The recent drought in the US has drawn attention to the niche but rapidly growing crop insurance market, writes Helen Yates.
There has been a lot of debate over whether last year’s US dustbowl was caused by climate change. A report from the National Oceanic and Atmospheric Administration (NOAA) Drought Task Force and the NOAA-led National Integrated Drought Information System claims it was not. Instead, the ongoing drought was caused by a “sequence of unfortunate events which conspired to create a four-month sequence of record rainfall reduction over the central Great Plains”, found the report.
In spite of the report’s conclusions, scientists predict that climate extremes will become more common in the future as a result of human-induced climate change. This has big implications for the whole agricultural sector. Intergovernmental panel on climate change (IPCC) scientist Kevin Trenberth, climate analysis chief at the National Centre for Atmospheric Research, says last year’s drought in the US was “natural variability exacerbated by global warming. That is true of all such events from the Russian heat wave of 2010, to the drought and heat waves in Australia”.
Experts predict there will be increasing volatility in crop yields and prices over the coming years thanks to changes in weather patterns. Last year for instance, researchers from Stanford and Purdue universities found that climate change’s impact on corn price volatility could far outweigh the volatility caused by changing oil prices. This has implications for all the stakeholders in the agriculture value chain and is something insurance can increasingly protect against.
Impact of the drought
The worst drought in 50 years in the US blighted 70 to 75% of corn and soybean production. It produced the highest-ever crop insurance losses of US$11bn, including pay-outs from the federal multi-peril crop insurance programme, according to Swiss Re’s Sigma report. Yet because US agriculture is so strongly subsidised and because the insurance industry is currently swamped with capital, the drought has not led to a rise in premium rates.
“The magnitude of the loss in the US crop market last year was equivalent to a one-in-30 to 35-year event,” says Julian Roberts, executive director of agribusiness and weather risks at Willis. “Oddly enough however, because the structure of the US crop insurance market is determined in advance by federal procedure and is substantially subsidised, the net effect has been for prices to remain unchanged or even fall, which is counterintuitive given the size of the loss.”
Other markets are far less subsidised than the US. Here any significant fluctuations in yields must be borne by the producers and others along the chain, such as regional traders and exporters in addition to lenders. Traditional crop insurance products protect against either the loss of crops due to natural disasters (crop-yield insurance) or the loss of revenue (crop-revenue insurance) as a result of a decline in food prices.
Adverse weather – including drought, flood, hail, freeze and windstorm – is the primary cause of catastrophic crop losses, the cause of more than 90% of crop losses in the US. “The main perils are too much or too little rain and too much or too little heat in addition to which you might add the mechanical and physical damage from wind and flood; and there’s hail of course,” says Roberts. “Hail is the godfather of crop insurance. It’s been around in Europe in various forms for a couple hundred years. The other major concerns are pests and diseases which are sometimes insured and sometimes not. They are included in the US multi-peril programme for the most part.”
While cover for hail is common and generally available, multi-crop insurance – which covers all kinds of weather events including hail, flood and drought as well as pest infestations – is more complicated and hence commands higher premiums. This type of cover is often subsidised by governments.
Weather index products
Index-based crop insurance products are becoming increasingly popular thanks to fast, effective and efficient claims-settlement processes. “Farm-based insurance conventionally requires somebody to measure something, which makes it time-consuming and costly. How much neater, therefore, would it be if you could perhaps take a data stream from a satellite that happens to be passing over and say: ‘It’s red, green or blue’ and work out a payout on the basis of that?” says Roberts.
“Index-based programmes adopt that approach. If it’s a weather index programme, which we do a lot of, you must first establish the pertinent weather parameters,” he continues. “An obvious index might be a simple measure of total rainfall in the crop area. If drought is a principal component of what you’re worried about at a given location you could say: ‘Rather than measuring bushels of grain on the farm why don’t we agree amongst ourselves that x% less rainfall than normal is worth y million dollars to you’.”
“Determining and calibrating an index which achieves the most robust relationship possible with expected loss is essential,” he adds. “Index-based products confer fantastic simplicity of operation but have the potential disadvantage of so-called ‘basis risk’ if not calibrated properly.”
Here basis risk can present a particular problem within micro-insurance. This is the risk that a farmer, or producer, experiences a loss but an insurance payout is not triggered because, for instance, there has not been enough of a drop in rainfall to warrant it.
Insuring the value chain
Applying the laws of supply and demand to changes in crop volumes, it follows that prices – for the most part – should go up when yields fall. By applying these principles, insurers are able to offset, or hedge, their risks and offer innovative revenue protection products that take some of the volatility out of the equation.
“The US programme has a very large exposure to crop prices because much of the programme involves revenue protection, being the combination of both yield and price,” says Roberts. “The insurer can then hedge its commodity price risk in the market. So this works well in the US where reference can be made to a traded market for commodities like corn and soya on, say, the Chicago Board of Trade.”
“The way we’re looking at it is that it’s really affecting the whole agri value chain,” says Christina Ulardic, head of market development Africa at Swiss Re Corporate Solutions. “If you have a storage operation and you count on a certain marketshare coming from a certain region, if that region production wise is short your margins will be hit as well. And it goes all the way to the traders. If you get a certain tonnage from a certain region, if that tonnage is reduced by 50% your revenues – what you handle – will be reduced as well unless you can diversify and you substitute.”
“Insurers are less in the commodity price business,” she continues. “We at Swiss Re do offer revenue products that would be a combination of changes in terms of volumes – from yield shortfalls for example – in combination with price fluctuations at liquid commodity exchanges. We can only do that in combination with volume and we need liquid price discovery mechanisms – then we can cover the price component. If you cover volume and price in combination you’re essentially hedging revenues.”
While commodity prices will continue to drive the growth of crop insurance in the well-established markets, there are growing opportunities in emerging markets where currently, insurance penetration is very low. Increasingly, insurers and reinsurers have sought to diversify their exposure to the US crop insurance market by taking shares of the developing crop insurance markets in regions such as Asia, Latin America and Africa.
The biggest challenge in these markets is access to data and modelling, but the appetite for risk transfer products is growing, thinks Ulardic. “On the African continent a lot of agriculture is rain-fed and a lot of agri value chain players are faced with the fact that subsistence farmers will not invest,” she says. “They will not invest out of fear of losing their produce in rain-fed agriculture. If you want somebody to take up inputs you need to make sure those people are financially protected.”
She adds: “Governments are very supportive of stable income streams in rural areas, and as agriculture becomes more commercial, everyone wants better living standards, more profit, and more mechanised agriculture, etc. For that you need to have a stable income. Insurance takes out some of the volatility.”