Building Agribusiness Risk Management System: Strategy and Stages of Development Roman Shynkarenko Agricultural Insurance and Risk Management Consultant Most Ukrainian experts in agricultural risks insurance rely in their works on an analysis of the present state of agriculture in Ukraine and on an overview of the insurance system adopted in the Soviet Union (e.g. insurance programs run by Derzhstrakh, the state-owned insurance monopolist). Some specialists have taken the trouble of analyzing insurance systems existing elsewhere, but a mere replication of somebody else s experience in Ukraine s conditions is impossible for a number of reasons. Analysis of international practices demonstrates that, as of now, no country in the world can claim to have an effective, transparent, and independent system for hedging agricultural risks. There are countries which offer insurance of a limited number of risks, or where insurance is available only from private companies. In other countries, such as the USA, Canada, and Spain, the government spends a lot on insurance subsidies. Ukraine and other NIS countries need to find their own ways to design their systems taking into account limited financial resources, technologically outdated agrarian sector, and often underdeveloped system of agricultural produce marketing. Lack of analytical material with a comprehensive and practical approach to building a system of agricultural risk insurance in Ukraine is why the Agribusiness Development Project specialists wrote this and other articles on the subject. This article aims to present an overview of options available for developing a system of agricultural risk insurance. The author outlines the main principles underlying such a system, such as the optional nature of insurance, rules of the government s involvement in and interference with the process of managing damage caused to agriculture by catastrophic risks. The government s involvement in the creation of such a system may take a much broader range of forms than currently exist in Ukraine, and the author attempted to consider different forms of governmental support. The overview is intended for use by stakeholders and experts involved in the development of an agricultural risk insurance system in Ukraine. Development Strategies and Stages Having an agribusiness risk insurance system in place is a driving force for sustainable development of the agribusiness sector. Insurance - the transfer of risks to another party for a specified fee - is just one of many risk management strategies, which should be used only once an agribusiness company has identified all risks it can potentially incur and has selected those it would like to insure. Typically, insurable risks include bad weather conditions and the risk of falling short of profit targets. This article discusses the main stages of developing an insurance system for the agribusiness sector, and forms of governmental support available to agricultural risk insurance. Overall on a global scale, agricultural producers consider bad weather, price fluctuations and legislative changes as the highest risks facing a company. Results of surveys undertaken by the www.agroinsurance.com Page 1 of 7
International Finance Corporation in 2002 and 2003 show that agricultural businesses in Ukraine indicate that prices, changes in legislation, and weather conditions are major risk factors. Considering that the legal framework in Ukraine is not yet fully formed and market infrastructure does not yet meet the needs of agribusiness, insurance companies cannot be expected to have the capacity to help the state manage such risks. Moreover, Ukraine s insurance sector in its current form cannot offer effective weather risk management tools. Agribusiness is an important part of almost any economy. Often the government provides support for both producers and insurance companies. The purpose of doing so is to develop an insurance infrastructure, standardize terms of insurance, improve quality of insurance services and to cut the cost of insurance for agribusiness users. International practices offer a variety of methods to develop an agribusiness insurance system: - Insurers provide insurance services and receive no government support (Sweden); - Financial aid is provided to cover catastrophic losses (Germany, Italy, USA, Canada); - Government takes part in reinsurance pools (Portugal, Spain); - Subsidized premiums on some insurance products (hail, spring frosts etc. in Spain, France, Austria); - Subsidized multi-risk insurance programs (Canada, USA etc.) 1. Government bodies design insurance systems for the agribusiness sector in consultation with professionals involved in the commercial insurance sector, and normally this is done in several stages outlined in this article. It is important to note that insurance systems are never static. The systems evolve, practices and mistakes get analyzed, and then governments in cooperation with insurance companies try to find the best solution to design effective and affordable risk management instruments. Such reforms have been carried out in Greece, Italy, Canada, USA and some other countries. Adoption of the Common Agricultural Policy (CAP) and subsequent cuts in agriculture subsidies will shortly bring about striking changes in the insurance systems of EU countries. Key Principles of Agribusiness Strategy and Insurance System The need for government involvement. It is important to remember that there are no countries with 100% solid governmental support for agribusiness insurance and risk management. Not only does government support entail costs for the national budget, but also more often than not it causes distortions in the sector and often results in the mismanagement of funds ( rent seeking ). The voluntary nature of participation. Mandatory agricultural insurance has always been perceived by producers as one more tax to pay, therefore it is important to provide for other incentives in agribusinesses and to make insurance voluntary. 