the U.S. National Climatic Data Center has called the most severe drought to descend on the American Midwest since 1956, insurers and reinsurers are preparing for worst-case scenarios and setting aside significant reserves.

While the extremely dry conditions have drastically cut production in key crops, especially corn and soybean, agricultural groups are hedging their bets until the harvest is complete in the fall. When the dust settles, (re)insurers are expected to face their first crop insurance underwriting loss since 2002.

Munich Re was the first major crop insurer to publicly set aside $200 million in reserves in August. For the German-based reinsurer, one of the world’s leaders in the agriculture market, about 70% of its premium income in agricultural insurance is derived from the United States.

“Based on current estimates, Munich Re anticipates a net burden of approximately €160 million ($200 million) [before tax] from losses under crop failure covers, as a consequence of the persistent drought in large agricultural areas in the USA,” the company notes.

“We do think it will be severe and probably one of the severest losses for this market ever,” Munich Re chairman Nikolaus von Bomhard told CNBC. “It’s too early to tell what the exact claim will be because we have to wait until the harvest is done.”

Other crop insurance companies have followed suit, with projections as to how hard the 2012 drought will hit their bottom lines. In a second-quarter earnings conference call with analysts, ACE chairman and CEO Evan Greenberg said the company is adjusting its year-to-date crop loss ratio in the third quarter up by five points, equal to roughly $68 million in after-tax earnings. The company’s worst-case loss scenario would be an additional $200 million after taxes, Greenberg reported.

“The U.S. drought is indeed a ‘catastrophic’ event,” Gregory Locraft, insurance analyst at Morgan Stanley, writes in a recent note to clients. It is “likely the largest [insurance] crop loss in history.”

The top U.S. crop insurers include ACE USA, QBE North America, Rural Community (Wells Fargo), American Financial, Fireman’s Fund (Allianz), Endurance, XL Reinsurance America and Munich Re America. Wells Fargo’s Rural Community Insurance Co. was the largest approved provider of crop insurance in 2011 with $1.79 billion in policy sales, notes National Association of Insurance Commissioners data compiled by Standard & Poor’s (S&P). Zurich-based ACE was second largest, with $1.67 billion in sales, followed by QBE Insurance Group Ltd.

STUNTED HARVEST

The largest 12 crop insurers had total direct premium written in 2011 of $12.4 billion, of which $5.8 billion is in the top 12 drought states, notes the S&P report released in August, Drought Will Hurt U.S. Crop Insurers, But Won’t Dry Them Up Completely. The states most affected by the drought include Arkansas, Georgia, Illinois, Indiana, Iowa, Kansas, Mississippi, Nebraska, Oklahoma, South Dakota, Tennessee and Wyoming.

 “Farmers in the most affected states are expecting one of their worst harvests since the drought in 1988,” the report states. “As a result, crop insurance books of business will see some of the worst underwriting results since 1988. Primary insurance companies will share crop losses with the federal government and private reinsurance companies, making the underwriting losses easier to take,” S&P adds.

 “Underwriting losses will be a drag on earnings, but by themselves, will likely not affect the capital of most insurers that we rate,” says S&P credit analyst Jason Porter. “Consequently, we do not expect to take any rating actions solely because of crop insurance losses at this time.” 

Estimates of total insured losses from the U.S. drought vary from $4 billion (University of Illinois agricultural economists) to more than $5 billion (S&P).

ROCKIES TO VALLEYS

The facts of the 2012 drought are staggering.

Drought covered more than 60% of the contiguous 48 states as of mid-August 2012, reports the U.S. National Weather Service’s Climate Prediction Center. Almost a quarter of the country was experiencing extreme to exceptional drought, primarily in a large swath generally extending from the central Rockies eastward through the Mississippi and Ohio River valleys. The U.S. Department of Agriculture (USDA) reports that 51% of the corn crop was in poor or very poor condition across the 18 primary corn-producing states, as were 38% of soybeans (18 states). For the contiguous 48 states as a whole, 59% of pastures and rangelands were in poor or very poor condition.

The USDA has declared natural disasters in more than 1,800 counties in 35 states, more than half of the country’s total, mostly because of dry conditions. The department twice has slashed its forecast for this year’s corn and soybean output because of the drought and now expects the nation to produce 10.8 billion bushels, the lowest amount since 2006. Corn and soybean production, which together account for more than half of total annual U.S. agricultural production, are the top exports for farmers south of the border. The United States accounts for almost 40% of world corn production and 35% of world soybean production.

The USDA predicted in late July that the drought is expected to result in price increases of 4% to 5% for corn and beef and poultry this year.

In Canada, the growing season for farmers has been much more variable. Statistics Canada reports that while Ontario experienced its driest summer in 47 years, the Prairies are anticipating record canola production in 2012, as well as increases in wheat and barley.

In its latest crop estimate issued in late August, the agency says that Prairie farmers anticipate a record 15.2 million metric tonnes of canola – surpassing the record of 14 million tonnes set in 2011. Total wheat production on the Prairies is expected to reach 24.8 million tonnes in 2012, up 9.7% from 22.6 million tonnes in 2011, while barley production is anticipated to rise 23.8% to nine million tonnes.

