Agricultural Insurance Must Adapt
Photo: iStock.com/SimonSkafar
Agricultural insurance is one of the most fascinating and diversified fields of the actuarial practice. Although agriculture represents only one sector of the economy, actuaries can draw on three different specialties:
- General insurance techniques for crop production
- Investment techniques for cattle price insurance
- Life insurance techniques, potentially for hog mortality and morbidity insurance
Although traditional actuarial approaches have been applied in agricultural insurance for decades, this may be coming to an end. The paradigm of historical losses as a fair indicator of future losses may no longer hold. As a result, programs that have worked well to date may need to adapt to a new future. Climate change is the new threat, and the risk is different. As weather patterns are changing, extreme events are becoming more extreme and more frequent. A key question for agricultural insurance policy is how programs can evolve to address climate change risk and preserve the financial viability of the agriculture industry. From an actuarial perspective, an added challenge will be to price the risk.
Producers understand their farm risk better than anyone, and they continue to adopt new techniques and technologies to mitigate these risks. This includes the use of drought-resistant seeds that allow plants to survive during periods of drought; intercropping, where several crops are planted in the same field to help the plants be less susceptible to disease; and precision agriculture, such as the application rate of fertilizers to accurately reflect the soil requirements of a particular area.
Farmers’ Practices Are Evolving
As producers’ farming practices continue to evolve, so must the insurance programs that support them. Currently, producers can purchase crop insurance, which provides insurance for crops that experience a loss in yield whether it is due to an insurable cause of loss in the quality or quantity of the insured crop. Producers select from a variety of coverage levels and price options. The premiums charged are the product of expected production, cultivated acreage, expected price, coverage levels and premium rates. In a near future, at least three of these factors are expected to increase materially, with compounding effects to premiums:
- Expected production due to enhanced production practices
- Expected prices due to greater worldwide demand
- Premium rates due to greater yield volatility because of the changing climate
This situation has the potential to make crop insurance programs less affordable for producers and the governments that subsidize premiums. It also emphasizes the importance of designing programs capable of offering the right coverage with the right premium.
Traditional pricing for crop insurance is relatively straightforward: It is to determine how much programs would have paid in the past under current program conditions with current benefits. Crop insurance programs are continuously enhanced to respond to industry needs. They can evolve in myriad ways, such as trending the expected production to account for technological changes, adding new deductibles to respond to producer demand or offering new benefits like quality coverage to compensate for crop grades lower than what was expected. Once historical losses are restated, other considerations, such as the number of years to include in the averaging period, stability versus responsiveness of premium rates and the size of the area associated with a particular premium rate, also are considered by the premium rating methodology.
However, there is one implicit assumption underlying all of those actuarial techniques: Historical weather patterns that have caused production and quality losses are static and represent the true risk. Regardless of whether the last 15, 25 or 50 years are used in the averaging of losses to calculate the base and catastrophic loss premium rates, the frequency and severity of extreme events are currently deemed constant.
What Happens as the Climate Changes Over Time?
As the climate changes, current premium rating methodologies may no longer produce rates in line with expected losses, simply because rates would constantly be catching up to the changes in climate events. Instead of generating premiums sufficient to cover future losses, current methodologies would generate premiums covering past losses and past climate states and potentially mask the true costs of the program. This is not good news for program stakeholders and bears the question: Is it time to shift premium rating methodologies from backward-looking historical patterns to forward-looking simulations?
Predictive climate models have evolved significantly in the past few years, especially in the area of regional climate models. Much finer resolutions, from several thousand kilometers to a few kilometers, allow for the simulation of key weather parameters like heat, rain, frost, hail and consequently drought, flood and even risk of pest infestation. Climate models now can simulate thousands of climate scenarios for regions small enough to be overlapped with soil types and topography.
The last piece of the puzzle is to translate these climate events into yields. Solutions have started to emerge as some companies have developed models that estimate the yield of a particular agricultural product based on climate conditions during the growing period. In other words, yields are estimated as a function of rain and temperature as well as other variables. There will be a time when premiums could be calculated for the various insured perils based on simulated yields using models informed by the various climate scenarios.
