Agricultural insurance: a panacea?

Ake Olofsson1

1. Background

Disasters hit hard. Adverse weather events such as drought, excessive rains, storms and hurricanes cause
heavy losses to farmers. So do pest and animal diseases. Small farmers with few assets have very limited
means to compensate for losses and are therefore normally those who suffer the most. Disasters cannot
often be prevented from happening but they can, to some extent, be predicted and arrangements can be
made to reduce their impact. However, in some cases, disasters cannot be predicted and farmers will have
to cope with the losses after the event occurs instead.

Weather and similar risks belong to the category of non market-related risks, as opposed to market-related
risks that refer to uncertainties about the prices producers will receive for commodities or the prices they
must pay for inputs, etc. To manage risk means to take care to maintain income and to avoid or reduce
loss or damage to a property when undesirable events occur. Managing non-market-related risks offers
basically two options to the farmer. The first option is to reduce as much as possible the actual exposure
to the risk. For certain types of weather events, such as storms, this can mean building stronger wind
shelters. For animal diseases it could mean vaccination of livestock. The second option is to develop the
means to cope with the effects of risk. For example, to build up reserves of some kind, normally savings
or other types of accumulated saleable assets, that the farmer can tap into. To buy a crop and agricultural
insurance policy that pays an indemnity if the crop is lost is another example. In reality, farmers normally
apply a combination of these two options.

1
Rural Finance Officer, Rural Infrastructure and Agro-Industries Division, FAO Headquarters, Rome, Italy.
Agricultural insurance has gained increased attention in recent years as a tool for managing the risks
associated with farming. Many pilot programmes have been developed targeting, in particular, small-scale
farmers in developing countries who do not have access to this type of service.

2. Issues

a) Scope and nature of insurance

Insurance is a financial product. It pools risk by collecting relatively small premiums from a large
population and funding relatively large payouts to the small portion of that population that suffers losses
from a specified risky event. Agricultural and crop insurance is the branch of insurance that is geared to
covering losses from adverse weather and similar events beyond the control of farmers. Agricultural
insurance is not limited to crop insurance; it also applies to livestock, forestry, aquaculture, etc.

Basic to an understanding of how insurance works is the reality that insurance does not and cannot
eliminate risk. Nor can it directly increase a farmer’s income. It only helps manage risks to the farmer’s
income and spreads risk across the farming industry or the economy or, in the case of international
reinsurance, the international sphere.

The scope for effective and economic agricultural insurance can and does often change over time.
Farming enterprises and systems are dynamic. As they change over time they present different and new
patterns of risk and new ways by which farming technology and farm management techniques can cope
with production and other risks. In order to respond to the changing environment, the design of insurance
solutions must be an equally dynamic field of research and development. An insurer must at any time be
able to establish the link between a loss that is insurable and the cause of that loss.

b) Limitations of insurance

Agricultural insurance is not the universal solution to the risks and uncertainties that farmers face. Rather,
insurance can address part of the losses resulting from some perils. Besides, there is no one single
universal insurance product that meets all the demands of farmers. Each insurance product is suitable for
a certain set of conditions. Assessing the suitability of a given insurance product, e.g. single-peril or
multiple-peril insurance, means considering, among other things, the production system, farm size, the
type of asset to be covered, the key peril or perils to which the farmer is exposed, the risk location, data
availability, accuracy of data, etc.

The cause and effect relationships in agriculture are not always readily observable and there are many
variables that affect agricultural production, not all of which are insurable. Agricultural insurance is an
important component of risk management, but does not replace good onfarm risk-management
techniques, sound production methods and investments in technology. When coupled with these factors,
agricultural insurance could indeed prove to be efficient in enhancing the wellbeing of farmers and
enhancing the security of agricultural production.

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c) Cost

Insurance is a business. It is sold and bought in a market. As in any business arrangement, both sides of
the transaction must expect to benefit. The farmer must perceive that the premiums and expected benefits
offer value and the insurer must see opportunity for a positive actuarial outcome, over time, and profit.

