WHITE PAPER A PROPOSAL AND RATIONALE FOR GOVERNMENT- SPONSORED CATASTROPHIC REINSURANCE IN SUPPORT OF AGRO-INSURANCE IN UKRAINE

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1 International Finance Corporation 30A, Spaska Str., Podil Plaza, block 2, 6-th floor Kyiv, 04070, Ukraine Tel.: , Fax: WHITE PAPER A PROPOSAL AND RATIONALE FOR GOVERNMENT- SPONSORED CATASTROPHIC REINSURANCE IN SUPPORT OF AGRO-INSURANCE IN UKRAINE IFC Agri-Insurance Development Project Проект фінансується Канадським агентством міжнародного розвитку (CIDA)

2 A Proposal and Rationale for Government- Sponsored Catastrophic Reinsurance in Support of Agro-Insurance in Ukraine White Paper Table of Contents 1 Introduction Catastrophic Reinsurance Scheme Basic Requirements Recommendations...7 Illustrations Figure 1: Role of GOU CAT Reinsurance with a Trigger at twice premium collected 4 Figure 2: Potential expansion of government CAT reinsurance 4 Figure 3: Catastrophic insurance layers 5 Appendix The Negative Effects of Ad Hoc Assistance 8 1

3 1 Introduction The insurance concept is based on a principle of pooling risk among insurance participants by collecting premium (the cost to purchase insurance) to cover losses due to specific risk events that could be detrimental to one individual. Annual premium surpluses accumulate in the pool in good years to pay for losses that could exceed annual premium collected in bad years and to provide a return on investment where profit is a motivator. Each individual participating producer, through the insurance policy, is transferring or spreading risk geographically and over time (between years) to other producers and the insurance provider (company). The agro-insurance system in Ukraine is structured so that insurance polices are offered to agriculture producers through private insurance firms who are motivated by potential profit earnings. Agriculture risk is highly correlated (systemic) meaning that in many instances, insured perils cause losses to a large segment of the insured population at the same time that can generate large annual insurance payments relative to premium collected. Insurance is based on the principle of attracting diversified risks (e.g. over time, across geography, among insured perils) into the insurance pool. As risks become more correlated (less diversified) the risk pooling mechanism becomes less advantageous. Insurance companies, regardless of the business line, often transfer their risk exposures to private reinsurance or capital markets. Given the inherent risks in agriculture production, private insurance firms are reluctant to participate in agro-insurance schemes unless there is a readily-available and cost effective reinsurance market to support them. While private reinsurance options are available, there are often capacity or cost constraints for emerging agro-insurance schemes. To encourage primary stakeholder participation (producer, insurance firms) in the agro-insurance system, the Government of Ukraine (GOU) has decided to: (a) cost share insurance premiums with producers; and, (b) establish an agri-insurance fund for the system. Cost sharing producer premiums makes the cost of insurance affordable thereby attracting producers to the scheme and diminishing their reliance on ad hoc government assistance for disasters. This paper proposes to designate the agri-insurance fund as a catastrophic re-insurance system to backstop the entire system under development in Ukraine. Providing CAT reinsurance capacity (financial risk transfer for large-scale loss impacts) provides assurances to the insurance industry that ongoing access to reinsurance is available and promotes its development. Neither the private insurance/reinsurance industry nor the GOU can independently justify the necessary financial capacity to sustain a fully functioning agro-insurance system over time. Private insurance and reinsurance firms diversify their risk exposures by participating in a wide variety of agriculture and non-agriculture insurance schemes. Agro-insurance schemes must compete for reinsurance capital with other traditional and often more lucrative insurance markets. It is unlikely that affordable private sector reinsurance capacity will be sufficiently available to fully cover an enhanced Ukraine agriculture over the long term. The GOU has a wide array of social objectives and cannot overly support agriculture at the expense of other sectors even with a strong objective to foster agriculture industry expansion. Consequently, a public-private partnership in risk sharing is a logical and effective means to proceed with agri-insurance in Ukraine. The strategy proposed in this document 2

