Traditional Products. The two Traditional Crop Insurance Products are: Named Peril Crop Insurance (NPCI) Multi Peril Crop Insurance (MPCI)

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1 Traditional Products Traditional crop insurance relies on the principle of indemnity, where losses are measured in the field either after the event (named peril crop insurance) or through yield measurement at harvest (multiple peril crop insurance). The two Traditional Crop Insurance Products are: Named Peril Crop Insurance (NPCI) Multi Peril Crop Insurance (MPCI) 1 Module 1A Designing Index Based Weather Risk Management Programs

2 Traditional Products Named Peril Crop Insurance Named peril insurance involves assessing losses that occur due to a specific peril(s). The claim is calculated by measuring the percentage damage in the field soon after the damage occurs, through an on-farm assessment by a loss adjustor. Advantages: Named peril crop insurance is understandable and transparent, as defined rules are used for measuring the damage and there is an agreed sum insured. Disadvantages: One of the disadvantages to named peril insurance is that it is only suited to perils causing measurable, sudden-impact damage to crops. As such, it cannot easily address drought, pest, and disease. Hail insurance is the most common form of named peril insurance and has been available in a number of countries for over 100 years (mostly in North America and Europe). Hail insurance is possible because hail damage is easily identifiable; field assessments of damage can be accurately carried out and hail losses are typically localized, rather than widespread. 2 Module 1A Designing Index Based Weather Risk Management Programs

3 Traditional Products Multi Peril Crop Insurance Multiple peril crop insurance (yield-based crop insurance ) establishes an insured yield (e.g., tons/ha) as a percentage of the historical average yield of the insured farmer. The insured yield is typically between 50 percent and 70 percent of the average yield on the farm. If the realized yield is less than the insured yield, an indemnity is paid equal to the difference between the actual yield and the insured yield, multiplied by a pre-agreed value of sum insured per unit of yield. Because it is often difficult to determine the exact cause of loss, yield based crop insurance typically covers many different causes of yield loss (multi perils). Under a MPCI policy, these contributing causes to yield loss are not differentiated, as it is very difficult to identify the set of perils that may have created the losses and then to perform a loss assessment that attempts to separate the actual loss by peril. It is often difficult to tell whether the loss was due to a weather event or to poor management practices (which is difficult to define). Therefore, multiple peril crop insurance typically covers drought, which is rarely covered under traditional named peril insurance because it is nearly impossible to isolate how much loss of yield is due to drought versus other factors. Advantages: MPCI covers all risks of loss or damage, unless specifically excluded. Disadvantages: Some of the disadvantages of MPCI is that it suffers from adverse selection (the less efficient farmers tending to insure), moral hazard (enhancement of yield loss by farmers), and high costs of loss assessment. MPCI is a more universal product type (less differentiation of technical details by crop type), and is the base product for the subsidized federal crop insurance program in the United States and most of Canada. Only in South Africa is this product not subsidized and 3 Module 1A Designing Index Based Weather Risk Management Programs

4 Index Based Products Index based products indemnify farmers based on changes in an index rather than an assessment of damage. The index acts as a proxy for yield; therefore, changes in the index should result in changes in yield. The types of indices used as a proxy for yield can vary from indices based on area yield to different weather parameters. The two Index Based Insurance Products described in the following pages are: 1. Area Yield Index Insurance 2. Weather Based Index Insurance 4 Module 1A Designing Index Based Weather Risk Management Programs

5 Index Based Products Area Yield Index Insurance Area yield index insurance pays indemnities based not on farm-level yield shortfalls but on realizations of an index that is highly correlated with farm-level yield shortfalls. Area yield index insurance pays indemnities based on estimates of the area yield. A threshold is established that is less than the expected county yield (e.g., 80 percent of the expected county yield). Indemnities are paid whenever the realized area average yield (e.g., county average yield) is less than the threshold. These products date to the 1950s when products were first offered in Sweden. Area yield insurance is also available as an insurance product in Canada (since 1977) and the United States (since 1992). India s national crop insurance program (since 1985) is based on area yields. Based on the number of farmers insured, it is the largest crop insurance program in the world with about 18 million farmers insured in The program has mixed social and market goals and the actuarial performance is quite poor (average loss ratios exceed 400 percent). 5 Module 1A Designing Index Based Weather Risk Management Programs

6 Index Based Products Index Based Weather Insurance Index Based Weather Insurance is based on realizations of a specific weather parameter measured over a pre-specified period of time at a particular weather station. The insurance can be structured so that it pays whenever rainfall or temperature is so high or so low that it is likely to cause crop yield losses. For example, the insurance can be structured to protect against either too much rainfall or too little. An indemnity is paid whenever the realized value of the index exceeds a pre-specified threshold (e.g., when protecting against too much rainfall) or when the index is less than the threshold (e.g., when protecting against too little rainfall) The indemnity is calculated based on a pre-agreed sum insured per unit of the index Index based weather insurance is most appropriate for highly correlated weather risk s like excess and deficit rainfall and excess and deficit temperature. In order to be effective, a strong, quantifiable relationship must exist between weather risk and yield loss. This is necessary to establish the index on which the contract will be based. Because payouts are based on weather data, index based insurance has relatively low administrative costs and does not face moral hazard issues. Index based weather insurance for agriculture is a growing market and increasingly being used to manage risks associated with drought, high and low temperatures, and excess rain. Some recent index based programs have been implemented in India, Malawi, and Nicaragua. 6 Module 1A Designing Index Based Weather Risk Management Programs