Insurance companies have to collect significant amounts of data on climate, production conditions, yield
distributions, prices, etc. to be able to develop models for determining probable farming losses and for
establishing premium and indemnity levels. In addition to meeting the cost of paying indemnities,
premiums must also cover several other areas of cost such as office premises, staff, equipment and
running costs, as well as costs associated with the acquisition of clients, i.e. advertising, farmer education,
etc. As with other types of financial services, such as credits and loans, the more dispersed the client base,
the more heterogeneous the farm production systems, and the smaller the insured value, the higher the
administrative costs become. In the context of developing countries where farms tend to be small, data
tend to be unreliable and difficult to obtain in a timely manner, and where infrastructure such as roads and
telecommunications in the rural areas are poor, the administrative costs can easily escalate. High costs
translate into high premium levels, which normally makes insurance unaffordable for the majority of
small farmers.

d) Potential

Agricultural insurance is a growth business area. This growth is driven not only by the increasing
commercialization of agriculture and the growing underlying value of agricultural production. The
increase in value of agricultural assets, which has increased the sensitivity of agricultural value chain
participants to loss, has also raised the demand for insurance. International trade policy developments and
the availability of new types of insurance products are other factors that have contributed to a renewed
and accentuated interest in crop and agricultural insurance.

The classic crop insurance products account for, by far, the bulk of all crop insurance written globally.
There are two main types, damage- or indemnity-based and yield-based products. Damage-based
insurance is based on a measure of the actual loss incurred by the policy holder, often caused by single
perils such as fire, hail, windstorm or frost. Yield-based insurance, often called “multi-peril” or all risk-
inclusive insurance provides cover against all perils that affect production unless specific ones have been
explicitly excluded in the contract. It is thus geared to a level of expected yield, rather than to the damage
that is measured after a defined loss event.

e) Insurance today – the global picture

Crop insurance is primarily a business which involves developed country farmers with only a minor
percentage of global premiums paid in the developing world. From a geographical perspective, the bulk
of the premiums are written in the United States and Canada, with approximately 62 percent of the
market. This is followed by Asia with 18 percent and Europe with 16 percent. The balance comprises 2
percent in Latin America and 1 percent each in Oceania and Africa. In developing countries, insurance is

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mainly available only to larger and wealthier farmers. Although the development of new insurance
products that are more suited to developing country farmers may change the current geographical
representation, small-scale farmers are most likely still to be excluded from the mainstream.

Most of the insurance programmes that have not proved durable were set up on the basis of unrealistic
expectations.

3. Innovations

Two fairly new insurance products that have caught a lot of attention are (i) products based on insuring a
level of crop revenue, and (ii) products where insurable damage is determined on the basis of an index
derived from data external to the insured farm itself.

a) Crop revenue insurance

Revenue insurance products protect insured parties from the consequences of low yields, low prices or a
combination of both. The essence of crop revenue insurance products is to combine production and price
risk - production and price being the determinants of gross revenue from a given crop. Under normal
supply/demand conditions a production shortfall might be expected to result in a rise in price. To some
extent such a rise will cancel out the financial loss for the grower who suffers the production shortfall.
But this will only be the case if the farmer harvests a sufficient crop and sells it at a sufficient premium
over the expected price. Crop revenue insurance is designed to meet any remaining shortfall in revenue
from crop sales under such a scenario.

The extent to which this type of insurance product could apply to developing countries will depend
primarily on the development of local crop futures markets. A necessary precondition for this product is
the existence of developed commodities and derivative markets that enable insurers to protect themselves
from price decreases and to pass all or part of the price risk to other risk takers.

Given the advantages to the grower and to the insurer, crop revenue insurance is likely to grow in
importance, though for smaller crop areas, as with yield assurance, it will always suffer from the problem
of high administrative cost per unit of value.