This is a game-changer for pricing agricultural insurance products, and at the right time, too! It means production losses compensated by the program do not need to be estimated from historical losses anymore. One can simulate climate scenarios, transpose them into yields based on current crop mixes, and calculate losses with coverage levels and other program parameters. If historical climate events are no longer representative of the future, these modeling tools can transform agricultural insurance pricing.
While premiums could reflect climate risks more accurately, incentives also could be provided through premium discounts to incent and reward environmental best practices. Currently, in most Canadian provinces, crop insurance programs charge producers the same premium rate for a given geographic area. A surcharge or discount is applied based on the historical performance of the producer; for example, the number and amount of previous indemnities. In other words, premium discounts are retrospective as opposed to prospective. Rather than waiting for several years of a producer’s historical performance to calculate a discount, crop insurance programs could shift to individual underwriting to account for individual production practices to set coverage and premiums. The base premium rate could apply risk differential factors to determine the premium for individual producers.
Actuarial Science Steps In
In time, insurance programs could offer accurate premium discounts for practices such as optimal crop rotations or for cover crops to mitigate soil degradation. This would require predictive modeling of commodity yields, in which different production practices would be analyzed to assess which ones reduce risk the most—and by how much. In the interim, incentives for using beneficial environmental practices could be offered to encourage the uptake of best practices. This is where actuarial science becomes an art: Offering a rebate for a particular practice without knowing the degree to which it could reduce a risk may be risky for the program in the short term. However, incentivizing behavior for the benefit of the environment should pay dividends over the long term.
Climate change will not only impact yields, but it also will create uncertainties around market prices and the costs of production (i.e., inputs). For instance, perfect weather conditions in some areas of the world could create surplus production and lead to lower commodity prices and consequently lower farm revenues. Wet growing conditions could require more applications of herbicides or fungicides, which would increase farm input costs.
An ideal agricultural insurance program should not just cover weather-related production risks; it should also cover price and production cost risks under the same insurance policy. Consider the model of comprehensive car insurance where collision and theft—two different risks—are covered under one policy. Over the past decade in the United States, significant progress has been made to broaden the agricultural insurance programs, where revenue insurance has almost completely replaced traditional yield protection programs.
Experimentation Is Key
In Canada, exploratory work has begun on the potential design of a revenue-based insurance program. Commonly referred to as Whole Farm Revenue Insurance, the program would provide producers with “whole” farm revenue protection. Producers would share their cropping plans before the production cycle, and the program administrator would calculate the expected production and forecast price for each commodity. Market price forecasts typically consider a variety of macroeconomic conditions, including weather, policy and international trends and demands. Barring any extreme shocks to the commodity markets, calculated expected revenue should be a fair value. Expected revenues from each commodity are the product of expected production and expected price. Then, they are rolled up at the farm level to derive the whole farm guaranteed revenue when multiplied by the coverage level the producers select. Payments would be triggered when actual revenue from actual production and actual market price is lower than guaranteed revenue.
To keep the insurance program as simple as possible and avoid complicated margin insurance products, the Whole Farm Revenue Insurance program also could incorporate an in-season prefunded adjustable coverage level. If the cost of a particular input increases above a predefined benchmark during the season, the program administrator could increase the guaranteed revenue by a specified percentage (from 70 percent to 80 percent, as an example). No supplemental premiums would be required, as the cost of this rider would be included in premiums.
Conclusion
The climate is changing. All stakeholders—from producers implementing new production practices to policymakers designing program innovations capable of accounting for climate change—must adapt. Actuaries need to adopt new techniques and embrace innovation, too. It may be possible to offer versatile agricultural insurance programs that provide comprehensive coverage under one insurance policy.
Whole Farm Revenue Insurance, with coverage based on expected revenue from a particular crop mix, can respond quickly to unforeseen climate events and ever-changing market conditions. New tools such as climate scenarios and simulated commodity yields could, on the other hand, assess future expected losses better than using historical experience. Modeling tools ultimately will inform stakeholders about potential program cost increases, so adjustments can be made before affordability becomes an issue.
The roles of actuaries working for governments are varied and not limited to statutory valuations. We provide advice to design innovative solutions to complex problems in the best interest of producers, policymakers and the public.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries or the respective authors’ employers.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the official position of Agriculture and Agri-Food Canada.