7 Index Based Products The Issue of Basis Risk A major concern with index-based weather risk management products is basis risk. Basis risk is the potential mismatch between contract payouts and the actual loss experienced. The effectiveness of index-based insurance as a risk management tool depends on how well farm-yield losses agree with the underlying weather index. In addition to affecting the efficacy of the product, the level of basis risk associated with the index can also raise regulatory concerns regarding the definition of insurance. This concern relates to the question of whether insurance based on a weather index can substitute for a traditional crop insurance policy and indemnify the grower for his losses. Although present in all agricultural insurance products, basis risk is most often discussed with regards to index-based products. Basis risk is a concern for all weather variables but it is particularly important for rainfall, which exhibits a high degree of spatial and temporal variability. For example a weather station on which a weather contract is based may not experience the same rainfall patterns or totals during the calculation period as the end user wishes to protect. This can be true even when the client s fields are located relatively close to the weather station. To understand basis risk, hail is a good example to consider. Hail is a highly localized meteorological phenomenon and the spatial variability of its occurrence can be quite high. In some cases, there can be variability even at a distance of a few yards. So, although it can be indexed to an observing weather station, an index-based product at a weather station may not be an effective risk management strategy for a client suffering from hail risk. Although, historically, an index and losses may correlate strongly showing that an index could be used as an underlying trigger to indemnify losses in an insurance contract a good correlation is not a guarantee that the underlying contract payout will match the actual loss experienced. Basis risk, therefore, is always an issue when dealing with an index-based risk management solution. 7 Module 1A Designing Index Based Weather Risk Management Programs

8 Which Product is Appropriate? You might be asking yourself what the best insurance product is for managing financial losses as a result of crop failure. In reality, there is no single product which is optimum in all situations. Some weather hazard s or crop types (see module 1, book B: Selecting an Insurance Product ) are extremely difficult or impossible to insure. Where a weather hazard or crop type is insurable, the most suitable product may be a named peril traditional insurance policy, a weather index insurance policy, or an area yield index insurance policy. However, for an individual-farmer, a multiple peril insurance (MPCI) policy is very rarely the most suitable product since, while popular with clients, MPCI is extremely problematic to implement, particularly in the case of small farm holders. When determining the appropriate type of weather insurance product for the client, various factors need to be considered. These include the weather insurance product characteristics, benefits, and challenges. These are discussed in the comparison table on agricultural insurance products. For example, both area yield index insurance and weather index insurance do not require farm-level loss adjustment. This, and other factors associated with these products, makes them significantly less costly to deliver and most appropriate for highly correlated risk s. However, these index insurance products require accurate, consistent, and secure measures in terms of the underlying index (i.e., either the relevant weather variable or the area yield). Also, since indemnities are based on the realized value of the index rather than on the policyholder s actual losses, it is possible that the insurance payout will not exactly match the actual loss. This is due to the basis risk which is encountered when using a weather index as a proxy for yield loss. Basis risk has been explained briefly in this section, will be discussed in more detail later in the course, and is a main drawback of weather index insurance. When considering traditional projects, there are some significant drawbacks to implementing a program. These products are particularly difficult to implement in the context of developing countries. They include: Adverse selection: the tendency for higher risk farmers to insure under voluntary participation. Moral hazard: under MPCI insurance, in particular, farmers may accentuate claim s through neglect or manipulation of yields. High underwriting costs: requirements to gather data from individual farmers to establish the policy. High loss assessment costs: high costs, and control difficulties, in assessment of simultaneous losses at the individual farmer level. The interest in both area yield index and weather index insurance arose from a recognition that index insurance offered some opportunities to overcome the constraints of traditional insurance that are stated above. 8 Module 1A Designing Index Based Weather Risk Management Programs

9 In particular, features of index insurance products can lower the threshold of insurability (which is the level of farm size and technology at which insurance is viable) required in operating traditional insurance products. Furthermore, index insurance is a product which potentially requires a lower degree of specialization in agriculture for the staff of insurance companies when compared to the more traditional products. Therefore, this insurance product can be simplified and adapted for small farmers. 9 Module 1A Designing Index Based Weather Risk Management Programs

10 Which Product is Appropriate? Initial Requirements 10 Module 1A Designing Index Based Weather Risk Management Programs

11 Which Product is Appropriate? Loss Assessment 11 Module 1A Designing Index Based Weather Risk Management Programs

12 Which Product is Appropriate? Payout and Equity 12 Module 1A Designing Index Based Weather Risk Management Programs

13 Which Product is Appropriate? Insurance Coverage 13 Module 1A Designing Index Based Weather Risk Management Programs