Topic 6: Tools for mitigating risk
Shauna Phillips
School of Economics
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High degree of production risk- ABARES report Hatt et. al (2012)
High degree of production risk variation within agriculture- ABARES report Hatt et. al (2012)
Types of agribusiness risk
› Output side
– Product destruction (fire, hail, etc.)
– Product yield variability (drought, flood, etc.)
– Product value deterioration, due to quality deterioration and/or adverse price variation
› Input side
– Supply variability – Price variability
Yield V price risk (Hatt et. al 2000)
› More options for farmer to hedge price risk than yield risk. › Why?
– Yield risks less systematic than price risks, so higher degree of customisation is required for yield risks management option
– Moral hazard
– Adverse selection-asymmetric information
Nature of price risk (Kingwell, 2000)
› Price risk faced by Australian broad acre farmers:
– price risk across time and across commodities
– underlying distributional form of prices faced by farmers has important ramifications for farm management
› Many broad acre farms in a financially sound position, but less than a fifth have annual farm cash incomes of more than $100,000.
› Relatively low cash incomes in combination with sound equity position: suggests farmers don’t see value in expenditure on price risk management.
› Furthermore, they may not have the time or resources to profitably commit to price risk management.
Nature of price risk (Kingwell, 2000)
› Larger farms with large cash incomes or large cash expenditures are more likely to invest in price risk management.
› Price risk management more common in cotton production that broad acre farming in Australia.
› Irrigated cotton farm has approx. 4 times the annual expenditure of broad acre farm and 20 times its cash income.
› Hence cotton industry has more incentive to manage price risk to cover greater cash costs and to protect farm profit. Also, cotton growers need intra-seasonal cover because of their potentially large short-term borrowings to finance a crop.
Hypothetical distributions for wheat (Kingwell, 2000)
› Wool and wheat prices not the typical bell-shape: distributions are positively skewed (greater chance of receiving a low price but brief periods of very high prices).
• Storable commodities tend to have price distributions that are positively skewed- infrequent price spikes
Price risk varies through time
› Price risk associated with any particular commodity or enterprise changes through time.
› For example1970 to 1983 wheat price variability was greater than that for wool. The reverse was true for 1984 to 1997.
› Hence, the price risk faced by a farmer depends not only on the main enterprise of the farm (eg wheat versus wool) but also on the period during which the farmer is responsible for managing the farm.
Price correlations (Kingwell, 2000)
› Broad acre farming combines several enterprises. Correlations of price movements of the commodities move together can weaken or strengthen the effects of price risk.
› Price movements are not perfectly correlated. Wool and wheat have off-setting price movements.
› Lupin prices not strongly correlated with wheat or wool price movements.
› So, a portfolio of enterprises with off-setting price movements will lessen the overall price risk
faced by the farm business (next lecture).
› But reducing price risk is one of many management targets and enterprise selection is influenced by other agronomic considerations.
Are farmers using price risk instruments?
› ABARES farm survey (1997): most grain farmers in Australia did not use any of the newly available price risk instruments
› Historically, farmers accepted the pooling and averaging provided by marketing boards.
› 4 per cent of farmers used futures and options
› 25 per cent used some forward selling to lock in a price for their harvest.
Are farmers using price risk instruments? Hatt et.al. (2012)
› Many farmers self-insure and buying insurance would require a change in their cash flow management practices
› Do farmers trust modelling? › Fear of basis risk.
Risk-handling techniques
› Loss or risk control (avoidance, loss reduction, loss prevention, diversification) – Applied to idiosyncratic (farm specific) risk management
– Diversify geographically (operate farms in different rainfall zones)
– Diversify by mixing various crops and livestock on their farms.
