As agribusiness continues to grow and become more globalised and competitive it requires new risk management solutions, says Dr Roman Hohl

Agriculture is one of the largest single industries in the world with revenues of $1.5trn in 2004 at farm price, and is steadily growing.

Expanding global demand - but more notably, globalised supply side competition - has lead to increasingly intensive farming methods based on high yielding monocultures. Wheat production has doubled over the last 30 years. Global poultry production is currently over seven times the level of 1970, as livestock production has soared. Production levels of fish farms have grown at average rates of 10% per anum since 1990 and is the fastest growing food industry, now providing 30% of all global fish consumed.

Insurance cover has been available to farmers for well over a century.

It has been good business overall. Insurance premiums globally stood at around $7bn in 2004, with some $1.4bn of that being forwarded to reinsurers.

As a percentage of total global output, however, the figure is proportionally very small, for a number of reasons, including:

- Ad-hoc government disaster relief payments, state-administered insurance schemes, together with wider price/quantity support, are all in competition with the insurance and reinsurance sector;

- Many emerging and developing markets have little insurance history or risk management culture, an unreliable statistical base, and an unfavourable legal framework;

- Established agricultural insurance products, despite their widespread use, have complex and expensive loss adjustment procedures. Underwriting requires a detailed data exchange, good insurance expertise, and extensive administration. The cost of such schemes can be so high that farmers cannot afford coverage without (sometimes substantial) government subsidies; and

- Systemic perils, such as drought, are currently only partially covered, and are particularly expensive to insure. The 2003 European drought cost around EUR13bn in damage to agricultural and forestry production - very little of this loss was insured. The 1988 US drought is estimated to have cost agriculture and related industries $40bn, some of which was insured.

Expanding insurance coverage to fully cover systemic perils would markedly increase risk exposure for insurers and reinsurers, and could potentially create subsequent capacity squeezes in the industry.

THE TRADITIONAL WAY

Any form of agricultural insurance and reinsurance has to structure itself around the risk found at the farm gate. Established insurance products have focused on two key risks, price and production. Price risk is the difference between farm input costs and final product revenue. The highly globalised nature of commodity markets can cause notably unpredictable price patterns. Production risk refers to shortfalls resulting from severe weather, pests and diseases, epidemic livestock and fish diseases, and forest fire. Related to price and production risk is investment risk.

The need to constantly invest in modern production techniques requires funding. Banks providing those funds will often insist the farmer purchase insurance to secure loans through yield shortfall covers.

Hail coverage has been offered as standard for various crop types and has been expanded to include other specific natural perils for specialised crops. Multi peril crop insurance (MPCI) programmes cover the risk of yield shortfalls through a wide spectrum of natural perils, including drought. They are largely used in North America, but are gaining importance in Europe, South Africa and Latin America. Due to the nature of systemic perils such as drought, and the vulnerability of the exposure, the high premium rates charged for MPCI policies nearly always require government subsidies and high deductibles. Crop revenue insurance, as practiced in the US, provides yield shortfall and/or market price protection.

Livestock policies usually cover base mortality of cattle, pigs and poultry, with a growing demand for business interruption, and possible trade restriction cover following outbreaks of epidemic diseases. Aquaculture insurance protects fish farms against all risk mortality; and installations and equipment against natural hazards. With growing investment in timber plantations, forest owners are seeking to transfer key exposures to fire and windstorm risk from the insurance sector.

Such established insurance techniques have mainly focused on the individual farm. The assessment of low probability/high severity events in agriculture is difficult, particularly given the short time-series data available to the insurer - the industry cannot (yet) rely on probabilistic loss models as used in the catastrophe insurance market. Non-compulsory insurance schemes often face anti-selection and moral hazard, especially if systemic perils are covered. There are further concerns in the industry regarding the potential of intensifying weather patterns over the longer term.

NEW SOLUTIONS

The challenge for insurers is to broaden their existing range of agricultural risk management solutions to design products covering different risks and reaching more clients. Such products are already being developed.

On the production side, index yield programmes are based on the aggregated output of a commodity over a wide area. By definition, aggregated index programmes are risk management instruments for larger production entities, governments, grain elevators and rural banks that depend on stable geographic crop production over a wider area. Fruit transporters, packing houses and storage places are likely to be increasingly interested in yield index covers, as production levels become more volatile through an increased reliance on monocultures. Such schemes, although still small in number, have been implemented in Canada and Australia.

Weather index programmes have been inspired by the energy industry. The indemnity is directly linked to a parametric weather index measured by a dense network of weather stations over a wider area. Such covers have relatively low administration costs, and high accuracy, if crop yields are highly correlated to the index over the crop cycle.

Whilst weather covers are attractive for larger agribusinesses, small-scale farmers remain conservative in risk management, given both subsidised insurance premiums and the localised nature of farm production. Structures linked to rainfall deficits are in place in countries such as Mexico, Canada and India, hedging larger farming communities and provincial authorities against drought losses. Their implementation is supported by the World Bank as part of rural development products in developing markets. According to a weather market survey by PricewaterhouseCoopers in 2004, the agriculture sector had the second largest percentage of inquiries about weather risk management.

Additional capacity to the agricultural industry may come through the capital markets, most likely in the form of weather index covers. In the longer term we may also see agricultural cat bonds covering future yields in key markets.

GOVERNMENT INVOLVEMENT

The role of government is crucial to the functioning of the agricultural industries. In mature markets co-operation between government and the insurance and reinsurance sector is well established. Government subsidises the farmer's premium, reduces ad hoc disaster payments, and shares the risk and administrative cost with the insurer. The insurer in turn actively manages the major loss element of the farmer's risk.

Much maligned agricultural support schemes, such as the European Union's Common Agricultural Policy, are shifting away from production subsidies to single farm support payments (based on previous subsidy payments).

Part of the policy restructuring pressure has come from the World Trade Organisation (WTO), with its ambitions of opening agricultural sectors.

Of note is that under WTO rules, agriculture insurance premiums are regarded as production-independent (referred to as a "green box instrument"), and can be subsidised by government. The development of state programmes and insurance pools that protect their members through outward reinsurance are set to gain in importance in emerging markets in Asia, Africa and parts of Latin America.

With only a small proportion of global agricultural output currently insured, collaboration between government and insurers and reinsurers, together with new insurance solutions may play an integral part in the development of an industry that is still, strategically, economically and politically, crucial to many countries. Collaboration and innovation means progress in this key sector.

- Dr Roman Hohl is underwriting manager for Agribusiness at Converium.

MAJOR GLOBAL AGRICULTURAL LOSSES (Both insured and uninsured)

- The 1988 US drought cost agriculture and related businesses some $40bn.

- The drought and fires in Europe during 2003 are estimated to have cost around EUR13bn in agricultural and forestry losses.

- Compensation costs to livestock farmers of the 2001 foot-and-mouth outbreak in the UK stood at £1.4bn. The wider costs to the rural economy were around £9bn.

- The direct cost to Canadian livestock farmers of the 2003 BSE epidemic stood at CA$3.3bn, with further estimated costs to the wider economy put at CA$1.8bn.