INDEX BASED INSURANCE AND AGRICULTURE – Where Are We Heading?

Index-based insurance covers are slowly but steadily on its way to become a standard solution for protecting the global food supply chains. The agriculture insurance market is predicted to gradually move towards index (or parametric) based solutions that are much simpler to understand, with easier claims procedure and higher transparency than current indemnity solutions, albeit slower to be taken up.

Even with its obviously attractive benefits like a quick payout, agriculture index insurance's share commands only around 8% of the total agricultural insurance market GWP(estimated GWP for 2017 - USD $33 B). By and large, farmers still prefer traditional indemnity insurance solutions, however index solutions can insure risk that were previously not covered such as Non Damage Business Interruption of farm operations.

Typically, farmers are uninsured for the increasingly devastating impacts of natural catastrophes and bad weather events caused by climate change. This is particularly so for the smallholder farmers in Asia. To make matters worst, traditional indemnity crop insurance has a number of imperfections which ultimately could put global food production at risk.

Since the very first seed was planted on earth, farmers have endured the whims of the weather. Traditional indemnity type insurance covers have often struggled to offer applicable, affordable insurance coverage to tackle the numerous complex types of weather-related and other market related risk (eg price fluctuations)

Globally, climate change is hurting agriculture with its increasing frequency and severity of threats ranging from floods to droughts, hail to frost, typhoons to bush fires. Faced with such a dire predicament, a more effective and sustainable way of insuring agriculture must be developed and adopted to better support the expected growth of the global population (projected to be 9.7 B by 2050).

Major Protection Gaps

The size of the agricultural insurance market is estimated to be in excess of USD $30 B GWP with a majority of the policies focussed on covering crops. Not surprisingly, much of the premium growth is contributed by Asia, with China taking the lead as it continues its march towards being crowned the world’s largest insurance market by the mid-2030s.

The existence of large protection gaps for severe weather events in traditional insurance markets poses serious problems for both corporates and smallholder farmers. According to a 2018 Lloyds report (A World At Risk - Closing the Insurance Gap), there exists a USD $162.5 B global protection gap with 90% of economic losses stemming from various severe weather related natural disasters which remains uninsured in most developing countries.The report highlighted that Japan, Indonesia and Philippines are heavily exposed to Natural Catastrophes as they are located along the Ring of Fire region of the Pacific where most earthquakes and volcanic eruptions occur.

Limitations of MPCI

Multi-peril crop insurance (MPCI) is the oldest and most common form of traditional agricultural indemnity product available in the market. It can cover most risks in one insurance policy. Apart from bad weather events such as frost, drought, flood, hail and typhoons, it could also insure for plant diseases, fires, even damage to crops/plantations due to wild animals and in certain cases even cover theft.

However, MPCI policy wordings commonly contain high deductibles, multiple exclusions and requires a tedious claims process for both the insurer and the insured. Most countries which have MPCI programs enjoy government subsidies that drives their adoption rate. An estimated 65 % of MPCI premium in the US is supported via government subsidies, China supports 80%, India supports 85% and France 65 %. The Mexico government goes the extra mile to provide free insurance for poor smallholders farmers. In SEA, Indonesia has a rice insurance scheme that is 80% subsidised by the government.

Index-based Insurance

Taking into account the above mentioned short comings of a MPCI policy, there is a growing interest and need to explore index-based crop insurance as an add-on or even an alternative option to MPCI.

In a nutshell, an Index cover is based on data obtained from government or 3rd party weather stations, satellites and various data producers. Index insurance offers a relatively quick, transparent and economical option to protect crops. Other innovative indices could also be deployed, such as NDVI (Normalised Difference Vegetation Index), which uses satellites to measure vegetation color variations to create an index (eg. A payout is triggered if the "greenness" of the insured area falls below a pre-defined benchmark)

The practical attractiveness of an index insurance cover is that the payout is triggered by a pre-agreed event rather than some physical damage that needs to be assessed and verified by a loss adjuster. Index covers are structured using historical data for a specified weather threat and a wide range of indices can be deployed subject to availability/quality eg. rainfall, wind speed, humidity and temperature.

Since the payout is determined via 3rd party weather stations or satellites data, effectively no proof of damage is needed to verify the crop's conditions. Consequently, no loss assessment is required to be performed. As a result, the claims process is much faster than traditional indemnity insurance which can take months or even years. For Swiss Re Corporate Solutions' index covers, our payout would be within a month or even less, upon verification that the pre-agreed trigger was reached

For example, in Indonesia, Swiss Re Corporate Solutions worked with a pineapple producer to develop a weather-based index cover to protect its operations from major financial losses due to a drought during the growing season. We analysed the correlation between rainfall and drought with the historical yield result. Based on this analysis, a cumulative rainfall index was designed. If the cumulative rainfall during the agreed coverage period falls below a pre-agreed index, the insurance payout is triggered. The cumulative rainfall index is set at a level at which the lack of rainfall would have a severe negative financial impact.  

