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Ann Druyan, an American author and producer specializing in cosmology and wife of the late Carl Sagan, once said:

For most of the history of our species we were helpless to understand how nature works. We took every storm, drought, illness, and comet personally. We created myths and spirits in an attempt to explain the patterns of nature.

That may be true, but it's hard not to take Mother Nature personally when the price of everything from ribeye steak to 2% milk is about to go up. The worst since 1956, the North American Drought of 2012 has already pushed the price of corn (NYSEARCA:CORN) to record highs.

While many articles on Seeking Alpha have focused upon the effects of drought on things like commodities futures or the price of fertilizer, I intend to take a different route by focusing on the people who get to foot the bill directly: Crop insurers.

A Quick Trip Down Memory Lane

In the 1820s, the first crop insurance policies were offered to French and German farmers. The firms that underwrote the policies flopped almost immediately, due to inadequate risk distribution. However, since the risk was isolated, it was possible to implement the hail risk into financial instruments, and Swiss firms like Madgeburg Hail proceeded to do so. This is known as limited-peril crop insurance.

While limited peril insurance offered some protection from localized disasters, such as freeze for Citrus, fire or hail, it left farmers exposed to general disasters such as drought. The U.S. Department of Agriculture implemented the first multi peril crop insurance program in 1938, as a result of an election year promise by Franklin Delano Roosevelt to farmers wiped out during the Dust Bowl years.

Today, farmers pay about 46% of the actuarial fair premium for government subsidized insurance. Of the policies offered, the 65/75 (65% coverage level and 75% payment rate) is the most common. However, the government doesn't insure farmers directly. Instead, the FCIC (Federal Crop Insurance Corporation) spreads the risk by subsidizing approved commercial insurers which insure agricultural commodities using FCIC-approved acceptable plans.

And that's where losses come in.

Bring On The Pain

Up until now, crop insurance has been one big corporate hand-out. The government approved companies haven't taken a loss writing crop insurance in a decade.

Well, there's a first time for everything.

Crop losses due to inclement weather resulted in the highest payouts on record last year, reaching $10.7 billion as of April 30 of this year, and could go as high as $11 billion once all claims are processed. The previous highest payout year was 2008, when losses topped $8.7 billion. Claims on crop insurers like American Financial Group (NYSE:AFG), Wells Fargo (NYSE:WFC), ACE Limited (NYSE:ACE), QBE Insurance Group (OTCPK:QBEIF), Endurance Specialty Holdings (NYSE:ENH), and Archer Daniels Midland (NYSE:ADM) are rising by the day. Keep in mind, that ratio of losses to premiums during the 1980s and 90s was approximately $2 for $1.

So how much did they write? About $11 billion, according to Tom Zacharias, the president of National Crop Insurance Services.

Let's take a look at exposure.

QBE Insurance Group's ((issuer default rating [IDR] of "A") net profit took a 45% hit to profits in 2011, and its 2012 losses on crop insurance are estimated to be high as $270 million, according to Morgan Stanley. The Sydney-based company's shares fell 13% in Q1 due to a late surge of claims from flooding in Thailand. QBE's will give its official report on the drought's impact on profits will be available in a little less than a month from the time of this writing.

According to its 2011 financial report, American Financial Group ([IDR] A-) typically reinsures 15% to 25% of its gross written premium with FCIC. Last year, it reinsured 52.5% of premiums not reinsured by the FCIC in the private market, and purchased stop-loss protection for the rest of its crop insurance business. The company planned to write a similar amount in 2012. AFG has reduced its guidance for the year, citing the drought.

Endurance Specialty Holdings ([IDR] A-) has the greatest amount of crop insurance as a percentage of its total book at roughly 25% of net premium written. According to Endurance CEO David Cash,

Although it's not possible at this time to predict what final crop yields and prices will be for the year, it's safe to say that there is the potential for material losses to be incurred by the crop insurance industry in the back half of 2012.

While it is still too early to make any precise predictions as to the impact of the emerging drought we'll have in our ultimate losses for the 2012 crop year, our internal scenario modeling today projects a full year net loss ratio of approximately 100%. This net loss ratio is based on an internal scenario that produces countrywide gross loss ratio of approximately 150% for our agricultural insurance business. By way of comparison, the countrywide gross loss ratio in 2002 was approximately 125% for the industry.

If the 2012 crop year does ultimately produce a 100% net loss ratio to Endurance this would result in Endurance recognizing a net underwriting loss of approximately 50 million for our agricultural insurance line of business in the second half of this year.

Wells Fargo ([IDR AA-]) - While Wells Fargo has underwritten about $1.8 billion in crop insurance in affected states since last year, more than three-quarters of that has been reinsured. Taking that into account and using loss estimates from the severe 2002 drought, the analysts came up with a potential hit of $380 million, or 5 cents per share.

Wells Fargo refused to speculate what the ultimate impact might be.

Ace Ltd ([IDR A+]) According to Evan G. Greenberg, Chairman and CEO of ACE:

Based on conditions as they stand now, and given our portfolio mix by state and crop, we will adjust our Crop Insurance loss ratio for the year up in the range of five points during the third quarter, bringing our crop-related-business combined ratio to between 93 and 94 percent."

He said about $68 million after tax in estimated losses for Q3 is "our best estimate at this time.

Archer Daniels Midland On August 3rd, Standard & Poor's Ratings Service lowered its outlook on Archer Daniels Midland Co. from stable to negative, citing the impact of the drought on the agribusiness conglomerate's income over the next year to year and a half. S&P also warned that future rating downgrades were possible if its earnings do not improve.

Hit to Taxpayers

The crop insurance industry is subsidized by the U.S.D.A., which provides about 60% of each premium dollar in addition to kicking in more than $1 billion each year for insurers' operating costs.

Conclusion

While Wells Fargo is one of the largest underwriters of crop insurance, its strong balance sheet and diversification makes it the least vulnerable. The best short opportunities are likely Archer Daniels Midland and QBE Insurance Group . As Seeking Alpha's Dana Blankenhorn pointed out, ADM's business model is based entirely on the abundance of cheap corn - something that no longer exists.

QBE's vulnerability stems from the fact that it has yet to release its estimates of the drought's impact on earnings. In 2011, QBE's earnings suffered disproportionately compared to its competitors in the industry. A deeper hit in 2012 will begin to cast serious doubts on its risk model.

Source: Drought May Saddle Crop Insurers With Record Losses