1 See Risk Management Tools for EU Agriculture with a special focus on insurance, January 2001. www.agroinsurance.com Page 2 of 7
Clear rules should be set for governmental involvement (assistance) in the case of catastrophic risks. This kind of assistance should not be mandatory but establish clear eligibility criteria. The allocation of such aid must be fair and free from administrative bias. In other words, everyone who has sustained a loss and meets appropriate requirements should be eligible for indemnity. Overview of major insurance programs Single risk insurance. Commercial companies have a proven track record of providing singlerisk insurance and insurance of a set of risks without any support from the government (e.g. hail insurance). Multi-risk insurance. Such programs require thorough preparation and zoning. Often governments have a number of ways to render support for these programs. Governmental support however should not be used to push out commercial insurers from the market. The government may support insurance products for strategically important industries and/or types of agricultural produce. Index insurance. This type of insurance is based on various indexes (weather parameters, yields, cattle epidemic etc.). This is a relatively new type of insurance available in some countries. It can easily be supported by the government, since it requires lump-sum, low costs. Potential forms of governmental support All forms of governmental support that are listed below should be evaluated based on their effectiveness depending on the situation in the country s insurance sector, the goals and objectives of governmental support, and consequently, their impact on the state budget. All of these forms of support have their strengths and weaknesses. International experience demonstrates that it makes much more sense to introduce simple crop insurance for specific risks, which the state budget can afford, rather than undertake large-scale programs with limited budget resources. Investments in infrastructure. The government funds the development of insurance products, actuarial calculations, and installation of up-to-date meteorological equipment. Coverage of administrative costs. The government covers part of or all costs of the administration/monitoring of agricultural insurance contracts. With this support, insurance companies will have the incentive to promote products which are strategically important for the government, as well as other commercial insurance products in rural areas. Subsidies to insurance premiums. The government reimburses a portion of insurance premiums on separate insurance products for insurers in cases where agricultural businesses cannot afford to pay for the actuarially grounded cost of insurance. www.agroinsurance.com Page 3 of 7
Subsidization of payments on catastrophic insurance products. The government covers the cost of catastrophic insurance products in full (e.g. loss of entire harvest due to a catastrophic event), where coverage is low. This form of governmental support is more effective than ad hoc payments in catastrophic events, improving the producers insurance culture. Catastrophic programs are good for planning contingency reserves in a clear and timely fashion. Involvement in funding catastrophic pools. The government forms and accumulates a fund, either together with insurance companies or alone, to make payments from on catastrophic risks. This form of assistance can help to identify clearly the terms on which help is provided as needed. Involvement in/establishment of reinsurance pools. The government is involved in or establishes reinsurance pools, from which funds are disbursed to insurance companies to compensate clients for a loss they incurred. These companies can act as intermediaries for the reinsurance of large risks overseas. Governmental involvement can help to speed the process of establishing a standard for insurance procedures and claim processing, and to identify insurance priorities. Once financial stability and a sufficient level of reserves are achieved, the government may withdraw from pool management and limit itself to overseeing operations. This helps to utilize governmental resources in a more efficient manner without losing control of the situation in the sector. Financing/establishment of a service of independent underwriters and insurance arbitration. Parties in insurance sector frequently face controversial cases, and insurers often have little opportunity to make sure that the amount of loss and compensation are assessed