Ontario and Quebec represent a different story. For most regions of these provinces, record low rainfalls have had a negative impact on crop production and livestock feed. In particular, the two crops most adversely affected by this summer’s lack of rain have been corn and hay. Other crops hit with the variable moisture have been soybeans, canola and grain.

Ontario’s apple growers are also reporting an estimated 30% drop in harvest. Pastures, too – critical to grazing livestock – have all but dried up in several regions, putting livestock farmers in critical need of water and food for their animals, notes the Ontario Federation of Agriculture.

There have been just over 7,500 damage reports in the province as of August 23, says Gail Simkus, manager of product management and industry relations for Agricorp, Ontario’s Crown corporation responsible for agricultural insurance. “We expect more damage reports to roll in. In 2011, we paid $82 million in claims and, at this point, we are looking at more than that this year. However, we won’t know final claims numbers until the harvest,” Simkus says. 

Roughly 15,000 farmers covering 5 million acres purchase production insurance from Agricorp, although there are other types of insurance programs offered by the corporation. For production insurance, farmers typically pay 40% of the total premium cost, while the federal and provincial governments contribute the other 60%. The arrangement is similar in every province in Canada, with agricultural insurance delivered provincially by a Crown corporation or branch of the provincial agricultural department in conjunction with Agriculture and Agri-Food Canada.

There is no private property and casualty insurer involvement in agricultural insurance in Canada, except through reinsurance contracts. Agricorp deals with approximately 30 multinational reinsurers with expertise in the agricultural sector, Simkus reports, and generally purchases excess of loss reinsurance with a contingent layer. “With sound rates, prudent fund management, and backstopped by reinsurance, we are confident that we will be able to address this season’s potentially higher claims than in recent years.”

Unlike Canada, the U.S. system of agricultural insurance is a public-private partnership. Under the Federal Crop Insurance Program, 15 private insurance companies are authorized by the Risk Management Agency in Washington to write multiple peril crop insurance, notes information from National Crop Insurance Services. This crop insurance is sold though private insurance companies, but a portion of the premium and the expenses of the private companies is subsidized by the federal government. Private insurers sell and administer the coverage; in return, the federal government backstops the firms with payments and reinsurance. 

More than 80% of cultivated farmland in the U.S. is covered by the federal multi-peril crop insurance program (MCIP). The USDA’s Risk Management Agency reports that crop insurers have paid $948.6 million in claims this year through August 13, although it adds that it is still too early to estimate what industry losses will be for the season. In a report released in mid-August, Moody’s Investor Services states consolidation has taken place in the crop insurance market since the 1990s.

 The top five crop insurers – all national underwriters – now account for approximately two-thirds of direct premiums written.

“Over time, the government has reduced expense reimbursements to [Multiple Peril Crop Insurance] crop insurers, which in turn has contributed to consolidation, offering competitive advantages to larger, diversified insurers,” Moody’s notes in the report. The rating agency also cautions that smaller insurers focused on agriculture or with businesses concentrated in loss-affected areas “appear considerably more vulnerable on a direct basis than their more diversified industry peers.”

LOSSES PROJECTED

A report by Milliman released in late July estimates that crop insurer underwriting losses for 12 major corn- and soybean-producing states could top $2.8 billion. The report, authored by Carl Ashenbrenner, covers the states of Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota and Wisconsin.

The report arrives at its loss estimate by projecting premiums collected in the 12 states along with the federal MCIP loss ratio for 2012. It projects a 147 loss ratio in 2012 for the states, while acknowledging “a considerable amount of uncertainty to these projected underwriting losses.”

However, Ashenbrenner adds, “forecasts by the National Weather Service’s Climate Prediction Team are not showing improving drought conditions through September 30, 2012, which could further lower crop yield and increase crop insurance indemnities.” Another study by agricultural economists at the University of Illinois estimates the drought will trigger gross indemnities of roughly $30 billion this year, with an underwriting loss of about $18 billion. Of that, the U.S. government is expected to assume approximately $14 billion, while private sector insurers are likely to face a loss of $4 billion, the university states.

In late August, catastrophe modelling firm AIR Worldwide put projected losses resulting from farmers claims related to the crop insurance industry at $13 billion, with an upward potential of $20 billion.

“AIR’s current estimate for this year’s crop insurance losses point to a gross loss ratio for the whole industry of 120% to 180%,” says Gerhard Zuba, senior principal scientist at AIR Worldwide. “After government recoveries, which are available through the standard reinsurance agreement between crop insurers and the government, the total responsibility for the insurance companies and their private reinsurers, net after accounting for premiums collected, will be about $1 billion to $3 billion.”

INCIDENCE CONSEQUENCE

While the short-term effects of the 2012 drought will lead to substantial (re)insurance losses and push up food prices, the longer-term trends of drier conditions linked to climate change pose several otential risks for insurers, government and society. In a “Climate Challenge List” released by Lloyd’s in mid-June prior to the Rio + 20 conference, it states “the incidence, onset and severity of drought is increasing across Europe, the southwest U.S. and West Africa, with mounting economic and human costs. A 2011 European Commission study estimates droughts in Europe had cost their economies $100 billion over the last 30 years.”