› Risk transfer (insurance, hedging, contracting, limited liability) – Applied to systematic risk management
› Loss financing (External: insurance, hedging. Internal: retention, self- insurance)
– Applied between idiosyncratic and systematic risk types
Loss or risk control
› Loss prevention: reduces the frequency with which losses occur
– Management responses to limit losses; for example, implementing a monitoring
programme for pest/disease outbreaks – Includes simple avoidance
› Loss reduction: reduces the severity of the loss, if it does occur – Loss limiters; for example, automatic fire-sprinkler system
Loss or risk control
– Most basic loss limitation action is keeping duplicate back-up copies of key data/files in various locations
– Physical separation of at-risk assets: might space collection of fire-vulnerable buildings/assets out in a given area to prevent fire spreading
– Includes diversification actions: might plant wheat and canola in order to spread the commodity price risk to revenue
– Although, diversification can be costly, particularly on farms where commodity diversification might require different equipment
Risk transfer
› Refers to a variety of techniques that a manager can use to shift the financial responsibility for losses away from their organisation/firm/farm
– Transfers can be made to risk-bearing financial institutions, under contractual arrangements, or under limited liability arrangements
– Transfers of risk occur when one party lowers their risk by shifting it to someone else, often for a specified price e.g: futures and options contracts and crop, fire and hail insurance.
› Risk-bearing financial institutions adopt a specified risk in exchange for some fee
– Insurance agencies adopt specified risks, at the cost of the respective insurance premium
Risk transfer
› Contractual transfer agreements
– Might be that all risk for losses is transferred at some stage of the sale/marketing channel process; for example, when the product exits farm gate, the farmer no longer has responsibility for losses
› Limited liability
– Firms/farms may be set up under a limited liability doctrine, so that losses of the business may not be attached to the personal assets of the owner
Loss financing
› When firms/farms are unable to transfer risk to third parties, or control their exposure to risk, they need to find a way to pay for their losses
– Might be achieved through external means: via some forms of insurance and/or hedging activities
– Self-insurance and risk retention require development of internal mechanisms, such as savings or credit, to cover losses
– Within a large organisation, unexpected losses in one area might be covered by profits in another
– Many farmers have Farm Management Deposits as a tax effective way to save for difficult years.
– Many farmers have off farm investments in property and stocks.
Choosing an appropriate risk handling technique
› Low frequency, low severity losses
– Usually absorbed by firms/farms using credit or existing savings
– Over time, might be able to implement loss control strategies
› Low frequency, higher severity losses
– Usually managed with insurance mechanisms; not always available in agriculture – Alternative is to apply loss control/loss reduction options
Choosing an appropriate risk handling technique
› High frequency, low severity losses
– Large firms/farms usually self-insure using internal savings or credit – Smaller firms/farms might seek insurance mechanisms
› High frequency, higher severity losses (disasters)
– Disaster mitigation using loss control/loss reduction options
– Mostly concerned with risk transfer options, such as insurance
Product value deterioration
› Many agricultural products are perishable, and can deteriorate in quality › Price changes may happen due to supply shocks or changing consumer
preferences
– Government price-supporting activities are a mechanism to mitigate price risk
– Some price risk may be offset by vertical integration
– Could also sell product in advance of production, which involves fixing the price in the present for delivery at a specified future date
Farm-level price ‘insurance’
› Output and input prices can be ‘insured’ by a number of mechanism – Primarily, forward buying/selling via various combinations of financial
› Futures contracts are a highly standardised form of forward selling/buying contract:
– Traded on an organised exchange (ASX, CBOT)
– Specify a product, delivery date, delivery mechanism and exchange price – Payments (to and from) are backed by the exchange
– Agreement is backed by a good-faith deposit-margin
Product destruction insurance
› Fire, pests, etc., may suddenly destroy products on-hand or in storage
› A firm may build a contingency fund to cover such events
› Alternatively, a firm can transfer this risk to an insurance company,
– Insurance companies are specialised risk bearers that spread the risk over a wide area and groups of people or businesses
– By incurring risks that are (as much as possible) uncorrelated, they can greatly reduce the amount of risk they actually bear
– e.g. when a fire destroys wheat crops on one side of the country, it is unlikely that fire will concurrently destroy wheat crops on the other side of the country
Role of insurance
(2) Lower frequency, higher loss, less idiosyncratic:
– More formal responses, e.g.
credit markets
(3) Low frequency, high to very high loss, systematic/covariate: – Need to transfer risk to
formal risk market, i.e. insurance
(1) High frequency, low loss, idiosyncratic:
– Self and informal
insurance is effective, i.e. savings
Farm-level destruction and yield insurance
› General considerations:
– Based on historical data
– Can be farm-based or area-based or proportion of output
– Indemnity is triggered if yield, revenue or some other index, in a given year, crosses some pre-agreed threshold
– Producer needs to pay some fee (a premium) to participate in the programme
– Government might subsidise the programme (effectively the norm in the U.S.)