4 presents an approach that will allow effective utilization and clarity of roles for both public and private sector reinsurance capacity. 2 Catastrophic Reinsurance Scheme. A government supported CAT reinsurance scheme in the context of a public-private partnership, such as exists in Ukraine, is shown in the Figure 1. In the schematic, the horizontal lines define layers of risk within the overall insurance portfolio across the vertical coloured bar. The 100% line represents the annual premium collected from producers and government based on the cost-sharing formula currently used in Ukraine. The schematic assumes that this premium includes a load for administration and profits and for illustrative purposes this premium load is shown as 20% of the premium collected. The dotted 115% horizontal line represents a level of risk that (i) insurance companies generally retain themselves; and (ii) that reinsurance companies generally do not reinsure (too close to the risk action, i.e. little/frequent losses). Some insurance firms may prefer this line to be higher (>115) others lower (<115) and this is the reason for the line being dotted. The 200% horizontal line represents the threshold of the CAT reinsurance layer and is identical for all insurance firms and hence becomes an insurance pool at the catastrophic level only. In general, the insurance companies in Ukraine are not seeking an insurance pool for the non-catastrophic risks since they are attracted to the potential to derive underwriting profits from retaining some of this risk internally. In some situations, insurance firms may not wish to retain all non-catastrophic risks and/or they find that private reinsurance is expensive or not readily available. As an option, GOU reinsurance could be expanded below the CAT layer (Figure 2) and made available to insurance firms as part of a pooled insurance consortium to improve their purchasing power and spread their risk geographically across all insurance firms in this pool. The right hand side of figure 2 represents a blow up of the layer of risk not covered by the GOU reinsurance. Without an expansion of the GOU reinsurance, this area of risk would have to be either retained by the insurance company OR reinsured by some other means. While figure 2 represents an area where the government reinsurance pool could be expanded this is not an expansion of the CAT reinsurance. The GOU could choose to retain the CAT and optional non-catastrophic risk that they accept themselves or transfer the CAT and noncatastrophic pooled risk to the private sector. 3

5 Figure 1. Role of GOU CAT Reinsurance with a Trigger at twice premium collected 200% 115% 100% 80% 0% Catastrophic Risk Risk Excess Basic Premium Administration and Profit Basic Risk Premium Above 200% reinsured through CAT (government) reinsurance pool 200% 200% Reinsured through non-government sources or retained by insurance firm 115% 115% Exposure retained by insurance firm 0% Figure 2. Potential expansion of government CAT reinsurance 200% Retained by insurance firm or private reinsurance Potential government pool Catastrophic Risk 200% 115% 100% 80% Risk Excess Basic Premium Administration and Profit Basic Risk Premium 115% 100% 80% 0% 4

6 3. CAT Reinsurance versus Catastrophic Insurance Protection The catastrophic reinsurance protection identified in section 2 is focused on losses to an entire insurance pool when insurance claims exceed a percentage (200% in our example) of annual premium collected. If premiums collected accurately reflect full risk exposures then this catastrophic layer trigger should represent a significant loss to the insurance portfolio. Other definitions of a catastrophic loss are described in insurance products worldwide that should not be confused with a catastrophic portfolio loss. For example, CAT insurance coverage is a term used in the US system to describe risk protection offered in insurance policies to cover a production loss that exceeds 50% of expected normal or probable yields for an individual producer or the production of an area in an area-yield insurance design (Figure 3). If yields, for example, are 50% or less than the expected or probable yield, then such losses would trigger an insurance payment from the CAT layer of the insurance policy. Often, there is a different premium cost-sharing for this insurance layer (more from government, less required from the producer) than in the non-cat insurance coverage layers to encourage farmers to enroll in this insurance program. Governments use this approach to reduce demand for ad hoc assistance and/or ensure that all producers regardless of income can participate in some minimal level of risk protection. In another example, the province of Manitoba, Canada, offers a two-tiered crop insurance design in which the lowest 50% of insurance coverage is offered without a risk premium (there is a minimal administration cost) to producers. This lower level of insurance coverage can be equated to the CAT insurance coverage layer in the US system. In general, these low levels of insurance coverage are exponentially less expensive than higher coverage levels since the likelihood of a loss in these layers is much reduced. These low cost layers of insurance coverage, often described as CAT insurance coverage, are promoted by the World Bank for some client countries where the issue is to provide some level of risk protection to large numbers of producers and/or rural poor. 1 Regardless of the insurance structure, CAT insurance coverage should not be confused with the portfolio-wide CAT reinsurance protection described in section 2. Figure 3. Catastrophic insurance layers Yield (% of Probable Yield) Layer Description No loss Above average yield 100% Deductible A small yield loss 90% Base Layer A loss in the base layer 50% Catastrophic Layer A loss in the catastrophic insurance layer ; loss exceeds 50% of the probable yield 1 National Agriculture Insurance Scheme: Market-based solutions for better risk sharing. World Bank Report No , February

