Tools of Risk Management in Agriculture

Tools of risk… M. Łozowski

Tools of risk management in agriculture

Mieczysław Łozowski,

Ph.D.,

ZdzisławObstawski,

Ph.D., M.Sc.

Department of Economics

WestPomeraniaUniversity of Technology inSzczecin

Mieczysław Łozowski, Ph.D., Zdzisław Obstawski, Ph.D., M.Sc.

Department of Economics

WestPomeraniaUniversity of Technology in Szczecin

Abstract

The result is that natural disasters or episodic diseases and pandemics may cause, especially for insufficiently reassured insurers, significant problems with solvency. Often a solution is appropriate reassurance programmes or, as a last resort, the state support, for instance by disaster funds. If reassurance or state guarantees are not available, the character of mentioned systemic risks influencing agriculture make insurance companies take high premiums, appropriate for building appropriate capital reserves. The effect may be a situation when many farmers cannot afford to pay a premium.

Key words:therisk, management, agriculture,insurance, subsidy, fond.

1. Introduction

Insurance, according to many specialists, is the best tool of risk management. For a risk to be insurable, among others two basic requirements must be met:

Tools of risk… M. Łozowski

management of adverse effects of an “unsymmetrical situation”[1] and overcoming implications of a “systemic risk”, in particular in agricultural and disaster risks, consisting in suffering losses by many people at the same time. The result is that natural disasters or episodic diseases and pandemics may cause, especially for insufficiently reassured insurers, significant problems with solvency. Often a solution is appropriate reassurance programmes or, as a last resort, the state support, for instance by disaster funds. If reassurance or state guarantees are not available, the character of mentioned systemic risks influencing agriculture make insurance companies take high premiums, appropriate for building appropriate capital reserves. The effect may be a situation when many farmers cannot afford to pay a premium. Therefore, it should be explicitly stated that all programmes of comprehensive agricultural insurance may need a strong diversified support of the public sector.

Governments in many countries support the creation of crops and livestock insurance systems, treating it as a form of subsiding and supporting the development of agriculture. Then, the insurance of basic crops often functions as an obligatory insurance or in connection with loans given to farms, both regular ones and often partly refunded by particular governments. They are a security of borrowed capital against the effects of unpredictable random incidents[2]. Moreover, in many countries so-called disaster funds are decreed and managed every year. All assistance of that kind is given on the basis of a disaster declaration.

2. The most important tools of risk management in agriculture

Two basic strategies should be included in proper risk management in agriculture. They concern production diversification programmes or the strategy of risk sharing and risk transfer, such as participation in mutual funds and insurances, commercial insurance, production contracts or futures. The listed instruments, in

Tools of risk… M. Łozowski

particular insurance, used within a coherent programme of agriculture protection against the effects of natural disasters, are the main subjects of this study.

Mutual funds and insurances are owned by participants. If mutual funds are organised regionally, their advantage is that farmers organise their own control decreasing a moral danger and undesirable selection. A disadvantage of regionally organised mutual funds is a danger that many or all farmers will suffer losses at the same time. It may be noticed that, e.g. in Poland, they are not always sufficiently organised to found an effective mutual fund structure.

The greatest threats for the agricultural production and production facilities in the European countries include external climatic and environmental conditions, such as: intensity of precipitation, unfavourable temperature distribution, humidity, and the frequency of plant diseases and pests. Those factors cause hurricanes, hailstorms, droughts, fires, flooding and frosts, as well as other natural disasters[3]. At the same time there is a discussion going on among specialists concerning defining new threats for agricultural production. They include, threatening not only agriculture, climatic changes with quite high certainty caused by man and, more and more often mentioned as a big risk, unknown influence of genetic manipulations on the environment. The mentioned threats may work on different levels, which eventually can almost always have a negative impact on crops[4].

But not only negative effects of climatic risks influence, in our region, the development of risk management methods in agriculture. They are mainly dependant on fulfilling many criteria influencing and shaping the insurance market, including

Tools of risk… M. Łozowski

political, technical, social and economic ones, as well as the co-operation of the market participants, i.e. public and private sectors, insurers, reassurers, and farmers.

It should be noticed that the agricultural branch in Poland and the European Union is continuously being influenced by external factors connected with agricultural policy and the announcement of reduction of subsidies and subventions. In view of external competition and increasing costs of insurance coverage, it may threaten economic foundations of the European agriculture.

The main advantage of funds over ad-hoc help is that they are not dependant on budget shortages. It should be noticed that such an interference in the insurance market may adversely influence the development of insurance products market in agriculture. Table no. 1 presents the typology of insurances offered on insurance markets.

Table 1. Specificity and typology of insurance used in agriculture

Source: Own study based on the analysis of the report: Agricultural Insurance Schemes, European Commission, Directorate General JRC, Joint Research Centre ISPRA, Institute for the Protection and Security of the Citizen, Agriculture and Fisheries Unit, Summary Report, 11/2006,

Table 1 shows a type of insurance classified as “crop insurance” despite the fact that some of them are locally called multi-risk insurance and cover all main climatic threats (plant diseases and pests are not usually covered).

In European crop insurances, it’s necessary to establish which risk caused a loss, whereas American MPCI insurance includes crop losses as a result of pests and diseases, and losses are calculated simply as a difference between a guaranteed and actual yield. The European system has higher costs of loss compensation, but helps to minimise and avoid moral risk, one of the biggest problems of the American insurance system.

It should be noticed that an index insurance is based on a common index adopted for a given area. In area and crops insurance a compensation is paid to a farmer and a trigger depends on a statistical annual yield in previously defined area, usually an administrative unit. An area and income insurance is based on an yield from an area multiplied by a price in a given area. If an average yield/income in this

Tools of risk… M. Łozowski

area is below a certain threshold, all farmers in this area insured for this crop receive compensations. Indirect index insurance does not concern an average yield in a given area but a meteorological index or satellite images. Whether derivatives can be included in this category of insurance.

