Combination of Drought and Insurance Increases Farm Profits

Don Hofstrand
retired agricultural economist
Iowa State University
agmrc@iastate.edu

A severe drought encompassed Iowa and the Midwest in 2012.   It reduced crop yields for most Iowa farmers.  However, the Midwest drought also increased crop prices.  Low yields and high prices, when combined with crop revenue insurance, created high returns for most Iowa farmers.

Crop revenue insurance is a method of guaranteeing a minimum level of revenue.  In 2012, a large majority of Iowa farmers carried crop revenue insurance.  Although a wide range of insurance coverage levels are available, 80% is a popular coverage level.  The corn and soybean insurance prices, based on the futures market during February of 2012, were $5.68 and $12.55.  In October of 2012, the drought had increased the future prices, and subsequently the insurance prices, to $7.50 and $15.39.    

Revenue, costs and returns for a typical Iowa corn and soybean farmer with crop revenue insurance is shown in Tables 1 and 2 under five scenarios of yield and selling price.  The scenarios are defined as follows:
 

1. The first scenario reflects corn and soybean yields, prices and returns for an Iowa farmer if yields had been normal in 2012.  Iowa normal yields for 2012 are estimated at 170 bushel per acre for corn and 50 bushels per acre for soybeans. Estimated prices resulting from normal yields are $5.00 for corn and $12.00 for soybeans.
2. The second scenario reflects the 2012 drought.  The Iowa farmer’s yields reflect the drought reduced Iowa average yields of 139 and 44 respectively for corn and soybean.  The drought induced prices from limited grain supplies are estimated at $7.40 and $15.50 for corn and soybean (Wisner supply-demand balance sheet analysis).
3. The third scenario reflects the 2012 drought.  However, the Iowa farmer achieves normal yields.  As in scenario 1, the farmer’s yields are 170 and 50 bushels per acre for corn and soybeans respectively.  The drought induced prices are the same as scenario 2.
4. The fourth scenario reflects the 2012 drought.  The Iowa farmer’s yields are reduced to 115 and 40 for corn and soybeans respectively.  The drought induced prices are the same as scenario 2.
5. The fifth scenario reflects the 2012 drought.  The Iowa farmer’s yields are further reduced to 90 and 35 for corn and soybeans respectively.  The drought induced prices are the same as scenario 2.

Corn revenue, costs and returns for an Iowa farmer under the five scenarios are shown in Table 1.  Scenario 1 represents the economic results from a normal crop.  It shows the lowest profitability of all five scenarios.  This results from the lower selling prices that would have resulted from the U.S. supply of a normal crop. 

In Scenario 2 the Iowa farmer’s yield was reduced by 31 bushels per acre from 170 to 139.  However, the corn price is estimated to have increased by $2.40 per bushel (48%) due to the reduced corn supply.  The 48% price increase more than offset the 18% reduction in Iowa yield.  So, revenue increased from $875 to $1,054.  Because costs are the same for all scenarios, the $179 increase in revenue is transferred directly to profits.  So, irrespective of revenue insurance, the drought increased profits for the average Iowa corn farmer.

In Scenario 3 the Iowa farmer did not suffer from a reduction in corn yield.  In this case the Iowa corn farmer benefited from the price increase but did not suffer from a reduced yield.  The farmer’s revenue is $1,283 or $229 higher than revenue in Scenario 2 and $408 higher than Scenario 1.  The increase in revenue transfers directly to profits. 

Scenarios 3 and 4 represent an Iowa farmer whose yield reduction is large enough to trigger significant insurance indemnity payments.   Because the insurance price is similar to the expected sale price, the insurance proceeds essentially offset the reduction in corn sale revenue.  Revenue is $1,034 and $1,036 for Scenarios 4 and 5 respectively.  Because the Scenario 2 corn revenue is close to the revenue guarantee, the Scenario 2 revenue of $1,054 is similar to those of Scenarios 4 and 5. 