Insurance types
› Conventional insurance
– Multi-peril or named peril
– Compensate actual losses
› Index insurance
– Compensate loss based on index
– Not compensate based on actual loss
Conventional insurance
› Many forms of conventional insurance are possible at the farm-level
– Named peril insurance: e.g. frost, hail and fire – Commercially available and common in Australia
– Multi-peril insurance: yield focus
– LimitedcommercialavailabilityinAustralia,
– FirstpayoutsinJanuary,2015
– http://www.abc.net.au/news/2015-01-14/multi-peril-crop-insurance-payout/6015664
– Crop revenue insurance: protects against any source of revenue loss, i.e. prices and yields – Doesn’texistinAustralia
– Mutual funds or farmer pool
– Effectively,arisksharingcooperative – Doesn’texistinAustralia
Insurable losses (Hardaker et al. (2004))
1. A large number of homogeneous insured facing independent risks – necessary for the insurer to be able to pool the risk and avoid adverse selection
2. Accidental and unintentional losses – if losses are influenced by the management of the insured, there will be moral hazard problems
3. Determinable and measurable losses – the amount of loss and the extent to which it was caused by an insured event need to be unambiguous for proper loss assessment
4. No catastrophic losses – the losses must be sufficiently independent and individually constrained so that there is an acceptably low risk of total losses so large as to threaten the solvency of the insurer
5. Calculable chance of loss – necessary for the insurer to be able to rate the risk to a set premium, which may be problematic for low frequency, catastrophic loss events
6. Economically feasible premium – if the premiums are too high, as would be required for high frequency but non-catastrophic events, clients will find it more profitable to retain the risk and absorb it as part of normal operating expenses
Demand for insurance (Hatt et. al 2012)
› Has drought policy reduced demand (see exceptional circumstances support; Farm Management Deposits –week 12 lecture)?
› Farmers weight costs and benefits against alternative strategies (off farm income, borrowing, diversification etc)
Conventional insurance
› Some conventional insurance suffers from the dual problems of moral hazard and adverse selection
Moral hazard occurs when the farmer’s optimal decision may be different when they have insurance, as compared to when they don’t have insurance
In other words, a farmer with insurance cover might act more carelessly than a farmer without cover
Adverse selection relates to a situation where farmers that choose to insure at a given rate (premium) are also the ones who are exposed to greater hazard
Farmers who don’t face risk, don’t buy insurance
Think about your car insurance – why do insurance companies ask so many questions?
Conventional insurance
› The consequence is more expensive insurance products, so, the government often has to subsidise premiums
– Existing programmes are very costly and usually subsidised
– There is no currently known successful crop insurance which doesn’t exist on the back of government support
Conventional insurance
Fire and hail insurance
› Fire and hail insurance available in Australia – these are viable but multi peril crop insurance isn’t. Why?
› Fire and hail insurance:
– low moral hazard & damages are easy to assess.
– minimal adverse selection.
– low systemic risk.
– Hence, premiums for fire and hail insurance are low
Rainfall insurance
› Moral hazard is minimal.
› Adverse selection is unlikely.
› Low transaction costs, hence reinsurance easy to obtain.
› Downside: rainfall insurance involves basis risk (individual farm’s yield is imperfectly correlated with rainfall).
› Weather derivatives: similar to rainfall insurance for insurers as no moral hazard, adverse selection and transaction costs are low, systemic risk easy to manage. For farmers: problem of basis risk.
Rainfall insurance – basis risk
Source: Hertzler (2007)
Moral hazard, adverse selection, & systemic risk in MCPI
› MCPI -moral hazard e.g farmers may fail to fertilise or spray for pests.
› To an extent this moral hazard can be managed by coverage levels: insurer only
covers a proportion of production and farmer covers the rest.
› Transaction costs involved in checking farm crops
› Insurers may also fail to keep sufficient reserves or not reinsure and be unable to pay the promised indemnity claims.