The crop revenue approach follows from a new trend in agricultural insurance. This is to define the
insurable interest as an income stream rather than as the expected value of the produce at risk. This
automatically leads to a consideration of linkages between short-term farm loans and insurance. Farmers’
capacity to service interest and principal payments on agricultural loans depends on the income stream
that he/she produces. Revenue insurance gives both the farmer and the financial institution certainty that
income estimates on which loans are based will largely be realized.

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b) Index insurance

With index insurance, the claim is calculated on the basis of the value of an external index, not on losses
measured in the field. Indices, such as rainfall, temperature, wind speed, etc. are variables that are
naturally highly correlated with agricultural losses, and insurance products based on them are designed to
reflect as accurately as possible losses incurred by the farmer when a certain index value is recorded. For
example, a wind index is based on wind speeds as measured at a named meteorological station. The index
insurance starts to pay an indemnity when wind speed exceeds a specified level termed the threshold or
strike. A meteorological trigger of this type cannot, however, be used for certain perils, such as hail, that
normally impacts on a very limited area of land. Rather, it is suited to weather perils that impact over a
wide area such as drought and other single catastrophe perils.

The current strong interest in weather index-based insurance is prompted by the belief that it offers an
apparently practical solution to many of the barriers to classic crop insurance for small-scale, dispersed
farmers in less developed areas of the world. In particular, it avoids the issues of moral hazard and
adverse selection found in other types of insurance products. Moral hazard means that a farmer’s
behaviour may change as a result of taking out insurance. Insured farmers may for instance undertake
riskier production because they know that the insurance covers a possible loss. Alternatively, farmers may
not do all that they could do to reduce individual vulnerability to adverse climatic conditions. Adverse
selection means that people who are more likely to suffer the insured event will be more willing to take
out insurance. Index-based insurance gets round this because an individual farmer is only one of a large
number of producers whose output determines the index or the data used to construct the index. An index
such as rainfall is also independent and observable and cannot be influenced by the insured. Because the
payment of the indemnity is based on deviations from the index, no assessment of losses at the individual
insured party level is needed. The indemnity process therefore becomes quick and inexpensive to
administer, which has a positive impact on premium rates.

Despite these apparent advantages, take-up of index products by both insurers and farmers is still low.
From the farmer’s perspective, as the insurance product is based on an index and the indemnity level is
based on deviations from the index, individual producers face “basis risk”, i.e. actual losses are not
always fully correlated with the weather trigger. For example, a wind speed index insurance will normally
not cover crop losses because of excess rain, flood, storm surge and salinization of soils - events that are
associated with tropical storms/hurricanes. Farmer acceptance of the product may therefore be less than
expected.

From the point of view of the insurer, it can be a costly and time-consuming task to assemble the data and
construct the appropriate indexes. Although meteorological data, often for 50 years or more, is available
in many countries for the design and rating of the insurance, the accuracy of the data, the recording
procedures and the representativeness of weather stations in terms of numbers, locations, etc. may not be
at the required level. The absence of efficient extension services and training programmes are other issues
that impact negatively on the take-up of weather index insurance products. Finally, new legislation may in
some countries be required to legitimize index products.

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4. Good practice

a) Insurance administration

The management of insurance as a business has several stages. The overriding aim in the design of
administrative structures and procedures is to lay a foundation for minimizing costs. Loss costs are
particularly difficult to estimate, especially in the early years of an insurance product. Since the potential
clientele comprises small and often widely dispersed growers, administrative costs can easily escalate to
the point of non-viability of the business. Product administration and management require good
knowledge of insurance which in turn normally means that a licensed insurance provider has to be
involved.

b) Market identification

Buying insurance means increasing the upfront costs for a farmer. The advantages of buying cover must
therefore be clear, with careful positioning of any proposed insurance product. Where it is believed that
insurance could have a role, careful attention must be paid to benefit/cost considerations for both the
insured and the insurer. In general, the more commercial the operation, the more likely is it that insurance
could be designed to address certain of the risks involved.

c) Product development

Once the administrative business structure has been identified, i.e. prime insurer, reinsurer, handling
agents, etc., attention must be given to developing a product or line of products that meet an already
identified demand. It is at the stage of product development that it is necessary to identify the point at
which insurance could most economically impact on and contribute to farmers’ risk management
strategies.

