Insurance of Climate Riskin Agriculture

Martin Odening

Department of Agricultural Economics and Social Sciences, Humboldt-University Berlin, Germany

Presentation at the ICAR Forum 2008

October 14, 2008, Bucharest

2

Motivation

3

Mitigation

•Reduction of Greenhouse Gases

•Immission Certificates

Insurance

Adaptation

•Crop rotation•New seeds•Irrigation

•Crop insurance•Weather derivatives•CAT bonds

Strategies for Coping with Climate Risk

4

Insurance coverage

Premium subsidies

Catastrophe aid Participation Reinsurance

Germany hail, supplementary insurance

none only for uninsurable risks approx. 35% for hail< 1% for MPCI private insurance

France Multiple peril crop Insurance

60% government aid for natural disasters (drought, earthquake, flooding)

20%private insurance

Greece comprehensive insurance

50% n.a. n.a. n.a.

Italy hail, frost, drought

50% for hail80% for MPCI

only for uninsurable risks n.aprivate insurance

Canada Multiple peril crop insurance

50% for extreme and uninsurable disasters

50% private and public insurance

Luxembourg comprehensive insurance

up to 50% n.a 10% n.a.

Austria comprehensive insurance

50% for hail- and frost insurance

only for uninsurable risks 78% for hail56% for MPCI

private insurance exclusively

Spain comprehensive insurance

55% only for extreme disasters approx. 42% private and public insurance

USA Multiple peril crop insurance

35 up to 100% only for uninsurable disasters 80% private and public insurance

Agricultural Insurance Systems

5

Source: PricewaterhouseCoopers

mil

lion

US

DWeather derivatives: Market Development

6

• no moral hazard

• no adverse selection

• no assessment of damage required (low transaction costs)

• payoffs not only in case of extreme weather events

Advantages of index-based insurance

• high basis risk

• sometimes difficult to price

• lower familiarity by users

Disadvantages of index-based insurance

Index-based Insurance / Weather Derivatives

7

1. Rainfall sum

22

1 1 1

0

T s

t mint s

I min , y y

2. Rainfall deficit

11

1

T

tt

I r

= rainfall at day t

tr= reference level for minimum daily rainfall

minr

R2 = 0.22

R2 = 0.52

3. Rainfall and Temperature

R2 = 0.85 2 23 1

0 1 2 3

1 14 5

June April

April June

I T T I

I T I T

, : average monthly temperatures for April and JuneApril Junet tT T

: deviation of a weather variable from its long-term average

Weather Indexes for Wheat

8

0

0.2

0.4

0.6

0.8

1

0 50 100 150 200Distance (km)

Cor

rela

tion

Coe

ffic

ient

estimated observed

Rainfall deficit

321 exp edeed

De-correlation function for precipitation in Brandenburg, Germany

9

0

0.2

0.4

0.6

0.8

1

0 200 400 600 800 1000 1200Revenues

Cum

ulat

ive

Den

sity

Fun

ctio

n

without option; distance 40 kmwith option; distance 40 kmwith option; distance 140 km

Pro

babi

lity

(€/ha)

Revenue Distribution with and without Hedging

10

1 ENSO – El Nino Southern Oscillation is the index measuring the Pacific sea surface temperature

Country Index type Risk level Status Comments

USA Area based crop yield Farmer level Marketed Subsidized by the government

USA Area average crop revenue Farmer level Marketed Facilitated by commodity markets

Canada Area based crop yield Farmer level Marketed

India Area based crop yield Farmer level Marketed Subsidized Mandatory if linked to credit

India Cumulative rainfall Farmer level Piloted and marketed Linked with credit

Mongolia Area average livestock mortality rate

Farmer level Piloted Governmental intervention on the certain trigger of herd loss

Mexico Cumulative rainfall Public reinsurance program

Piloted and marketed

Mexico Vegetation National level Marketing stage Purchased by the government

Ethiopia Cumulative rainfall National level Piloted Financed by the World Food Program

Malawi Cumulative rainfall Farmer level Piloted Linked with credit

Uganda Cumulative rainfall Farmer level Contracts are actually designed

Kenya Cumulative rainfall Farmer level Contracts are actually designed

Tanzania Cumulative rainfall Farmer level Contracts are actually designed

Nicaragua, Honduras, Guatemala

Cumulative rainfall National level Contracts are actually designed Not adopted

Vietnam Cumulative temperature / Flood level

Farmer level Contracts are actually designed Not adopted

Ukraine Soil moisture / Air moisture

Farmer level Piloted and discontinued

Peru ENSO 1 based Farmer level Contracts are actually designed

Morocco Cumulative rainfall Farmer level Piloted Not adopted

Overview about Practical Experiences with IBI

11

• Factors determining the demand for IBI- Risk exposure of the farms- Hedging effectiveness of the instrument- Risk attitude of the decision maker- (Non) Existence of effective alternative risk reduction instruments- Transparency of insurance products- Cost of insurance- Policy environment

Preconditions and Success Factors of IBI in Agriculture

12

• Factors determining the supply for IBI- Cost of insurance product development- Cost of delivery- Cost to control adverse selection and moral hazard- Cost of loss adjustment- Market potential and volume- Risk premium- Political, legal and institutional factors

Preconditions and Success Factors of IBI in Agriculture

13

Indicators for the Potential of IBI in ECA Countries (1)

Aspect Indicator Rationale

Importance of agriculture Share of agriculture in GDP Value of agricultural production Share of agricultural labor

What is at stake?