In China, we worked with an International agri-chemicals company to provide parametric insurance as part of a client loyalty scheme. The scheme, aimed at helping the manufacturing company’s local farming customers should a typhoon strike, also worked to differentiate its business in the market and grow sales. If farmers’ crops are damaged by a typhoon, they are entitled to a free-of-charge replacement for their purchased products. This allowed the farmers to get back on their feet quickly.

Yield Index Insurance

Historically, India was one of the first countries to adopt parametric insurance covers that incorporated both weather and yield elements. In this case, the pre-agreed index trigger is set as the average official published yield of the insured location unit.

Under the older scheme or CCIS (Comprehensive Crop Insurance Scheme), different amounts of payout are triggered according to the harvested yield (Actual Yield) which is determined by local government institutions and insurers via crop-cutting samples. The compensation works out as Threshold Yield minus Actual Yield multiplied by Sum insured. The Threshold Yield is defined as the average yield of the crop in the insurance unit based on historical yield data of 3 years for Rice and 5 years for other crops and multiplied by a certain percentage fixed by the insurer. Effectively, every farmer who participated in the scheme that is in the insured unit receives a payout depending on the percentage of their loss. A newer NAIS ( New Crop Insurance Scheme) has also been implemented in India.

In 2016, a new subsidised scheme was mooted by Indian Prime Minister Narendra Modi, the Pradhan Mantri Fasal Bima Yojana (PMFBY) which replaced all the then-prevailing yield insurance schemes in the country. It is available to all India farmers and helps protect against yield losses.

Although yield index insurance is available to many Asia Pacific countries, it is usually government monitored, controlled and defined. Insurance markets in APAC, especially those in India and China, mainly cover the cost of production only and not the revenue. In the unfortunate event of a severe weather event that wipes out all the crops, it will leave the farmers to survive on their meagre savings before they can grow and harvest their next crop for income.

We at Swiss Re Corporate Solutions also offer yield protection to the Malaysian Palm Oil sector where we utilise government yield data as an Index to trigger a payout in the event of yields falling below a 5 year average pre-agreed yield trigger.

Myriad Possibilities

There exists myriad number of possibilities for the application of index insurance, especially when blended with newly emerging technologies ( eg Blockchain, Insuretech etc) and new data sources (eg. Drones). This points to the fact that the application of Index insurance is only limited by the quality & availability of the data and the index structure that is utilized.

For index insurance, modelling needs to be applied to compare the index with historical data to study correlations, improve assessment of the risk and calculate the required insurance premium

Complexity of the model will vary and is dependent on the type of risk that needs to be covered. There is also the challenge of trying to determine the most closely correlated index for that particular risk. In certain situations, it can be relatively simple for example the correlation is very high between high temperatures and drought occurrences. In other cases, like crop yields, the relationships can be difficult to establish as there are several key factors at play at one time, which can make it difficult to create an acceptable and workable model.

Interestingly, in China, there is a growing trend for "Futures + Insurance" type of parametric covers which takes into consideration both the price from futures markets and the yield of the crop. Likewise, Swiss Re Corporate Solutions has designed similar covers for clients in China.

Hybrid solutions (Parademnity)

Swiss Re Corporate Solutions offers hybrid solutions that possess both the benefits of parametric and indemnity covers (Parademnity).

Hybrid solutions typically require a greater amount of time to structure on both our part and the client. For example, more data will have to be collected from the farms or plantations. Swiss Re Corporate Solutions is probably one of the few insurers in the industry to provide hybrid covers and are willing to underwrite them.

Basis Risk

It is important to openly acknowledge that Index covers inherently comes with what is termed Basis risk. Basis risk is generally unavoidable, it is a matter of whether it is high or low in an offered Index solution. In fact, there is also Basis risk present in Indemnity solutions that can come from not properly understanding the coverage of the policy wordings. Simply put, Basis risk occurs when a loss event has poor or no correlation with the index employed ( ie a loss occurs but there is no payout as the trigger is not achieved)

For example, when the weather station designated for determining the payout due to drought is too distant from a farmer’s plantation, the data might not correlate with the actual weather condition experienced by the plantation ( ie Its raining near the weather station but the insured plantation suffers drought conditions). Steps must be taken to reduce the amount of Basis risk in all insurance covers, each solution needs to be rigorously studied and calibrated to the risk it insures. (Eg. Data from of satellite imagery and IoT sensors can help improve monitoring the risk and determine more accurate triggers)

In conclusion, Index Based Insurance is here to stay and we need to take steps to refine it to serve the Agriculture industry effectively. Educating the industry is also an important task. Stay tuned for more in the coming months.