Product development is a highly skilled task that requires detailed knowledge of farming coupled with a
sound appreciation of the principles and operational imperatives of insurance. One of the many challenges
to the insurance industry is maintaining the skills and expertise at the underwriter, loss adjuster, and
reinsurer levels, not only to provide adequate levels of insurance but also to assist the agricultural industry
to improve its risk management practices to enhance production.

d) Marketing

Implicit in any attempt to start crop insurance is the assumption that there is real demand for the product.
Whereas automatic insurance has many advantages, it is not always possible to design this type of policy.
Working closely with representatives of the farming sectors will help ensure that the service and products
are in real demand. Similar linkages should be established with banks, farm product buyers and others
with business connections with the insured farmers.

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e) Setting indemnity and premium levels: deductibles

It is vital that a balance be struck between premium and indemnity levels, and that this balance be
continually checked in order to ensure the financial sustainability of the programme and its ability to meet
commitments to the insured farmers. As most insurance policies do not offer full coverage against losses,
the level of deductible, also known as an “excess”, which applies, becomes a key issue. The deductible is
an element of risk sharing and is expressed as the percentage of the loss that is borne by the insured. A
deductible means that minor losses will not prompt a claim and therefore no loss assessment will take
place.

Insurance products in agriculture are seldom launched on the basis of all the data an insurer would wish to
have in order to set premiums at the level required to meet expected indemnity liabilities. Experience
must be gained during the early years of a programme. During this period adjustments can be made to the
indemnity and premium levels and also to the percentage of deductible applied.

f) Collecting premiums

The main objective is to keep costs as low as possible, so there is a strong incentive to build linkages with
existing providers of services to the farmers. Perhaps the most obvious linkage is between the insurer and
banks serving the same clientele, with the loan included as a component of the seasonal cropping
expenses. Since the premiums in such cases are paid in bulk by the banks to the insurer, costs are
minimized. Small-scale farmers would however most likely still be excluded from the mainstream since
their access to financial institutions in general is very limited.

g) Handling claims

Again, cost containment is very much an objective in designing procedures for the notification of claims,
for assessing losses and for paying indemnities. Clearly the big divide is between the older, traditional
type of policy in which losses need to be assessed on each farm, and the newer types of policies, such as
index-based insurance, in which a more wholesale approach is possible.

h) R-insurance

When the total exposure of a risk or group of risks presents a hazard beyond the limit which is prudent for
an insurance company to carry, the insurance company may purchase reinsurance (i.e. insurance of the
insurance) from international reinsurers.

It is important to establish strong linkages with international reinsurers at an early stage of a crop
insurance development process. These companies can assist with technical advice and can also be
instrumental in ensuring the necessary adherence to correct application of premium-setting procedures,
and settlement of claims. Although the opportunity for profit may be some years away, such companies
are often prepared to become involved in a new geographical field of business. They operate with long
term time horizons, which can work very much to the benefit of a nascent crop insurer.

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5. Action areas/recommendations

a) Roles for government

Whereas, as a business, insurance belongs in a business setting, the very nature of crop insurance means
that there is bound to be strong governmental involvement. Most governments have a close interest in risk
management in agriculture, both for productivity reasons and because of concern for the wellbeing of
rural populations. This often means in practice that governments are active not only in an overall policy
sense. They can also be more closely involved with interventions ranging from the initial investigation of
the feasibility of introducing crop insurance products to their eventual promotion, and even to financial
participation. A government presence in the market fills a void left by the private sector, which is
sometimes reluctant to enter this market segment because of high start-up costs and high distribution and
administrative costs. The private sector also often offers insurance products with premiums that are
beyond the financial capacity of small farmers.