In Canada, of the 10 costliest disasters to have hit the country, six of these were droughts, notes information from the Blue Economy Initiative. The drought of 2001-2002, for example, drained more than $5.8 billion in gross domestic product from the Canadian economy, the initiative reports. 

Aside from crop insurance, drought may be thought of as uninsured risk as it is unlikely that the dry conditions will spur a wave of personal/commercial property or business interruption claims. However, there can be trickle down or “knock-on” effects of drought.

Drought may have an impact on other climate-related risks, such as wildfires, dust storms and land subsidence. Although farmers may be covered by insurance, it is important to note other losses and damages (both insurable and non-insurable) related to droughts may be far-reaching.

Drought can be a contributor to extreme wildfire events. Munich Re reports that drought conditions in Texas in 2011 caused $1 billion in insured losses. The persistent drought resulted in the worst wildfire year on record in the state.

WAVE OF HEAT

Droughts and heat waves accounted for two of the deadliest natural disasters in the world since 1980, including a 2010 heat wave in Russia that caused 56,000 deaths and almost $2 billion in economic losses, states a 2011 report by Munich Re. A 2003 heat wave and drought in Europe resulted in 70,000 fatalities and $13.8 billion in overall losses. 

The major parts of the direct economic losses of heat waves are secondary effects such as drought, subsidence and wildfires, Munich Re notes. Extreme dry conditions can also lead to more powerful dust storms, particularly in the southern U.S. “Drought can exacerbate dust storms, with the southwest U.S. experiencing an ever-increasing number,” according to Lloyd’s. “Last July 2011, a dust storm in Phoenix closed the airport and cut off power for 10,000 people.”

While these storms are a regular phenomenon in Arizona, New Mexico and Texas each summer, Thomas E. Gill, an associate professor of geological sciences and environmental science and engineering at the University of Texas at El Paso, told Lloyd’s that “there have been more-than-typical (and dramatic) amounts of dust with these storms, however, due to the extreme drought which the region has been experiencing.

That’s caused the desert soil to be extremely dry and didn’t allow for enough vegetation to grow to hold down the soil from the wind.”

Another risk of drought is land subsidence. The Claims Journal reports that the U.S. drought is already affecting buildings and homes in Iowa and Missouri, causing cracks in foundations. The Des Moines Register, for its part, has noted that the drought caused the ground surrounding homes to pull away from their foundations, leading to widening cracks in walls, sticking windows and doors and nails to pop.

The Claims Journal adds that the average repair cost is $3,000 to 5,000 and can exceed $30,000 – typically not covered by homeowners insurance. A 2011 study by Swiss Re explains that Europe is witnessing a dramatic increase in property damage as a result of soil subsidence. Climate change could magnify those risks, as prolonged dry spells can cause the ground to sink by so much that cracks appear in the earth, tearing apart the foun dations of houses, bridges, factories and other structures, states the report, The hidden risks of climate change: An increase in property damage from drought and soil subsidence in Europe.

A new loss model developed by Swiss Re and the Swiss Federal Institute of Technology (ETH Zurich) suggests that soil subsidence will worsen and spread in Europe, with some areas seeing a more than 50% increase in future losses. In France alone, subsidence-related losses have risen by more than 50% in the last two decades, costing affected regions an average of €340 million ($422 million) per year.

“As our climate continues to change, the risk of property damage from soil subsidence is not only increasing, but also spreading to new regions in Europe,” comments Matt Weber, head of property and specialty underwriting for Swiss Re. European property insurers face major potential losses from drought-induced soil subsidence, Weber suggests.

COMMON AS DIRT

Many climate experts say the risks of drought and its associated side effects are expected to increase in the long term because of climate change.

“Future precipitation trends, based on climate model projections for the coming fifth assessment from the Intergovernmental Panel on Climate Change, indicate that droughts of this (2012) length and severity will be commonplace through the end of the century unless human-induced carbon emissions are significantly reduced,” note Christopher Schwalm, Christopher Williams and Kevin Schaeffer in a recent article published in the New York Times Sunday Review, Hundred-Year Forecast: Drought. “Indeed, assuming business as usual, each of the next 80 years in the American West is expected to see less rainfall than the average of the five years of the drought that hit the region from 2000-2004.”

In the near term, insurers and reinsurers will have their answers in the next few months as harvest figures become available in the late fall. Many are bracing for a significant loss and anticipating the exposure.

However, some are optimistic that not only will (re)insurers weather the dry spell, but the 2012 drought may create greater interest in agricultural insurance across the globe.

Industry estimates indicate that only about 20% to 25% of the world’s agricultural production has so far been insured against natural disasters. But some expect that the drought in the United States could stimulate insurance development in major agricultural countries in South America and countries such as Russia and Ukraine.

Karl Murr, director of the agricultural insurance division of Munich Re, sees business opportunities out of the huge loss. “The (market) potential is still large,” Murr told Xinhua news agency. “The drought shows we need such an insurance system.”