Table 1. Corn Revenue and Returns (per acre)

Scenario	1	2	3	4	5
U.S. Yield *	Normal	2012	2012	2012	2012
Iowa Farm Yield *	Normal	2012	Normal	115	90
Iowa Farm Level Analysis
Grain Sale
Yield	170	139	170	115	90
Sale Price	$5.00	$7.40	$7.40	$7.40	$7.40
Sale Value	$850	$1,029	$1,258	$851	$666
Insurance Reimbursement
Proven Yield **	170	170	170	170	170
Insurance Price ***	$5.68	$7.50	$7.50	$7.50	$7.50
Insurance Coverage ****	80%	80%	80%	80%	80%
Revenue Guarantee	$772	$1,020	$1,020	$1,020	$1,020
Actual Revenue	$966	$1,043	$1,275	$863	$675
Indemnity Payment	$0	$0	$0	$158	$345
Direct Payment	$25	$25	$25	$25	$25
Revenue	$875	$1,054	$1,283	$1,034	$1,036
Cost *****	$734	$734	$734	$734	$734
Profit	$141	$320	$549	$300	$302

*  2012 U.S. and Iowa farm yields are based on USDA November Crop Report.
** Trend adjust yield will increase yield by about 12 bushels per acre.
***  The February and October insurance prices are assumed to be the same in Scenario 1.
****  Although a variety of coverage levels are available (60% to 85%), 80% is a common level chosen by farmers.
*****  Costs include revenue insurance premium, production inputs, labor, machinery ownership and debt payments, operating interest and farmland cash rent. 

A graphic representation of the costs and returns of the five scenarios is shown in Figure 1.  The non-drought return is the lowest and the drought with normal yields return is the highest.   Because of the equal offset of insurance payments for reduced sale revenue, scenarios 2, 4 and 5 are virtually identical.  So, revenue insurance provided Iowa corn farmers with a higher return than would have been achieved had the drought not occurred.


The results are similar but slightly different for soybeans.  Scenario 1 represents the economic results from a normal crop.  Once again it shows the lowest profitability of all five scenarios, although the results are similar to those of Scenarios 4 and 5. 

In Scenario 2 the soybean price is estimated to have increased by $3.50 per bushel (29%) due to the reduced soybean supply from the drought.  The price increase more than offsets the 6 bushel (12%) reduction in Iowa yield.  So, revenue increased from $625 to $707.  Because cost is constant for all five scenarios, the $82 increase in revenue is transferred directly to profits.  So, irrespective of revenue insurance, the drought increased profits for the average Iowa soybean farmer.

In Scenario 3 the Iowa farmer did not suffer from a drought reduced yield.  In this case, the Iowa soybean farmer benefited from the price increase but did not suffer from a reduced yield.  The farmer’s revenue is $800 or $93 higher than Scenario 2 and $175 higher than Scenario 1.  Once again, this increase in revenue is transferred directly to profit.

Scenarios 4 and 5 represent an Iowa soybean farmer whose yield reduction is greater than that reflected by the Iowa average yield.   The revenue in Scenario 5 is below the insurance threshold revenue and triggers an indemnity payment.   Revenue is $645 and $632 for Scenarios 4 and 5 respectively.  Different than corn, the Iowa average yield generates insurance revenue significantly higher than the revenue guarantee.  So the farmer whose soybean yield is similar to the Iowa average yield will receive a higher return than farmers with lower yields who receive insurance.

Table 2. Soybean Revenue and Returns (per acre)

Scenario	1	2	3	4	5
U.S. Yield *	Normal	2012	2012	2012	2012
Iowa Farm Yield *	Normal	2012	Normal	40	35
Iowa Farm Level Analysis
Grain Sale
Yield	50	44	50	40	35
Sale Price	$12.00	$15.50	$15.50	$15.50	$15.50
Sale Value	$600	$682	$775	$620	$543
Insurance Reimbursement
Proven Yield **	49	49	49	49	49
Insurance Price ***	$12.55	$15.39	$15.39	$15.39	$15.39
Insurance Coverage ****	80.0%	80.0%	80.0%	80.0%	80.0%
Revenue Guarantee	$492	$603	$603	$603	$603
Actual Revenue	$628	$677	$770	$616	$539
Indemnity Payment	$0	$0	$0	$0	$65
Direct Payment	$25	$25	$25	$25	$25
Revenue	$625	$707	$800	$645	$632
Cost ****	$550	$550	$550	$550	$550
Profit	$75	$157	$250	$95	$82

*  2012 U.S. and Iowa farm yields are based on USDA November Crop Report.
** Trend adjust yield will increase yield by about 3 bushels per acre.
***  Projected price and harvest price are assumed to be the same in Scenario 1.
****  Although a variety of coverage levels are available, 80% is a common level chosen by farmers.
*****  Costs include revenue insurance premium, production inputs, labor, machinery ownership and debt payments, operating interest and farmland cash rent. 

