Multi-peril crop insurance — what is the business case?

Take home messages

• Multi-peril crop insurance is not the ‘silver bullet’ to protect a poor performing business.
• Insurance will always increase costs so making sure you are purchasing the most appropriate product is important.
• If the insurance cover allows a business to make better long-term productivity improvements which improves long term profitability the cost can be justified.

Background

Multi-peril crop insurance (MPCI) is often quoted as a great way for farm businesses to protect themselves from the ‘disaster’ years which can impact heavily on farm viability and are often blamed for farm business failures. The reality is that farm businesses fail from a lack of profitability over a period of time which erodes their equity and their capacity to withstand the ‘disaster’ years. Any insurance will come at a cost and the cost will reduce profitability. MPCI can never be the ‘silver bullet’ to prevent farm businesses from failing. It may delay the inevitable demise of a non-profitable business if it encounters a poor year when it is laden with debt, but through a reduction in profit, it may also reduce the time it takes for a non-profitable business to reach unsustainable debt levels.

The best way a business can protect itself from a ‘disaster’ year is to be profitable and maintain a strong balance sheet. A strong balance sheet means having sufficient reserves of cash, or the capacity to borrow sufficient funds to cover a loss and still have enough money to pay for the inputs and operating costs to get to the next successful harvest and replenish these funds or repay the debt.

The reality of any insurance product is that the premium will be a calculation made by the insurance company around the likely frequency and size of the claims. The premiums are calculated to generate a profit for the insurance company through generating greater income than payouts over the customers who choose to buy that insurance product. Individual businesses may benefit if there are infrequent events that have a large impact. This is the reason fire and hail insurance is used by most grain producers. The premiums are around 1% of turnover and individual businesses can lose up to 100% of their crop in one event.

If you want good protection through MPCI you need to be prepared to give away some profit when you transfer risk. If the payouts are large and frequent the premiums will be very expensive. If the payouts are small and infrequent it won’t change the outcome of your business enough to make it worth having. For most products paying more for a higher level of cover provides a better outcome for the business.

Adverse selection is an issue that MPCI providers face. This is where the business that takes out the insurance tries to swing the balance of premiums versus payouts in their favour by selecting particular paddocks or situations which are a higher risk than the general risk that the insurers have calculated the premiums on.

If you think you can work the system and get an advantage due to adverse selection, you may have a few wins in the short term but in the longer term the insurance companies will change the rules and procedures to prevent this activity. One of the big advantages of taking MPCI is the confidence it provides a business to pursue long term profit outcomes that have a higher short-term risk. There have been examples, particularly in the Eastern States, where borderline soil moisture levels would have stopped some businesses from sowing early and taking the chance of follow up rain. However with MPCI they were prepared to take that risk with the knowledge that some of that risk can be off loaded to the insurance company for a fee. A strong balance sheet can provide similar confidence as the risk can be covered internally.

In the case of a farming business that doesn’t have the capacity to borrow more funds to continue farming, to make a difference long term, the MPCI would need to cover a significant portion of the cash operating costs of that business. The required cover would need to be at least 60 to 75% of the long-term average income.

Another unfortunate reality is that many MPCI products are based on average yields over the last five years. Many businesses will have the most need for a MPCI product when they have come through a series of tough years which has eroded their equity. They may then find themselves in a position where they no longer have the resources to recover from a disaster year so look to MCPI to lessen the loss from a disaster year. If your five-year average yield includes two well below average years, insurance which would normally be effective at a 70% level would now only cover 50% of your long-term yield average over a ten year period.

There are three broad categories of MPCI products:

1. Agreed minimum yield (example products: Cropsure and Primeguard)
2. Income protection:
   1. Include cost of production recovery, maintain revenue proportion.
   2. Example products: SureSeason Revenue, CertaintyTM (Latevo), Multi Peril Crop Insurance Australia.
3. Parametric/weather index: (example products: Celcius Pro — dry season/wet harvest/frost, SRG Corporate — weather risk management and transfer).

Agreed yield products

There are several products now available that have recognised the advantage of keeping the insurance simple and easier to administer which keeps the costs of delivery down and allows the insurance company to extract a profit without the premiums becoming too expensive.

The following analysis is based on Farmanco clients that used one of the ‘agreed yield’ products where the premium is based on a trigger yield which can be from 50% up to 75% (in 5% increments) of the clients’ five year average yields. This premium was converted to a percentage of the expected income to be covered which was consistent over the clients that used the product. The payout is only made if the actual yield is below the trigger yield. The payout amount is then the ‘trigger yield’, which is the ‘actual yield’ times the ‘agreed price’. The actual 2017 payout for the client is shown (Table 1), the rest of the figures are modelled using the same calculations over a 15 year period from 2003 to 2017.

The attractive aspect of this product was that you could protect a single crop type with the only stipulation that you had to protect all the area for that crop type for a farm or group of farms in the same locality. It was also a condition that you couldn’t come and go from year to year.