3. Review of agriculture protection in selected countries

3.1 Review of agriculture protection in countries outside the EU

Risk management tools, such as insurances and future market, are highly developed in North America. In the USA there are no insurances for particular risks but crop insurance covers most risks – from basic or disaster coverage (CAT), which guarantees 50% of an average farm’s crops, to 80 or 100%. Live stock insurance is not much developed. The USA and Canada has also developed revenue and income insurance.

In the USA there are both revenue and income insurances. 73% of premiums come from revenue insurance products, which include: area indexed revenue insurance; live stock prices insurance; gross margin live stock insurance, and the whole farm income insurance. Three standard revenue insurance products are Crop Revenue Coverage (CRC), Revenue Assurance (RA), and Income Protection (IP). The most popular is CRC, which offers the possibility to keep a higher price if a market price increases. The products concern main field crops: maize, soy beans, wheat, rice, cotton. Livestock Risk Protection (LRP) covers losses generated by a drop of prices for pigs, meat cattle, and fattening cattle. Livestock Gross Margin (LGM) protects gross margin between the value of fattening pigs and the cost of used fodder (maize and soy flour). Reference prices come from the future market. They protect against prices oscillation during a year. In the insurance of the whole farm income Adjusted Gross Revenue (AGR) information from a planter’s tax past is used in order to establish a level of guaranteed income. This insurance covers losses in

Tools of risk… M. Łozowski

income both in planting and breeding if less than 35% of a farm’s income falls on animal production. For AGR-lite insurance, available in a limited area and similar to AGR, producers are qualified regardless their income from animal production. GPR, or Group Risk Plan, is based on crops from an area, whereas GRIP, or Group Risk Income Protection, on “revenue from an area” (an area yield multiplied by a price). In 2004, policies concerning yield from an area and revenue from an area encompassed 7.4% of the whole insured area, but less than 3% of premiums.

About 17 private companies deal with crop insurance in the USA. They operate in an agreement with the Risk Management Agency USDA. About 45% of field production is insured (23% in the EU). An average premium rate is close to 9%, a lot higher than in Europe (4%), mainly due to the fact that they offer a wider coverage: revenue or yield insurance versus mainly insurances of one risk or combined risks. The subsidy to premiums is US$1,900 million (58% of all premiums). The US government also provides funds for administrative costs of insurance companies and ensures reassurance. Thus, the total support for insurance is 72% of all premiums (in the EU about €500 million = 32% support). In the USA, price risk protection is also achieved by counter-cyclical payments established in the Farming Act of 2002, provided that goods prices fall below an intended price.

Canada has a revenue programme based on a stabilisation account: CAIS (Canadian Agricultural Income Stabilisation). The programme was launched in 2003 and it replaced two earlier programmes: NISA (Net Income Stabilisation Account) and CFIP (Canadian Farm Income Program). Farmers annually pay a certain amount to individual stabilisation accounts, which they can use in a year of high losses. CAIS, based on a farmer’s production margin, is a programme for the whole farm available to qualifying farmers regardless a kind of production. The government subsidise the fund when producers take money from their accounts. The programme presently includes the coverage (60%) of a negative margin. The system is mainly operated by public insurance agencies. The subsidies from the federal government

Tools of risk… M. Łozowski

and province governments amount in total to €425.5 million (about 66% of premiums).

Area indexed insurance was tested for several years in such countries as the USA, Canada, Brazil, and India[5].

3.2. Review of agriculture protection systems in the EU countries

Risk management tools, such as mutual funds, disaster funds, or ad hoc payments are used in most countries. Ad hoc aid is often organised in a form of compensation programmes or funds, partly financed by the farming sector. There are also public subsidies and/or reassurance support in a direct provision of insurance or a public security network, as it is the case in Greece or Cyprus. Agricultural insurance is promoted in countries where the law forbids compensating losses that could be insured by ad hoc means or disaster funds. For example, in Spain, Austria, Portugal, Greece, and Sweden there are no payments from public funds if insurance is available. In France, the payments cover losses incurred as a result of risks or which there is no insurance or it has not been considerably dispersed. In Romania, public payments are transferred to farmers if they have insured “standard risks” such as hail.

In countries particularly exposed to unfavourable atmospheric factors and where agriculture, due to its fragmentation, needs cheap and simple insurance protection solutions are used, in various forms, consisting in protecting basic plant production against effects of casualties. In West European countries about 90% of a premium for crops ale located in a hailstorm risk, and 10% in other risks. In Spain, the government co-operates with farmers’ unions and insurance companies in operating the system. All insurance companies operate in a cartel in a co-insurance regime. In other countries, such as Austria, France, Italy, and Luxembourg, an insurance system is well developed and the majority of risks are covered depending

Tools of risk… M. Łozowski

on agreements. In the majority of countries, there is a basic coverage for hail and additionally crop insurance covering the most important risks.

Table 2.Review or organisation of crops insurance in selected countries

Source: Own study based on E. Wojciechowska Lipka, Przesłanki do budowy systemu ubezpieczeń polskiego rolnictwa na wypadek klęsk żywiołowych (Reasons for building an insurance system of Polish agriculture for natural disasters), AGH, Warsaw 1999, E. Wojciechowska-Lipka, K. Rojewski, L. Rybak, Ubezpieczenie upraw w USA (Crop insurance in the USA) Prawo, Reasekuracja, Ubezpieczenia (Law, Reassurance, Insurance) Warsaw 2002.