Agricultural Insurance – A Financial Tool for Farmers to Offset and Manage Risk

Agricultural insurance focuses mainly on 4 key lines of agricultural production: crops, forestry, livestock/bloodstock (high value animals such as thoroughbreds), and aquaculture (also known as fish farming). It can also include casualty (i.e., liability coverage), life, and/or health insurance. In some countries, usually more mature in their insurance offering and corresponding demand (e.g., USA), it is also possible to consider buildings, and farm machinery as part of an agricultural insurance policy.

To simplify, we consider agricultural insurance as a financial protection mechanism for crops, trees, livestock, and fish. Fruits, bark, fiber, wood are all considered as legitimate produces worthy of being part of the “Sum Insured” of an agricultural insurance policy. This insurance product, however, is rather limited on the market due to certain specificities of the agricultural activity and usually it requires underwriters specialized in fields such as agriculture, forestry, or environmental sciences, that understand well the biological and climatological mechanisms behind agricultural production.

The “insurability” of agricultural risks depends though, of certain factors that the underwriter will be attentive to:

• Must be a “real risk”: sudden, accidental, with unforeseen characteristics.  It can’t cover a risk situation where knowingly the probability of loss occurrence is 100% leading the insurer to constant pay-outs. Insurance is not a speculative, financial gain tool.
• Measurable in large numbers (i.e., to address the Law of the Large Numbers¹). Generally speaking, insurance companies that don’t have a broad portfolio of agricultural risks (or are specialized on the same), with a good geographical spread (which limits their exposure by distributing risk acceptance physically over a wide region or even different countries) do not provide such insurance product because they can’t rely on the Law of the Large Numbers to, as accurately as possible, predict the behaviour (in terms of losses and gains) of their portfolio.
• Cost of insurance premiums must be within the means of an average farmer (context, past experiences, financial literacy matter; for instance, low-income farmers in developing countries have limited resources, and may have other urgent needs where to spend them; at the same time, a lot of education and good value propositions are needed to make farmers understand the worth and added value of an insurance).

In addition, an agricultural peril (i.e., fire, flood, storm, landslide, etc.) to be “insurable”, also needs to have the following features:

• Allow insurers to develop actuarial assessments, obtain sufficient volume of insurance activity, and monitor outcomes
• Non-insurable perils (as they are not sudden, accidental, and unforeseen) may include but not be limited to:
  • Yield, and revenue reductions resulting from poor production practices (e.g., failure to irrigate or harvest)
  • Fraud (e.g., under-reporting of actual yield)
  • Changes in public policy or government regulations

The primary difference between agricultural insurance and other types of property insurance involves monitoring, and rating (pricing) due to the following factors:

• Weather and biological effects imply crop losses are much more costly to monitor than most other forms of property insurance
• Prices that are used to indemnify losses are subject to significant temporal and spatial variability
• Substantial amounts of high-quality data are needed to set actuarially (statistically) sound (that reliably express risk exposure) premium rates
• The wide variety of crop insurance products, triggering mechanisms, and public policy issues complicates crop insurance programs

Additional challenges that impair agricultural insurance monitor and rating are:

• Moral hazard: farmer takes certain choices knowingkly to change outcome from a randomized nature to a predictable one, aiming at having some financial gain (e.g., not watering his crops in specific phenological stages during a drought situation though he still has water availability)
• Adverse selection: farmer has greater material knowledge than insurer about his risk exposure choosing to, e.g., instead of insuring the whole farm, only insuring against landslide a plot located on a slope, knowingly that the probability of crops there located to be washed away during a storm is higher than in other location within his farm. Purposefully insuring risks with a higher exposure and not including others within one same owned location reduces randomization.
• Asymmetry of information: Insurer may not be in total knowledege of all the material factors that may affect risk exposure and consequently rating, etc. Adverse selection exploits assymetry of information.

Therefore, agricultural insurance products must be carefully constructed before being launched on the market, and designed to the distinctive circumstances of individual regions, and countries.

Poorly designed insurance programs will fail and generate losses for invested parties while creating distrust among producers, and the public. Successful programs must inspire a high degree of confidence among all stakeholders.

References:

¹ Ross, S. (2022) The law of large numbers in the insurance industry, Investopedia. Investopedia. Available at: https://www.investopedia.com/articles/personal-finance/081616/behind-law-large-numbers-insurance-industry.asp (Accessed: November 27, 2022).

Find more information in the articles below:

Agriculture and Risk

Risk Management Approaches in Agriculture

Insurance – A Financial Tool to Offset and Manage Risk

Agricultural Insurance – A Financial Tool for Farmers to Offset and Manage Risk