in an accurate and unbiased manner. Therefore the availability of independent experts ensures stability of the insurance system and its credibility in the eyes of insurants. Agribusiness Insurance Development Stages Analyze the Agribusiness Sector At this stage, it is important to perform an analysis of the agribusiness sector, its opportunities, challenges, and improvement potential. It is necessary to determine the direction which it is going to take and competitive advantages over other countries, and to outline main strategic sectors of agricultural production from the standpoint of government policy and national food safety. It is critical to determine the share of primary agricultural production and processing in Ukraine s GDP, maximum deviations, quantitative indicators of agricultural produce output in measurement units (tons, liters etc.), as well as in national currency and USD. These data can help to assess the potential need of the agribusiness sector for insurance products. It should be taken into consideration that insurance is one of many risk management strategies available, therefore not all agricultural and processing businesses will want buy insurance products. In the United States, where the government heavily subsidizes insurance premiums, only 20% of farmers are involved in insurance programs, which provide insurance protection for 75 crops. In Spain, the government provides heavy financial support for agribusiness and insurance companies, too, but only 31% of www.agroinsurance.com Page 4 of 7
agricultural firms choose to enter into insurance contracts. There companies offer their clients 58 insurance programs for agricultural crops, livestock and aquaculture. In Canada, where the government covers 50% of insurance program costs, only half of all farmers buy policies from insurers. Determine major risk types and risk factors This stage requires a general analysis of the agribusiness sector (a risk profile) by risk type and origin. It is important to list the most serious risks, their potential effects and the recorded scope of damage. In addition, it is necessary to draw a risk profile of an average agriculture enterprise, including the level of agricultural technology used, production output, and models of financial and operational management. The highest weather risks should be identified and distributed by country regions. A risk map like this will help to make risk management programs more accurate and to design region-specific insurance products. The collection and processing of statistical weather data are very important, and will be used later to design (determine) adequate insurance products, insurance rates and requirements for insurance and reinsurance pools. It is best if weather data are available in an electronic format, which makes them easier to work with and speeds the process of designing the appropriate products. Identify the market for agribusiness insurance Using sector analysis data, one can evaluate a potential market for insurance by sector, including grain crops, vegetables, fruits, vine-yards, livestock, the level of involvement (number of insurants) and an estimated cost of insurance. These data can be used to calculate an estimated cost of insurance products depending on insurant involvement, the cost of setting up the system, as well as the level and form of governmental support. Key partners, clients and users of insurance services Banks and other financial institutions, which provide loans to agricultural firms, form partnerships with insurance companies in developing the insurance system. Solid insurance programs can lower collateral requirements (in Ukraine, banks use the collateral ratio of 1:2 or 1:3, and more), and help form stronger business relationships between finance institutions and agribusiness clients. In addition, it is necessary to analyze the existing forms of cooperation between financial institutions and insurance companies and key products finance professional use (or would like to use). Evaluate the insurance sector This stage calls for an analysis of the insurance sector: the number of companies operating in the market, the number of those involved with agribusiness, and the performance of insurance companies. It is important to give a critical look to insurance products available to the agribusiness sector and to gauge the needs of potential clients. www.agroinsurance.com Page 5 of 7
The analysis of the insurance sector should also include an assessment of insurance demand and the clients credibility. These data form the basis for formulating an agribusiness insurance development strategy and deciding on a model of governmental involvement and support. Assess the legal framework This is necessary to identify existing policy challenges and to plan law-making activities in order to create an appropriate regulatory framework to stimulate development of insurance. Once the conception of agribusiness insurance development is in place, it will be necessary to finalize the changes and addenda to be made to existing legislation so as to ensure maximum legal support for innovative insurance products and measures in the sector. The majority of the CIS countries, such as Ukraine, Russia, Moldova and others, face regulatory barriers hampering the