› Adverse selection is a major reason most crop insurance schemes fail. Farmers know more about their farms than does the insurance company. Verifiable data on farm yields rarely exists.
› Systemic risk – unlikely that any crop insurance program could have survived the recent droughts in Australia.
Studies have investigated the viability of MPCI:
› 1986: the Industries Assistance Commission recommended against a crop insurance program.
› 2000: the Multi-peril Crop Insurance Project (Ernst & Young 2000) concluded that crop insurance was not feasible without government subsidy. Survey evidence: estimated a take-up rate of MPCI of 18 per cent after three years at viable premium levels. This falls short for viable from insurer’s perspective.
› MPCI Task Force (2003)
Multi Peril Crop Insurance Task Force (2003)
Multi Peril Crop Insurance Task Force investigated the viability of multi peril crop insurance for WA. WA is the largest and most reliable wheat producing state in the country
Task force designed insurance contracts for individual farmers.
Most wheat in WA delivered to receival points managed by one company, so time series yield data available 9 years on every farm (8 agroecological regions) in WA.
Several possible insurance contracts and recommended a contract with a 65% coverage level, a 70% election percentage and a 70% loss ratio.
Estimated premiums (0% – 14.5%) with most farmers paying relatively low premiums.
Market penetration of around 40 per cent of WA farmers would be required for viability..‘ no future for multi-peril crop insurance in the absence of significant government subsidisation of premiums or underwriting of risk’.
Multiperil Insurance (Hertzler 2007)
Proportion of farms in different risk categories
Estimated premiums (0% – 14.5%)
Risk categories measured by the coefficient of variation
premium for multi peril crop insurance (% of value of crop)
Many farmers would pay fairly low premiums.
37% farmers coeff var <.24, would pay 0.6% value of crop as premium What about adverse selection? › Task Force calculated premiums for riskiest 10%, 20%, 30% and 40% of farms in each of the 8 shires: Risky farms in all shires Riskiest farmers consider insurance a bargain, least risky consider insurance too costly Recommendations of the Multi Peril Crop Insurance Task Force (2003) › Determine what can be done by government to assist in: › 1. Setting up required infrastructure for weather derivative products; › 2. Developing independent, reliable data collection; and › 3. Improving grower knowledge of the products and their potential value to farmers. › 4. Consider how government could assist in developing a suitable model on which to base a relevant index for farmers that has a strong relationship to Western Australian crop performance. In short,.. › Crop insurance programs have not solved the problems of moral hazard, adverse selection, transactions costs and systemic risk. Governments are not prepared to subsidise crop insurance premiums or underwrite yield risks. › Therefore, to insure crop yields in Australia: weather derivatives or yield index insurance which solve many of the problems associated with crop insurance programs, but not the problem of basis risk. Index insurance › A modern alternative is in the form of index-based insurance mechanisms at the farm-level - Weather derivatives: insurance contracts written on rainfall or temperature indexes, with defined payouts after an agreed index threshold is crossed - Area yield and yield index insurance: define index on regional yields or on modelled projected farm-level yields › Low incentive problems - Overcomes moral hazard: the insured cannot influence the payout probability Index insurance › Largely resolves issues related to adverse selection - Insurer has the same information as the farmer, via the index, so insurance policies can be correctly calibrated for risk of loss › Because payouts are made based on the index value, there is no need for on-farm verification of losses - Monitoring and verification costs are low, so this type of insurance product can be offered at relatively low cost Cost of insurance Expected claims a farmer will make-amount they should put aside to self insure Essentially operating expenses- includes costs associated with asymmetric information Insurer needs capacity to make payouts-if risks non-diversifiable then use reinsurance markets Costs of insurance ( Burke et al. 2010) Index insurance › Problem remains with the formation of the index - Index for farmer in Dubbo might be written on BoM Dubbo rainfall gauge, which is not very near to the farm - Rain might fall in the Dubbo gauge, but not on the farm; likewise, rain might fall on the farm, but not in the gauge › Index is formed on th 程序代写 CS代考 加微信: powcoder QQ: 1823890830 Email: powcoder@163.com