According to a recent World Bank survey on public intervention in agricultural insurance, the most
common mechanisms for public sector involvement in such markets are premium subsidies, investment in
product research and development, training, information gathering, development of specific agricultural
insurance legislation; public sector reinsurance and administration cost subsidies.

Although government support is required, there are strong reasons for the business operations in
insurance to be handled by a commercial concern, namely efficiency and convenience in terms of
insurance operations complementing other commercially run services to farming.

This dual parentage of crop insurance can lead to tensions. The most crucial areas of concern lie in the
areas of premium setting and claims handling. In these areas experience has shown that undue and
inappropriate political influence on an insurer can be very damaging.

b) The way forward

Despite recent product innovations and a great number of index-based pilot insurance programmes having
been put in place, why is crop insurance for small farmers in particular not more developed? Apparently
many of the conditions for the risk to be considered insurable and for a self-sustaining market to appear
are simply not met. High administrative costs are among the most important impediments to a sustainable
market appearing. So is the clear mismatch between farmers’ preferences and willingness to pay. Farmers
seem to prefer insurance that protects a sizeable proportion of income from multiple threats, as opposed to
ones that cover income loss from one specific threat. Another impediment is distorted government
incentives. When governments intervene and make unconditional emergency relief payments, forgive
loan contracts, and/or offer subsidized emergency loans, it removes the incentives for farmers to purchase
insurance and for insurance companies to offer suitable products.

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Agricultural and crop insurance for small farmers will most likely continue to be high on the agenda of
governments and donors alike. Continued research will hopefully help overcome some of the current
problems. One question that might be addressed by research is: could collective insurance as opposed to
individual insurance for smallholders be a way forward? More work may also need to be done on
farmers’ perceptions of risk and their present risk-management strategies. Whatever new developments
occur, we still have to recognize that insurance, even when commercially sustained, can play only a
limited role in managing the risks related to farming.

Fiscally stressed, low-income countries would be better advised to concentrate on developing an

integrated and layered risk management system, rather than viewing crop insurance as a panacea. An
integrated and layered system would include on-farm, individual risk reducing and coping activities and
strategies, informal group-based or mutual insurance schemes (managed by competent farmer
cooperatives/associations if and when they exist and when legislation so allows), formal private market
insurance programmes, and government sponsored and financed disaster relief programmes.

In the case of individual small crop and livestock farmers, the recent debate points to the need to shift the
focus from insurance to improving on-farm risk management measures and tools, on the grounds that
there is more efficiency to be obtained from reducing small farmers’ exposure to risk than from coping
with the effects of risk. As far as risk-coping mechanisms (the category to which insurance belongs) are
concerned, building up assets, especially savings and deposits, appears to be a better alternative to
insurance.

In practice, agricultural insurance is almost invariably an adjunct to a whole set of risk management
measures of which adequate farm management practices constitute the most important. Insurance by itself
is no substitute for good production practices. The acid test of developing and operating an insurance
programme to complement other risk-management measures depends ultimately on the cost of the
programme and the expected benefit, both for the farmer and for the potential insurance provider.

Bibiography

FAO. 2007. Agrifood Systems Brief No.1. Crop insurance. Rome.

Iturrioz, R. 2009. Agricultural insurance.The World Bank Primer Series Insurance, Issue 12, November.
Washington.
Roberts R.A.J. & Dick, W.J.A. 1991. Strategies for crop insurance planning, FAO/AGS Bulletin No.
86. Rome.
Roberts R.A.J. 2005. Insurance of crops in developing countries, FAO/AGS Bulletin No. 159. Rome.
Roberts. R.A.J. 2007. Livestock and aquaculture insurance in developing countries. FAO/AGS Bulletin
No. 164. Rome.