How can an entrepreneur, whose production is grain dependent and the raw material prices have a fundamental importance in his economic calculation, find himself in this situation? Fortunately, if the risk we want to protect is somehow related to future and uncertain events, such as weather conditions, it is possible to design insurance covering this risk.
Every entrepreneur in his activity accounts for the risk of delays and lack of supplies that hinder or prevent production. The reasons for such conditions may be manifold. Some are typical for insurance risks (fire, flood, theft, IT system failure), and others have a more complex cause (e.g. bankruptcy of a key supplier, change in raw material prices). While securing the risks from the first category is quite common and does not pose any problems, the latter is typical risks related only to running a business, and standard insurance does not cover such events.
In the food industry, raw materials prices for production (most often agricultural products) during the year often and significantly deviate from the contract prices established when concluding a supply contract and estimating production costs. While the reduction in prices, occurring rarely and to a small extent, has a positive impact on the producer’s margin, the upward shift is a significant impact on the profitability of production of such enterprises as, for example, mills, feed processing plants, oil producers, meat plants. You might think that the profitability of any production activity is heavily dependent on the prices of raw materials, but for agricultural produce, price volatility can surprise even very experienced entrepreneurs.
Necessary Conditions for Parametric Insurance
Agriculture is a specific activity in which the productivity and effects of work depend on weather conditions. The more unusual the conditions are, e.g. prolonged winter, cold spring or dry and hot summer (recently observed due to progressive climate changes and the accompan
ying weather anomalies occur more often), the greater the negative impact on crops.
On the other hand, increasing globalization, also in agricultural markets, means that the situation in the local market may not have much in common with the current situation in a country. In many cases, global events have a dominant influence on the valuation of raw materials. Crop shortage occurring in globally exporting countries, associated with a smaller supply of grain in the market, affects prices everywhere. This is the situation in 2022. The poor harvest of cereals in the largest producers and exporters – Canada, Russia and the USA – caused an increase in prices on world exchanges. Increases by over 30% y / y are amplified by speculative actions of investment funds, which, not surprisingly when analyzing the market situation, buy consumer cereals for later resale. Seeing the sharp price changes, local individual farmers refrain from selling their production, counting on a higher price within a few months.
While crop shortages occurring locally, e.g. in one country, can be compensated by importing raw materials (cereals, corn, soybeans) from abroad, there is no simple alternative when the problem concerns a larger area. We had to deal with this situation this year – an additional element that made it impossible to supplement the shortages of raw material were sudden weather phenomena in Europe during the summer. In 2021, the number of hailstorms doubled the number of hail falls recorded in 2019, which has, so far, been the most violent period in the history of measurements. In addition highly increased the number of hailstones of the largest sizes, above 5 cm in diameter.
The main reason for the increase in prices was the lower cereal yields in the Northern Hemisphere, which resulted from weather factors. Cold and wet spring delayed plant vegetation, while the following hot and dry summer significantly reduced cereal development and the formation of appropriate grain quality. All of this resulted in a drastic reduction in crop yields and a supply deficit in the grain market, leading to increasingly higher prices.
Rescue in Parametric Insurance
How can an entrepreneur, whose production is grain dependent and the raw material prices have a fundamental importance in his economic calculation, find himself in this situation? Fortunately, if the risk we want to protect is somehow related to future and uncertain events, such as weather conditions, it is possible to design insurance covering this risk.
Assuming that the main factor we fear is drought (which is not local and most often covers large areas) and standard crop insurance is not available for producers other than field farmers, the solution is index (parametric) insurance. Parametric insurance is the optimal solution in many cases reluctantly accepted by insurers as part of standard solutions, e.g. the risk of drought for crops on poor-quality soils or spring crops.
Regardless of which parameter we take as the basis, the condition for triggering liability is the change of this parameter resulting in a decrease in the insured’s income or profit. The parameters for constructing an insurance index may vary, but each of them must have the following features:
Parametric Insurance in Practice
An important feature of parametric insurance is also the simplicity associated with the conclusion of the contract and its service (loss adjustment). In the case of weather parameters, the risk is estimated based on historical data, and the amount of information requested from the customer is limited. For this reason, this type of insurance is ideally suited to simplified sales models, e.g. through applications, even mobile. It is possible to structure the offer so that the client, also through the application, finds out that the risk occurred and he is entitled to compensation. He can report the claim with one click, and the payment is automatic.
In the case of a cereal processing company under consideration, drought risk affects the raw material prices the most. Therefore, the insured parameter could be the number of rainy days in the insurance period. Like rainy days, we can define those days with rainfall of min. 0.5 mm. In such a solution, compensation will be due if the number of rainy days (with rainfall above 0.5 mm) in the insured period is lower than the established limit, which means the risk of drought is more likely.
Parametric insurance is the best solution for a processing plant that expects protection against the risk of changing prices of the raw material or even a lack of supplies. In many cases, it is the only one available to the client whose needs are so non-standard not fulfilled by typical insurance available on the market. Thanks to the compensation from the index insurance, the client obtains additional funds for the raw material purchase at a higher price than the existing suppliers. The client also has the opportunity to purchase grain on the free market at current prices or may cover losses if it is not possible to buy it.
A similar insurance model may also apply to clients operating farms, who also experience price changes. A higher purchase price of grain means that in the next season, the cost of purchasing seed material will be much higher because the price of the raw material accompanies proportionally higher costs of storage and seed treatment. By using insurance based on the client-farmer index, the client-farmer gets the opportunity to compensate for losses caused by risks not be covered by the standard insurance, or its conclusion would depend on many factors that are not always influenced by the client-farmer (e.g. cultivation in a field with appropriate valuation class, reaching the appropriate stage of development by plants before the beginning of the insurance period).
As can be seen in the above examples, index insurance offers the possibility of protection in those situations where standard terms and conditions and standard insurers cannot help the client. Index insurance has multiple development opportunities if we consider the impact of climate change on agricultural activity, related uncertainty and the inability to use the standard insurance offer. Although due to their different structure, they may seem complicated, from the perspective of the ease of their conclusion and handling (claims settlement), they are a unique alternative to standard insurance.
This article is a part of our Foodprint publication focusing on issues and risks facing the Food & Agriculture industry. Read the publication and learn more about insurance solutions and the growing importance of risk management and alternative solutions like parametric insurance.
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Jacek Chojnacki
Practice Leader
Food & Agriculture GrECo Poland
T +48 609 600 960