The use of parametric index insurance in agriculture

Heard of parametric insurance?  We learnt a great deal about this interesting topic after catching up with Hub partners, Russell Mehmet from Willis Towers Watson (WTW) and Jonathan Barratt from CelsiusPro about a collaboration they are working on as part of the Australian Government Future Drought Fund Innovation Grants Program.  If your production income is affected by weather, then this topic should be front of mind!

Words, definitions, and explanations that describe how a parametric index insurance contract or weather certificate can be used in agriculture can seem complicated. But essentially, parametric index insurance are insurance contracts that help recover production costs and protect production income so you can continue in your operations.

As Network Partners of the SQNNSW Hub, Queensland Farmers Federation (QFF), UniSQ, CelsiusPro and WTW have been exploring the use of parametric insurance options in agriculture. A current two year project funded through the Australian Government Future Drought Fund Innovation Grants Program is exploring ways to minimise income volatility during drought. Researching the appropriateness of various insurance structures in agriculture is a key aim of the project.

There are two types of insurance used in agriculture: indemnity and non-indemnity. Indemnity policies take the form of traditional insurance covers such as fire, storm and tempest, hail etc., for buildings, machinery and contents; often these are referred to as ‘Farm Pack’ insurance.  These covers require proof of loss and a loss adjuster to value the claim. The process before a claim is paid can be lengthy, stressful and may not meet the immediate needs of the farmer when an adverse event has just occurred, and cash flow is critical.

Then, there are non-indemnity policies, such as parametric index insurance, which cover events that cause the losses. Rather than insuring the value of the machinery for example, the insurance covers the value associated with inputs or yield (the farmer chooses). The insurance is structured on the probability of an event occurring that causes damage. No proof of loss is required, and payouts are quick.  The policies are bound by predetermined parameters (triggers and thresholds), all agreed up-front when you purchase the policy. If the parameters are met, the policy is triggered, and a payout is made. Claims are processed quickly, which means farmers have income in the immediate aftermath of an event to meet the challenges of re-establishing the farm’s income flow. These policies are further broken up into two subgroups that cover catastrophic events like cyclones, floods, droughts and yield-reducing events like frost, heat, and quality downgrades.

Generally, farmers tend not to buy insurance to protect catastrophic and yield reducing events. The main reason is that insurance policies are hard to come by, don’t exist, are too expensive or government may partially fill the gap with a disaster recovery grant. However, our research into parametric index insurance is providing further clarity for our comprehension of the best application of these types of policies in agriculture.  For example, we know from discussions with farmers that in broadacre farming, a producer is prepared to invest $300 per ha of inputs to farm a crop that is hoping to return $900/ha. But what if, during the season, events such as a frost/heat spell occurs, the rains dry up or it’s a wet harvest? The potential to realise the $900 is reduced significantly. Then, the question to be answered is how the farmer can insure these risks and what is an acceptable premium to pay. If a farm business were to increase that investment to $330/ ha to include the cost of a parametric index product, there would then be the ability to offset that risk and protect production income.  Each season is different, and each farm has a different set of circumstances. The design of a policy needs to be flexible enough to meet the risks the farmer feels are important to them for the season.

The process of developing insurance structures involves sitting down with a farmer to develop a structure best for them. We ask questions about the priority risks in growing a crop. This information can be used to inform a policy that can be built from the ground up that addresses their priority crop risks.  The result is an insurance policy that is customised to the farm site, affordable and addresses perils that are current for the season. The risks a farm faces from season to season can change and parametric index insurance contracts have the flexibility to adjust to the changing needs of your business.    

The Bureau of Meteorology declared an active El Nino as a significant climate driver for the season ahead causing many farming communities to turn their focus towards a potential drought. One adaptation measure for drought that broadacre farms might undertake could be to reduce hectares under planting to conserve resources for when conditions improve. However, sometimes, this may not be a luxury farmers can afford, so farming continues. As the season progresses, so too do the costs. So, it’s important to be able to recover these costs should conditions turn from dry to drought and then from an average dry period to a 1 in 100-year event. Returning to our example, the farmer decides to sow a crop in a forecasted dry season. The required policy needs to cover the lack of rain from sowing through to flowering when the plant needs moisture the most.

According to our research, farmers want a policy where payouts escalate as the season progresses as more inputs are applied and the crop becomes more valuable. Intuitively, an insurance policy like this makes sense. Based on farmer input and using Insurtech, an affordable parametric index insurance solution on 22 farms in the Australian wheat belt was modelled.  The dry season policy lasted the entire season and was to be triggered once pre-determined levels of (lack of) rainfall were reached.  Using 40 years of crop data, further research looked at the effectiveness of the policy over the modelled crop data if the insurance was purchased by the farming business for 40 consecutive years.  Five specific efficiency tests were used, and, in all the regions, the results implied that the use of a parametric dry season policy was highly effective in reducing income volatility for all the farms tested over a forty-year period.

This is just one example where parametric index insurance can benefit farming businesses. Additionally, we know that when farming businesses remain viable through periods of extreme climate variability, so do their industries and the communities they support. The project team is continuing to undertake research in other industries as to how parametric index insurance solutions can aid primary producers mitigate different risk profiles.  It’s all about rolling up our sleeves, a bit of shoe leather, and, more importantly, continuing to listen to farmers about their needs.

For more information, visit the project website.