Insurance – A Financial Tool to Offset and Manage Risk

Insurance is a financial risk transfer mechanism based on the principle of an Insurer (or risk carrier, to whom the Insured transfers part or the totality of a risk – i.e., the wheat yield for the year) accepting an unknown future threat (i.e., storm, hail, flood, etc., events) against the payment of an agreed premium by the Insured.

The premium, or, in layman terms, the price the farmer (Insured) must pay to insure his/her assets, bluntly represents the exposure the Insurer has for accepting covering them. In addition, it represents certain Terms & Conditions the insurer‘s underwriter or underwriting team (the individual/s who identify the relevant material facts, analyze, and control the impact on the insurer’s portfolio of the liability being transferred to it) set to accept covering a risk liability. Insurers do their own risk management assessment.

The document that legally binds the Insurer and Insured, worded in a way that represents their contractual relationship, is called the “policy.”

Amongst other things, this document describes the insured, the insurer, the date of inception, and end of the insurance cover, perils covered, sum insured, location of the risk, premium including payment terms and deadlines, and lists a series of dispositions or clauses that describe what, when, how, is covered and in what form does the policy response to an event, guiding loss adjusters to accept or not a claim made under this contractual document.

“Law of the Large Numbers”

Insurers base their business, amongst other postulates, on the “law of large numbers” to estimate the losses a certain group of insureds may have in the future.¹

This statistical heuristic can be explained by the following example:

• when flipping a coin into the air, theoretically, there is a 50/50 (Theoretical Frequency of Occurrence) chance that we will observe it fall with either heads or tails showing upwards
• nevertheless, the number of times we flip the coin into the air matters:
  • empirically, when flipping the coin into the air just a small number of times (let’s say, 10), we see that the Real Frequency of Occurrence of heads or tails does not correspond to its Theoretical Frequency of Occurrence (5/5) but that it can randomly vary (i.e., 6/4, 2/8, 1/9, 10/0, etc.)
  • however, if we flip the coin into the air a large number of times (for instance, 100, 1000, 1 million times or more) we see that the Real Frequency of Occurrence becomes ever closer to the Theoretical Frequency of Occurrence of 50/50.

Transporting this “rule of thumb” to an Insurer’s portfolio of a specific, homogeneous insurance class or typology of risks (e.g., crop insurance), as the number of insureds and/or policies is scaled up, the more confident the insurance company will be in its prediction of the possible behavior of the whole portfolio.

The probability that the actual loss per exposure unit will equal the expected loss per exposure unit is higher. Henceforth, the premium is highly correlated (besides other considerations such as Terms & Conditions imposed by the Insurer to accept and cover a certain risk) to the Frequency and Intensity of past events recorded over time.

The rule of thumb from the “Law of the Large Numbers” may be less effective when policyholders (insureds) are independent of one another (e.g., diseases and fire occurrences can permeate from one policyholder to another if not properly contained) or because insurance consumers have individual risk preferences, time preferences, and price points for acquiring insurance. As the variety in demands increases, the potential benefit from the law of large numbers decreases because fewer people want similar types of coverage. Climate change is also driving the prediction of agricultural outcomes consistency (in terms of the time when they are due) and the level of expected yields to become less foreseeable.

Insurers usually have teams specialized in Insurance Statistics called Actuaries, which assist the Underwriters in pricing the risk and setting other Terms & Conditions.

Other important, common actors and stakeholders along the insurance value chain are:

• brokers – intermediaries who bring the buyer (the insured, i.e., the farmer), and seller (the insurer) closer together. They usually are not affiliated to a specific insurance company but procure insurance providers in the market spectrum
• agents – intermediaries like brokers, but that officially represent a specific (or more than one) insurer.
• surveyors – specialists in a particular technical field (e.g., crops, livestock, fish farming, forestry, etc.) who may be called upon by the insurer before issuing the policy, to help it better price the risk, set Terms & Conditions (or even not accepting the risk at all). Physically conducting a technical assessment visit to the potential insured’s location, and conduct an interview with the farmer, allows the insurance underwriter to retrieve information about the underwriting material facts (e.g., sum insured, security measures, professionalism of the farmer, location, past loss experiences, etc.)
• loss adjusters – like surveyors, they are called upon to visit and assess the insured location but to determine the veracity of a loss occurrence claimed by an insured, and the amount of indemnity to be paid if it is concluded the loss is valid, and no fraudulent behavior is at play. This is done when a policy is active, during its legal running period.
• reinsurers – like the farmer (insured), insurers also need to transfer their own liabilities to be able to spread risk and accept more clients as they are commercial companies, dependant on profitability. Insurers’ assets are limited and would never be enough to respond to a major systemic event afflicting a whole portfolio (e.g., an earthquake, a major flood) in case the insurer owned 100% of all the liabilities transferred to it by its clients. Reinsurers (insurers of insurers, hence Re-insurers) are usually major international corporations with geographical global operations. Major hubs where they are located are London, Zurich, Germany (Munich, Hannover), Bermuda, Singapore, Hong-Kong.

Principle of indemnity

Farmers’ crops, trees, animals, fish stock, buildings, machinery etc., are all considered hard, material, commoditized possessions (properties) which could be represented in a balance sheet’s assets.

This means that the Insured, at the time of a policy inception, has a certain financial position represented by the specific assets that are covered under the policy (i.e., for instance, an expected crop at the end of a season) at a particular point in time. We call this the “Sum Insured”.

The Sum Insured of a crop (i.e., wheat) is usually expressed in monetary terms (i.e., Euro/USD, etc.). by multiplying the Expected Yield (Kg per hectare) at season’s end (based on historical experience or averages in the region where he is located for the same crop) by a price per Kg that is reasonably accepted as representing market trends by the underwriter (there may be multiple variations to his approach though).

It also means that the insured being the individual (or corporation) owning such assets, he/her has an insurable interest (something to lose) in case an event caused by any of the perils identified in the policy and, within its Terms & Conditions, occurs. Insurable interest is the recognized legal relationship between the insured and the financial loss incurred by the insured at the time of occurrence of the insured event, according to the policy’s wording.

Agricultural Insurance is, hence, a form of property insurance.

The Principle of Indemnity states that:

• when a loss happens, the insured shall be put back into the same financial position as he used to occupy immediately before the loss, recognizing and safeguarding his insurable interest in the same
• the insured shall get neither more nor less than the actual amount of loss sustained
• risk coverage and claims payments are always subject to the limit of the sum insured, and subject to certain terms and conditions of the policy

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).

Read more 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