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.


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.


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 riskinclusive 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


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.


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.


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.


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.


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.


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.

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