By Ben Berkowitz and Tom Polansek
(Reuters) - The drought ravaging America's prime farmland is having an unexpected consequence that could shape the future of agricultural finance: in some cases, farmers who have amped up their insurance coverage may be giving up on their crops early rather than to trying to save them.
Anecdotal evidence and economic assumptions suggest that a record number of farmers are likely preparing to file insurance claims this year, opting to plow under their withered crops -- some without bothering to administer the costly pesticides and weed killers that might help salvage a dwindling harvest.
Call it "moral hazard" in the heartland: with the growing use of federally backed crop insurance, a shift toward larger policies and newer schemes that protect revenue, some experts say farmers may now be better off claiming a total loss than eking out a shrunken harvest -- a move that could exacerbate a 50 percent surge in corn prices by further reducing supply.
"Why spend money trying to save a crop when every bushel of crop you save is then going to reduce the indemnity that you would otherwise receive?" said Vince Smith, an economist at Montana State University who has been critical of the program.
"The higher level of coverage means that you need a small shortfall in yield in order to be eligible for an indemnity payment, so these moral hazard effects come into effect more frequently," he said, referring to the economic theory in which one party may take excessive risk to the detriment of another.
Indemnified losses are likely to significantly exceed last year's record $10.7 billion, experts say, a sum that will be shared by the government programs that subsidize the dozen or so specialist crop insurance firms that sell the policies.
Consumers across the world will also pay at the grocery store: as more farmers give up, the corn crop shrinks, propelling prices even further beyond last year's $8 a bushel. Some analysts began revising down their crop estimates this week on the basis that millions of acres may not be harvested at all.
As it plays out, the trend may have far-reaching implications in Washington, where Congress is in the final furlong of hammering out a multiyear farm bill -- the cornerstone of which was expected to be an expanded insurance scheme, something that now faces even greater scrutiny.
The growth in crop insurance is well documented. A decade ago, insurance covered about 75 percent of the U.S. corn crop; last year it covered 85 percent of all planted acres.
But more importantly, farmers have also been shifting toward policies that offer a greater level of protection.
In 2004, farmers who took out policies at 75 percent or more coverage represented less than 40 percent of the total sum of insured acres. By last year that share had risen to 63 percent, according to U.S. Department of Agriculture Risk Management Agency (RMA) data compiled by Thomson Reuters Lanworth, a natural resources intelligence firm.
While it is too early to see any definitive evidence of the total indemnity costs, early data supports anecdotal reports of greater activity. As of July 16, insurance indemnities for all crops stand at $446 million compared with $230 million at this time a year ago, according to RMA data.
At the same time, U.S. corn production is shrinking by the hour amid the worst drought in more than 50 years. The government slashed its production forecast by 12 percent just last week; by this week, analysts said output had likely fallen a further 7 percent due to the drought.
It is not just the level of coverage that matters; the type is also key.
Disaster modeling company AIR Worldwide, in a recent report on the drought, said most farmers in the Corn Belt took out revenue protection policies with a harvest price option -- contracts that will, in other words, pay them for the crops they would have harvested at the price they would have gotten at market even if they plow under instead.
To be sure, for every farmer thinking about cashing in on their insurance there are plenty who are still fighting the fight. Ben Hollis, who farms corn and soybeans in Petersburg, Illinois, raised his revenue protection level this year and held off on fungicide as a waste of money -- but he is adamant the two are not linked.
"If you continually try to raise (a) poor crop and cash in on your insurance, then you'll have a terrible average. I would resent the idea that I would ignore pesticide or fungicide because I have insurance," he said. "I want to produce something. When I do something I want to do it right."
CLAIMS, NO PLOWING YET
For the most part it is too early to see direct evidence of abandoned crops. Farmers generally must receive confirmation of their claim from the insurer before destroying their fields, and the speed of the drought is straining adjustors who would normally be busy only after the autumn harvest.
"Insurance claims are coming in like it's the fall," says Washington-based agricultural trade consultant John Baize, who has worked closely with farmers for over three decades.
Lanworth crop scouts toured more than 50 fields across northern Iowa, and dozens more in southern Illinois and northeastern Missouri, over the past two weeks without observing any plowed-under fields, they said.
However there was little doubt of widespread losses, potentially exceeding the drought of 1988 when more than five percent of planted acres in Iowa were not harvested in Iowa.
"We observed fields in northwestern Iowa with cracks in the soil nine inches long and one and a half inches deep -- what this crop needs is weeks of rain to abate the dry soil conditions," says Lanworth senior analyst Alexis Maxwell. Some fields had almost no pollinated ears of corn, she said.
"We saw a few crop dusters. It looks like some farmers just cannot give up hope on this crop and are trying to save it, but what we really need is not fertilizer but days of rain."
Still, the economics of calling in the insurance claims adjustor are growing more attractive daily.
If the fall harvest price is $8 a bushel, a farmer who has 80 percent insurance coverage and an actual production history of 180 bushels an acre would get $1,152 an acre if their field is a total loss and they did not sell any crops forward, according to Iowa State University economist Bruce Babcock.
Babcock noted that in the spring, when corn was planted, prices were around $5 a bushel. The farmer who thought he would get his 180 bushel/acre yield at that $5 price was expecting to make $900 an acre.
"So in fact this farmer with insurance may actually come out ahead if his field is a total loss and he did not forward contract the crop," Babcock said in an email interview.
Policies require farmers to notify insurance companies of crop damage within 15 days, adjustors say. But it can be difficult to know when the damage begins in situations like a drought, where stalks wilt a little bit more with every day.
After being notified, insurance adjustors visit clients' farms to assess the extent of the damage. They can cover about 1,200 acres in a day, which includes driving from field to field and surveying conditions, said Mark Mossman, vice president of claims for NAU Country Insurance Company.
It can be physically and emotionally draining.
"It's hot work," he said in an interview earlier this month. "We have to walk the fields and assess the fields and take many different counts. Frankly I think the psychological part, dealing with the farmer who has suffered a significant loss, is just as hard. It's their livelihood."
He says that insurance policies require farmers to carry out "good farming practices," which would include treating crop diseases if possible. But he acknowledged that some may be tempted to quit.
"As a farmer with a devastated crop you're going to start thinking, 'when do I stop throwing good money after bad?'"
INSURERS LOSE OUT
Insurers say they can still make money in this environment, given government reinsurance and strong premiums for coverage, but the impacts of the drought are clear nonetheless.
"The two-year period we are in right now will probably be the worst in the past 30 years for crop insurance. Prior to 2011 there hadn't been a significant loss year since 1993. That's a 17 year run of profitability," said John Berger, chief executive of the reinsurance company Third Point Re.
Third Point is a newer player in the crop market, which is dominated by the likes of ACE Ltd's Rain and Hail, Everest Re's Heartland Crop Insurance and ADM's Crop Risk Services. Most insurers declined to comment on claims or estimated losses ahead of earnings.
Under a master agreement with the industry, the U.S. Department of Agriculture pays an average 60 cents of each $1 of the premium. It subsidized up to $1.3 billion a year in overhead costs, and it shares the burden in case of catastrophe.
A spokeswoman for National Crop Insurance Services, a group that represents the nation's 15 or so private crop insurers, said it would probably be another month before members started to get a more complete picture of this year's losses.
"We're trying to be cautiously optimistic," she said. "Some areas will still produce a good crop while other areas won't."
(Reporting By Ben Berkowitz in Boston and Tom Polansek in Chicago; editing by Jim Marshall)