A graphic representation of the costs and returns of the five scenarios is shown in Figure 1.  As with corn, the non-drought return is the lowest and the drought with normal yields return is the highest.   Revenue from Scenario 1 is similar to that of Scenarios 4 and 5.  So, revenue insurance provided Iowa soybean farmers with a slightly higher return than would have been achieved had the drought not occurred.


 
Converting the per acre analysis for corn and soybeans to a whole farm cash grain analysis is shown in Table 3.  Profits are strong under all five scenarios.  However, the profits for all drought and crop insurance scenarios twice as high or higher as the profits under normal crop growing conditions. 

Table 3. Farm Revenue, Costs and Returns

Scenario	1	2	3	4	5
Corn (per acre)
Revenue	$875	$1,054	$1,283	$1,034	$1,036
Cost	$734	$734	$734	$734	$734
Profit	$141	$320	$549	$300	$302
Acres	500	500	500	500	500
Soybeans (per acre)
Revenue	$625	$707	$800	$645	$632
Cost	$550	$550	$550	$550	$550
Profit	$75	$157	$250	$95	$82
Acres	500	500	500	500	500
Farm (1,000 acres)
Revenue	$750,000	$880,300	$1,041,500	$839,250	$834,069
Costs	$642,000	$642,000	$642,000	$642,000	$642,000
Profit	$108,000	$238,300	$399,500	$197,250	$192,069

The insurance price for revenue insurance, at the farmer’s discretion at sign-up, can be maintained at the Projected February price or stepped-up to the Harvest October price if the Harvest October price is above the Projected February price.  The Projected February price for revenue insurance was $5.68 for corn and $12.55 for soybeans.  Due to the drought, the Harvest October Price had risen to $7.50 and $15.39 for corn and soybeans respectively.  Farmers with policies reflecting the step-up in price received indemnity payments that essentially offset the drop in crop revenue because the insurance prices and projected selling prices for the crop are essentially the same.  However, the Projected February prices were lower than the estimated selling prices.  So, for policies that do not step-up prices, the indemnity payments did not entirely substitute for the drop in crop revenue.  This resulted in declining profits for Scenarios 4 and 5. 

If the yield reduction for the Iowa farmer had been caused by local conditions and not a widespread drought, there would not have been a price induced price rise and there would have been no, or a very small, step-up in insurance price from February to October.  So there would have been no indemnity payment benefit from the extra premium paid for the price step-up alternative.

Table 4. Impact of Insurance Price Election

Scenario	1	2	3	4	5
Corn Insurance Price *
Profit ($7.50 Harvest Price)	$141	$320	$549	$300	$302
Profit ($5.68 Proj. Price)	$146	$325	$554	$266	$223
Difference	-$5	-$5	-$5	$34	$79
Soybean Insurance Price *
Profit ($15.39 Harvest Price)	$75	$157	$250	$95	$82
Profit ($12.55 Proj. Price)	$81	$162	$255	$100	$75
Difference	-$5	-$5	-$5	-$5	$7
* Difference in premium cost is assumed to be $5.00 per acre.

Although most Iowa farmers carry some level of insurance, there are some that do not.  The impact of no insurance is shown in Table 5.  In the first three scenarios, the difference between insurance coverage and no insurance is primarily the savings in the cost of the insurance premium.  However, in Scenarios 4 and 5 where significant yield losses occurred, the benefits from insurance were significant.  In Scenario 5, no insurance coverage would have resulted in a loss for corn and a small profit for soybeans.

Table 5. Impact of Insurance

Scenario	1	2	3	4	5
Corn Insurance Price
Profit ($7.50 Harvest Price)	$142	$321	$550	$301	$303
No Insurance	$157	$336	$565	$158	-$27
Difference	-$15	-$15	-$15	$143	$330
Soybean Insurance Price
Profit ($15.39 Harvest Price)	$73	$155	$248	$93	$80
No Insurance	$89	$171	$264	$109	$32
Difference	-$16	-$16	-$16	-$16	$48