Risk management in agriculture for natural hazards

Publication´s abstract

The paper provides a policy framework for why weather insurance may be a suitable as well as solid analytical approach that clearly illustrates characteristics and potential applications of the new instruments. In addition, the volume provides the economic and statistical details needed to fully understand the design and operation of these new instruments.

The paper discusses the following topics:

• A policy framework focused on the specific features of risk in agriculture and the limitations of traditional risk-management tools. Two common problems make the social cost of traditional crop insurance challenging: 1) the correlated nature of crop disasters, meaning a large number of insured will generally suffer losses at the same time; and 2) the high transaction costs of monitoring the insurance on individual farm yields because the insurer cannot control adverse selection and moral hazard. The case is made for why weather derivates can be used to remedy these problems.
• The second chapter illustrates in more detail the development of weather insurance. It provides a brief history of the weather market, together with a description of the various stages of developing such contracts: the identification and quantification of the risk exposure; the acquisition, analysis, and control of production and meteorological data; and the contractual structure needed for users given the host countries’ legal and regulatory environment.
• The third and final chapter focuses on weather insurance programmes in Canada, Mexico, Ukraine, and India. These four applications use weather data for the instruments. The Appendix introduces experience in Canada and Spain that uses satellite imagery to index and indemnify for extreme conditions for pastureland.

Conclusions:

• Index insurance products offer some hope for dealing with problems associated with monitoring and high transaction costs to mitigate moral hazard and adverse selection problems that plague traditional multi-peril crop insurance.
• More work is still needed on the basis-risk issue. The conceptual thinking to date focuses on the use of risk aggregators who could, in turn, develop both formal and informal mechanisms for mitigating basis risks. This could be a mutual insurance company or simply become the function of banks to give contingent loans to individuals who suffer hardships when the index insurance does not pay. Developments and other institutional arrangements to mitigate the basis risk that may accompany index insurance products need further consideration.
• The notion of blending index insurance instruments with the banking community merits more serious consideration. Once again, banks should be well suited to handle small event risks that are generally associated with basis risk.
• Numerous innovations can emerge from the concepts of index-based insurance. For example, ongoing work in Mexico examines the extent to which index insurance contracts can be used to hedge the inflow of water from the stream that feeds an irrigation reservoir.
• The approach to cover extreme catastrophic events via what is termed a Disaster Response Product (DRP) provides a suitable structure for disaster response without undue transfers and in a fashion that may not create market distortions.
• Pooling arrangements to retain as much risk within the country as possible are crucial before going to the international reinsurance markets. Once such have been organised, the consortium of insurance companies participating in the pool can more effectively approach the global reinsurance market for a stop loss.
• The concept of layering risk written on a standard basis, using the same rate-making procedures, opens many possible avenues for securitising weather risks.