7 While an area-wide loss can be traumatic when yields are less than 50% of expected production triggering a claim payment from a CAT insurance layer, the entire insurance portfolio may not trigger a catastrophic reinsurance loss as defined in section 2. For example, if: the affected area represents a relatively small portion of the geographical dispersion of the insurance portfolio, the agriculture crops in the impacted area are considerably of less value per unit than agriculture crops in other areas; or risk and premium collected in the impacted area is considerably less than in nonimpacted areas, then the total annual claims in the entire insurance portfolio may be substantially less than is needed to trigger a CAT reinsurance response or any reinsurance response for that matter. 3 Basic Requirements 3.1 Defining Catastrophic Risk Given the various interpretations of the term catastrophic loss it is important to clearly define both the term and the trigger for portfolio-wide reinsurance. The definition of CAT risk is a function of the insurance design and the structure of the insurance pool. It is not possible to define CAT losses or cost of CAT loss protection (portion of premium for CAT losses) without product design and data analysis. 3.2 Stakeholder Objectives Public-private partnerships in agro-insurance is an effective approach especially in fledgling markets were neither the government nor the private sector can carry the full risk exposure of the agriculture sector. However, these two stakeholders have different objectives; namely, government is primarily concerned with developing an agriculture industry, moving from ex poste or ad hoc assistance to ex ante or planned responses to disaster situations and, when exports are an issue, tailoring their assistance to producers to international trade agreements; whereas, the private insurance industry is primarily concerned with generating profits and return on equity for shareholders as well as appearing as good corporate citizens within the society in which they operate. These different primary objectives mean that when both interests are involved and necessary to provide reinsurance capacity and other support for the agro-insurance scheme, system designers need to be cognizant of the difference and structure operating mechanics to focus on success for both parties. In addition, keeping in mind that the primary goal of agroinsurance is to assist primary producers to prosper and thus facilitate the expansion of the agriculture sector, program designers need also to proactively engage producers to ensure their agro-insurance programs are well understood and fulfill their needs 6

8 3.3 Technical Issues The insurance pool could represent a compilation of risk from many crops, perils, producers, farm-management practices, geographical areas and overtime. Each risk and or combination of risks covered by any insurance policy entering the pool needs to be assessed with identical actuarial standards. In this case, actuarial standards include not only premium rating methods but also operational procedures (e.g. appeals process, data gathering, underwriting and loss adjusting techniques). To ensure consistency and foster understanding among producer clients, insurance firms should offer a standard repertoire of government premium cost-shared insurance products with a standard insurance contract and standard operating procedures. 4 Recommendations The Agro-insurance Fund as decreed by the President is defined as re-insurance directed at catastrophic (CAT) losses. The following steps are recommended to assist in the creation of the Agro-insurance Fund. Define CAT risk with input from government and insurance firms Model portfolio risk to develop cost effective strategies to integrate private and government supported reinsurance Government sets aside a portion of annual budget for agriculture insurance to create the Agro-insurance Fund Legislation should be to allow the Agro-insurance Fund to go into a deficit position to cover losses that are beyond the funding surplus accumulated in the fund (deficit funded by government) Agro-insurance premium methods are loaded to reflect the surplus (reduced premium load) and deficit (increased premium load) position of the Agro-insurance Fund. Determine if special provisions are required to collect surplus from non-catastrophic risk to eliminate a fund deficit As products are developed; define the CAT layer of the portfolio and an actuarially sound portion of premium for CAT coverage Adjust CAT portion of premium annually in actuarial premium calculations to reflect CAT fund balance Develop risk portfolio models to effectively and equitably integrate private sector reinsurance with government CAT reinsurance Develop a suite of approved insurance designs for government premium cost-sharing with standard actuarial premium methodology and operating procedures. 7

