Drought is one of the main problems of agriculture and requires a fairly developed risk management system in any society. In the CEE / SEE region, many countries are at an early stage in effectively managing the risk of drought.
Drought is one of the main threats affecting the entire food supply chain. It is catastrophic as it can at some point spread over vast territories in many countries, leading to extensive crop shortages.
According to the research done by the Food & Agriculture Organization of the United Nations, the share of agriculture in losses caused by the drought is 83%.
What is agricultural drought, and how to identify it?
According to EDO (European Drought Observatory), droughts are commonly grouped into three basic types: meteorological, agricultural and hydrological. Meteorological drought is a period with an abnormal precipitation deficit concerning the long-term average conditions for a region. When a meteorological drought leads to a soil moisture deficit that limits water availability for crops, the result is an agricultural drought. Hydrological drought is associated with the effects of periods of shortfalls of precipitation (including snowfall) on a surface or sub-surface water supply (i.e. streamflow, reservoir and lake levels, and groundwater).
Governments use various mathematical indices to mobilize drought loss prevention and financing measures. The most popular drought index for drought definition, recommended by the World Meteorological Organization, is the Standardized Precipitation Index (SPI). This index calculates the difference between the actual rainfall and the average 30-year parameter over a specified period, divided by the standard deviation coefficient. SPI has the advantage of distinguishing a particularly flawed year from others. However, other factors (temperatures, soil types, wind speed, yield density, etc.) are not taken into account. This means that SPI is adequate for identifying meteorological but not agricultural drought.
How to predict potential losses?
Our experience in CEE / SEE with the data of individual farmers shows that drought causes yield losses comparing the average of the previous five years at the level of 20-40% for winter crops and 30-60% for spring crops.
As for the macro level, official statistics record losses of 20-30%. In the Panevezys region of Lithuania, for example, high temperatures combined with a moderate rainfall shortage in April-May 2018 were quite catastrophic for cereals and oilseed rape. In 2021, we saw a fairly rainless July-August, leading to poor results for spring crops, especially late varieties (corn, beans).
When a drought starts, it is helpful to know how much yields can be lowered to enable further risk prevention and cost minimization by all stakeholders in the food supply chain. A detailed effort is dedicated to developing high-accuracy yield prediction models at various stages of crop development.
For example, the Land and Water Division of FAO (Food & Agriculture Organization of the United Nations) has elaborated AquaCrop. This special holistic yield prediction model takes into account 4 groups of factors: climate parameters (eg. rainfall, maximum and minimum air temperatures), crop parameters (phenology, canopy cover, rooting depth), soil parameters (soil profile and the characteristics of the groundwater) and the crop growing management.
Providing drought loss mitigation measures
The IDMP (Integrated Drought Management Program) of the World Meteorological Organization suggests many measures to mitigate the effects of drought in the short and long term periods. Emergency action and financial recovery must be taken if this is not enough to mitigate losses.
For example, the summer of 2018 recorded very high temperatures, which caused droughts that affected agricultural production heavily (e.g. arable crops and animal feed) in many EU countries. The European Commission has activated several measures and derogations at the request of many Member States. Farmers in Europe faced more or less support from the national public authorities, each managing the crisis depending on its intensity but, depending on its financial capacity, exposing each farmer to significant disparities in treatment.
On 15 August, the federal government in Berlin passed a motion that allowed German drought-hit farmers to grow animal feed in ecological focus areas (EFAs). Farmers were allowed to grow a mixture of crops for feed purposes on EFAs. As for the share of private insurance, only 5,000 hectares in Germany were covered against the drought!
What private crop insurance against drought do you need? How to make it more effective in CEE/SEE countries?
At first glance, the above examples of ad hoc government activities seem like a good way to finance negative financial outcomes. Still, governments face an additional unexpected burden on the state budget and a lack of verification of the application of crop yields by farmers, leading to the ineffective public money spending. Hence, private insurance can be a way to better finance losses.
11 CEE / SEE countries became EU members in 2004-2013, following the CAP (Common Agricultural Policy), which also means subsidizing private agricultural insurance. However, the drought is poorly insured or not insured at all. Even though drought insurance is offered, there are many restrictions applied by insurance companies in terms of high deductibles, compensation sub-limits, types of crops or insured regions, etc.
Why is such a “low-risk appetite”? First, crop insurance was introduced into the CEE / SEE region by German, Italian and Austrian insurers who focused mainly on the risk of hail. Before the 2018 drought, farmers and insurers hardly anticipated the need for such protection. As a result, there is a lack of extensive experience of insurance companies in assessing the risk of drought and loss adjustment. Moreover, it is technically challenging to deal with drought loss precisely and quickly. This has a cumulative effect on large areas that require a good network of highly skilled claims experts.
At the same time, the drought is a very catastrophic threat that can exhaust the collected insurance premium for many years ahead. To ensure such a risk, an insurance company needs a sustained and waste risk portfolio to reduce the volatility of expected losses. This can only be achieved through decisive government intervention in the development of crop insurance.
Strong cooperation between the government, agricultural associations and the private insurance market (Public-Private Partnership) should create the most favourable drought insurance conditions for all interested parties. Farmers want to be well insured at the best price. The government wants financial relief on the state budget and effective targeted assistance for farmers. Insurance companies want a stable portfolio with long-term profitability.
In addition, drought insurance should be available to farmers, meaning that the government has to subsidize the insurance premiums and participate in the reinsurance loss layers. Moreover, crop insurance should be the precondition for the farmer to obtain other financial assistance. In many countries, such a measure is not so popular as such compulsory insurance can be considered a new hidden tax. However, in countries with developing insurance markets and a low insurance culture, it is a necessary step to establish a robust drought risk insurance mechanism.
Last but not least, the government should set strict conditions on when and to what extent it engages its resources in financial aid after the drought. Measures should be predetermined as a drought crisis response plan, but it does not look chaotic. On the other hand, a clear understanding of when and how the government is involved constitutes a strict line between recovery of losses from public finances and the private insurance system. As far as EU members are concerned, such activities should follow EU directives stating that government intervention should not cause unequal opportunities in agriculture between EU countries.
Parametric insurance comes into play if traditional approaches fail
Parametric or index insurance compensation is paid when the actual index (parameter) value meets a condition (trigger), compared to conventional crop insurance which compensates for a direct crop loss. The most frequently used indices (parameters) in such insurances are weather data (rainfall, temperature, soil moisture, etc.) or official statistics for surface yields. As a rule, parametric insurance is applied for risks where standard insurance does not work or the risk appetite of conventional insurers is quite limited. Drought is such a case!
In the CEE / SEE countries, such an alternative drought risk transfer tool is getting more popular among farmers, agricultural inputs suppliers and food processors. It is simple to understand, requires less paperwork, and implies fast payouts. However, there are still several challenges hindering the development of parametric insurance in the CEE / SEE region.
Drought is one of the main problems of agriculture and requires a fairly developed risk management system in any society. In the CEE / SEE region, many countries are at an early stage in effectively managing the risk of drought. In particular, CEE / SEE governments should pay more attention to the development of private drought insurance. On the other hand, new innovative risk transfer tools such as parametric insurance could be considered. Ultimately, given the large budget gaps caused by COVID and the crisis surrounding Russian military aggression, are governments again ready to compensate farmers for the heavy losses caused by the drought?
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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