Structure of agriculture and agricultural production

Number of farms Number of commercial farms Average farm size and distribution Acreage and value of the 3 or 4 most

important crops Number of 2-3 most important livestock

Size and fragmentation of demand side; Identification of most important products; Diversification potential

Yield risk Average, range and volatility of per hectare yields of the top 3 products based on time series (at least 10 years) of yield data at lowest regional level

Assessment of yield risk exposure

Weather risk Average, range and volatility of rainfall sum (annual or during main vegetation period) based on time series of at least 10 years

Assessment of weather risk

Spatial heterogeneity of weather

Number of (micro)climate zones Estimation of geographi-cal basis risk

14

Aspect Indicator Rationale

yield Products Regional level (country, state, region) Length of time series

Data

weather Type of weather data Length of time series Number of weather stations

Informational basis for construction of indexes

Financial sector Number of banks / branch banks Financial depth (money supply to GDP) Financial leverage in agriculture (debt /

total assets) Farm capital per hectare

Potential interest in IBI Vulnerability w.r.t. risk

Insurance sector Number of (re)insurance companies Insurance premia to GDP Agricultural insurance programs in

place

Penetration of insurance and infrastructure for supplying policies; Potential interest in IBI

Legal environment and agricultural policy

Existence of (agricultural) insurance law

Share of subsidies in farm income Existence of direct payments

Income stabilization by alternative measures

Indicators for the Potential of IBI in ECA Countries (2)

15

Country Importance of agriculture

Fragmentation of agriculture

Yield risk Weather risk Spatial hetero-geneity of weather

Availability of weather data

Development of financial & Insurance sector

Legal environ-ment

Albania High Highly fragmented Low Low High Good Medium Moderate

Armenia High Highly fragmented Moderate High Moderate Good Medium Moderate

Azerbaijan Medium Highly fragmented High High High Good Medium Moderate

Belarus Medium Collectivized Moderate Moderate Low Medium Medium Bad

Bulgaria Medium Sharply dual Moderate Moderate High Medium High/Medium Good/Moderate

Croatia Medium Highly fragmented Low/Moderate Moderate High Good High/Medium Good/Moderate

Georgia High Highly fragmented Moderate/High Low High Good Medium Moderate

Hungary Medium Sharply dual Moderate Moderate Low Good High/ Medium Good

Kazakhstan Medium Sharply dual High High High Bad Medium Moderate

Kosovo High Highly fragmented Moderate Moderate High n.a. Medium Moderate

Kyrgyzstan Very high Normal Moderate High Moderate Bad Medium Moderate

Macedonia High Highly fragmented Moderate Moderate High Medium Medium Moderate

Moldova High Sharply dual High High Moderate Good Medium Moderate

Romania Medium Normal Moderate Moderate High Good Medium Moderate

Russia Medium Sharply dual High High High Bad Medium Moderate

Serbia High Highly fragmented Moderate Moderate High n.a. Medium Moderate

Tajikistan High Sharply dual High High Low Medium Medium/Low Moderate

Turkey High Normal Moderate Moderate High Good High/Medium Moderate

Ukraine Medium Sharply dual High High High Medium Medium Moderate

Uzbekistan High Sharply dual High High Moderate Bad Medium Moderate

Factors Influencing the Potential of IBI in ECA Countries

17

good

poor

low high

Bulgaria

Hungary

Croatia

Uzbekistan

Azerbaijan

Tajikistan

ArmeniaFYR of

Macedonia

Belarus

RussiaTurkey

Albania

Georgia

Serbia

KosovoKyrgyzstan

Ukraine

Demand for IBI

Preconditions for establishment of IBI

2 4

31

Romania

Moldova

Kazakhstan

Portfolio Analysis for ECA Countries

18

Weather constitutes one of the most important risk exposures in agriculture; it may hamper the economic development of the agricultural sector

Farmers: awareness of risk and active risk management

Insurers: supply of tailored and affordable insurance products

Science: rigorous evaluation of existing pilot projects; design and rating of index-based weather insurance

Governments/donors:- Improvements in legal and regulatory environment- Improvement in data collections- Assistance in product development- Knowledge transfer and educational efforts- Financial support for the coverage of catastrophe losses

Conclusions & Recommendations

19

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

<=2% 2.1-5% 5.1-10% >10%percentage of revenue

perc

enta

ge o

f th

e po

lled

far

mer

multiple peril crop insurance index-based drought insurance

Willingness to pay for Weather Insurance in Germany

20

actuarially fair price (= expected payoff) = 13.5% of the insured revenue

Premium loading = 20-25% surcharge on the fair price depending on the type of insurance

Insurance premium = fair price + loading = 16.54% of the insured revenue

WTA exceeds WTP => emergence of insurance market is unlikely

Cost of Weather Insurance

21

4200

4400

4600

4800

5000

5200

0 1 2 3 4k

Pri

ce

Wheat producer in Brandenburg

Seller

SaxonyThuringia

Actuarially Fair Price Crop rotation in Brandenburg

Indifference Prices for a Put Option on a Weather Index in Different Regions in Germany (in €)

22

Profit

Short future

Weather index on expiration

Present index value

a) F

utur

esb)

Put

-Opt

ion

Profit

Weather index on expiration

Strike

Production revenue

Hedged position

Hedged position

Production revenue

Long put

Hedging Strategy Using Weather Derivatives

23

Success Factors / Preconditions for IBI

Indicators

Theoretical Analysis Experiences with IBI

Quantification

‘Portfolio Matrix’

Aggregation

Data on ECA

Pre-Assessment of Feasibility of IBI in ECA

Recommendations for Donors / Goverments

Methods and Data Sources

24

recoveries

insurancepremium

farm

insurance transaction

insurer investor

weather bond price

principal & coupons

compensation

payment when weather event occurs

unconditional payment

securitization

Securitization of Weather Risk