9 Appendix The Negative Effects of Ad Hoc Assistance Agro-insurance is an ex ante or planned response to impending agriculture production shortfalls or risk impacts (some of disastrous proportions) on individual producers or groups of agriculture producers. Ad hoc assistance is an ex post reaction to agriculture disasters or perceived agriculture disasters that impact widespread areas and groups of producers. While ad hoc interventions by central governments and/or international organizations play an important role in responding to catastrophic events (e.g tidal waves, hurricanes, food shortages, terrorist attacks) they can have significant negative implications to the development and sustainability of a planned agro-insurance system. Government is a primary protagonist in the development of agro-insurance schemes and ad hoc responses to impacts of agriculture risks world-wide. Government is a functional component of society and reacts to social stimuli especially in democracies. Politicians seeking electoral support want to be seen responding to real and or perceived disasters as well as planning for the future with foresight and innovation. This dichotomy between proactive planning and reaction to events places pressure on fledgling agro-insurance programs especially those trying to utilize private sector expertise and risk capacity. While the impacts may not be as pronounced in mature agro-insurance schemes, ad hoc assistance in response to perils that are covered or could be covered under agro-insurance designs create cynicism among producers and proponents of the agro-insurance system. The impacts of ad hoc assistance on agro-insurance and agriculture in general can be obvious, subtle and/or multi-faceted. A selection of potential ad hoc impacts in no particular order includes: Disruption to government budget planning and administration - funds may have to be diverted from approved government programs to attend to the agricultural emergency robbing Peter to pay Paul and creating resentment among social strata. Borrowing from the future - Countries facing budget limitations may have to finance ad hoc expenditures creating increased pressure on loan rates to non-government sectors and/or repayment terms that impinge on future economic development and societal goals. Inequity among regions, agriculture commodities and peril situations - government budget pressures may dictate that ad hoc assistance can be provided in some instances and not in others. In one year when budgets allow, a region(s) with primary production in grains may receive assistance for a particular perilous loss while in another year another region with identical or differing crops may not. This lack of consistency, driven by unplanned responses, can generate inconsistent treatment among regions, crops and producers and create cynicism toward a system that is perceived as unfair. Reliance on ad hoc assistance - the knowledge that the government is likely to bail out affected parties creates continued reliance on ad hoc assistance and depresses the market for agro-insurance of any type. 8

10 Progressive farm management - in any agriculture setting, producers can be segmented into those that are technology leaders (adopting new technology) and those that follow. Ad hoc assistance has the tendency to maintain the status quo particularly for the majority of producers that lag behind the technology curve. Voluntary agro-insurance (with or without a premium subsidy) requires producers to make a pro-active participatory decision. They must pay a premium to transfer their risk and comply with basic farm management protocols to maintain insurance coverage. Ad hoc assistance requires no up-front commitment and often requires no pro-active farm management. Private sector involvement - insurance/reinsurance providers are reluctant to enter agro-insurance markets with highly correlated risk, low-margin returns and that require specialized technical know-how. Their reluctance is compounded by concerns that government will simply provide ad hoc assistance to producers in direct competition to agro-insurance schemes. Producer Lobbying - well-organized groups of farmers have a strong incentive to lobby the government for relief from a wide and varied number of adverse climatic and price effects. Their success leads to increased lobbying efforts and the extraction of concessions from government, particularly with the immediacy and reactivity of ad hoc assistance, is an attractive coup for agriculture leaders. Agriculture leaders, like politicians, respond to the majority of their constituents. Since many producers are followers in technology adaptation, including the use of agro-insurance, there is greater pressure on agriculture leaders in fledgling markets from producers that prefer to rely on ad-hoc assistance. Non-targeted support - ad hoc assistance, because of its reactive nature, is often not targeted to individual producers and/or regions in need. Often, the political pressures associated with ad hoc leads to an expanded, inaccurate and costly compensation environment relative to a planned response like agro-insurance. Potential for Collusion - ad hoc assistance is usually distributed through existing extension channels within government bureaucracy. In societies where corruption is more pronounced ad hoc assistance provides an avenue for collusion between potential recipients and local purveyors of the assistance. Since ad hoc assistance is often applied irregularly over time and in hurried response situations there is limited capacity to monitor distribution and/or benefit from post assistance audit reviews. While there are obvious reasons to move away from an ad hoc assistance approach to assist agriculture, there needs to be some recognition that it is difficult in a political environment for government to extricate themselves from using these mechanisms. This is particularly true in fledgling agro-insurance markets where all crops, regions and producers are not covered under developing programs. However, when governments make a concerted decision to engage in agro-insurance they need to provide a climate to proactively move forward with program development and when insurance coverage is available refrain from using ad hoc assistance. Ad hoc assistance in situations were agro-insurance is readily available is comparable to spending public funds to develop a hurricane early warning system and failing to turn it on. 9