development and introduction of new insurance products, such as index insurance, based on regional index yields and weather parameters. Accordingly, government agencies and policy makers, using consulting support from insurance companies, may assist in ensuring the timely adoption of regulatory documents necessary for the improvement of insurance business. Assess reinsurance potential An analysis of the reinsurance sector is important for making an adequately assessment of the riskbearing capacity of the doemstic insurance sector, and the options and terms of reinsurance available on international markets. The analysis can show what steps are needed to make sure that insurance rules and procedures on the domestic market meet reinsurers requirements. Assess and monitor the insurance system In developing the strategy, it is important to determine which insurance products are most suited to the needs of the agribusiness and insurance sectors. Then it is necessary to decide which of them are the most profit-making and productive: the conventional (single risk and multi-risk) insurance products or index-based ones. Index-based insurance is a new type of insurance, with some great strengths and specific weaknesses in comparison with conventional insurance. Some very advanced and successful agricultural firms need individually tailored insurance programs; therefore it is impossible to create an insurance product to meet the needs of all potential clients. However, standard products help to create basic instruments, which, if needed, may and will be customized to meet the clients needs. Therefore, insurance experts and government officials involved in the creation of agribusiness insurance system and planning government participation, should take into consideration other countries experience and their country s potential and use all available information to produce a sound strategy. While implementing insurance system or large-scale insurance products, it is very important to inform potential insurants about new products and those existing in the market, as well as about insurance procedures and terms. International experience demonstrates that the availability of governmental support and initiatives in financing and insurance is encouraging for directors of agricultural firms in improving their land use practices and increasing production. Another way is to improve the methodology of collecting statistical data and financial reporting among farming businesses. All of these changes can contribute considerably to the improvement of business www.agroinsurance.com Page 6 of 7
practices in agrarian regions by increasing financial stability and individual income levels both in rural area and across the country. The on-going monitoring and close scrutiny of insurance program outcomes can change or finetune insurance terms or insurance products. Taking such an approach can facilitate the employment of funds from the national budget, if the government provides the financing, and those of farmers who pay for their insurance. The government should invite insurance experts to perform the monitoring and analysis and hold consultations with representatives of insurance companies on a regular basis. We understand that the creation of agribusiness risk insurance is a large-scale and labor-intensive process. Ukraine does not have a system of sound agricultural insurance as yet, but it is our hope that, once the stages for the development of an appropriate insurance system are completed and a professional assessment of potential insurance products and forms of governmental support is made, the government and the insurance sector in Ukraine will be able to build an agribusiness risk management system capable of addressing complex issues facing the agribusiness sector. Bibliography: 1. Development of Farm Finance and Insurance System in Ukraine: Strategy Elements. Victoria Yakubovich, Agroaspect, Kyiv, 2002; 2. Development of Farming Sector Insurance: Choosing the way. Victoria Yakubovich, Agroaspect, Kyiv, 2002 3. Government support of agriculture producers: Canada case. Victoria Yakubovich, Agroaspect, Kyiv, 2002 4. State and prospects of development of agriculture risk insurance in Ukraine: analysis of survey findings. Victoria Yakubovich, Agroaspect, Kyiv, 2003 5. Multi-risk insurance. Farmer insurance government support programs in USA. Victoria Yakubovich, Agroaspect, Kyiv, 2003 6. Market for current weather risk management tools and trends. Roman Shynkarenko, Agroaspect, 2003, Kyiv 7. General principles of risk management in agriculture production and marketing. Roman Shynkarenko, Agroaspect, 2003, Kyiv 8. Risk Management Tools for EU Agriculture with a special focus on insurance. Report of European Commission, Agriculture Directorate-General, Directorate A. Economic analyses, forward studies, evaluation. January 2001. 9. Risk Management in Agriculture: a discussion document, Executive summary. DEFRA,UK 2001 10. Selection of papers. Approaches to Income Risk Management in OECD Countries. Workshop on Income Risk Management. OECD, Paris. May 15-16 2000 11. Selections of papers. Risk Management. Paving the Way Forward for Rural Finance. An International Conference on Best Practices. Washington, June 2-4, 2003. www.agroinsurance.com Page 7 of 7