Results and discussion

Table 1 shows that by taking the top level cover of 75% on canola, the client would have been paid out five times in 15 years, and in fact over the selected 15 years the payouts would have exceeded the premiums. The reality is that if the insurance company was getting this result consistently in a region they would increase the premium so that this situation would not continue. It’s also worth pointing out that if we had modelled 14 years without the 2017 figures the result would have been a cost of around $5/ha, rather than a net benefit. Mind you, this is still a good result given the size of the payouts, and therefore, will make a difference to a business.

The other interesting part of the modelled data is the strong influence of the five-year average and its impact on the trigger yield levels that can be protected. The trigger canola yields ranged from a low of 0.47t/ha (which is not that attractive) to a high of 0.90t/ha. This difference can make a real difference to the level of risk a grower in that region will take when sowing canola.

Table 1. Modelled outcomes for canola over 15 years for a client in the Medium/Low Rainfall Zone.

Table 2 shows the same analysis for the same client’s wheat yields. The modelling shows that the client would have received a payout in four of the 15 years and the payouts were about half the magnitude of the canola payouts. The net cost was $8/ha.

Table 2. Modelled outcomes for wheat over 15 years for a client in the Medium/Low Rainfall Zone.

Where your farm is located and what crop is being grown will influence the level of premium. The greater the variability in yield the higher the premium. Table 3 below shows the difference in pricing between a high rainfall environment and a low rainfall environment which tends to have more yield variability.

Table 3. Premium quotes for High and Low Rainfall Zones.

Income protection products

In 2013 Farmanco modelled the impact of an income protection product being offered across a number of rainfall zones for the production years of 2007 through to 2011 (Table 4). A representative client was selected and their data was used to model the outcome for each rainfall zone. The results are shown in Table 5. The years in this analysis include substantial variation in income, and therefore, it is a period where an income protection product would be expected to have the greatest benefit.

Table 4. Years in study and comments on relevant factors.

Table 5. Modelled outcomes for an income protection product for 11 clients across 11 rainfall zones.

How it works

The income protection products are often seen as the ultimate crop insurance product as they effectively protect against production and price risk as it is based on the variability of income.

It doesn’t really matter why the income has fallen when an insurable position arises. In agriculture, the possibilities are almost endless (pest, disease, rainfall, frost, hot Septembers, wet harvests, world commodity prices, etc.).

The calculation of the insurance premium is based on information about your business. The key information is:

• the area of crop, and
• the average amount of cropping income.

The income protection product needs to cover all the crop area and all the crop income to prevent adverse selection issues.

Of course, being a competitive industry, insurance companies are not willing to divulge their exact matrix for assessing an insurable risk. However, an insurance provider was asked for indicative quotes on a range of client data shown in Table 5.

This example product allowed a range of protection levels and has recently allowed protection levels to be increased through the season which makes it more attractive for areas that are prone to frost events. The analysis used the ‘70% of Average Income’ level of cover.

Assumptions

Premium calculation

The mid-section of Table 5 shows the premium calculation. The shaded lines within this section are the figures provided by the insurer, based on your income variation and the variation of income in the district. Presumably they may also be affected by the scale of operations, the management and, over time, your claims history.

The premium is calculated at varying tiers for different levels of income. The closer you get to your average income, the higher the premium.

From these tiers, the total premium is calculated. For example in the second column the premium would be $58 062 per annum. This is to cover 70% of the average income of $371/ha, or $717 326.

Alternatively, this client could choose to insure $200/ha for $24 163 ($13/ha) or $300/ha for $44 663 ($23/ha), i.e. the premium for $200/ha plus $100/ha x $20.50.

Crop insurance saving

Presumably, if you do take out MPCI you will not choose to also have crop insurance, hence you can allow for that saving.

Within the ‘Less crop insurance saving’ section of Table 5, this saving is calculated by:

• estimating the crop insurance (1.3% of average income), and
• estimating and removing the amount of successful claims.

The cost benefit calculations

Based on the information provided in Table 5 and on the earlier assumptions, whether the insurance cover would have been profitable for each business over the previous five years has been calculated, retrospectively.

Table 5 shows the annual premiums from Table 1 multiplied by the five years.

Each year of income has then been looked at to see if it has fallen below the five-year average. When income has fallen below the average, the expected insurance payout has been calculated (i.e. the amount required to bring the poor year back to the average).

Results and discussion

It is unreasonable to expect that you will fare well from the use of insurance over a long period of time! You often take out insurance to avoid the ‘big lumps’ but you reasonably expect that it will cost you something. As you can see in Table 5, some businesses would have benefited from the use of this product over the past 5 years and some would not have. The range of results as a percentage of total income over the five years is from a negative seven per cent to a positive six per cent. Given the average operating profit as a percentage of income in the last five years is 15 per cent if you are taking out insurance when you don’t actually need it, this could halve your profits. On the reverse side of the equation, if you happen to hit a couple of bad years when your business is under a lot of financial pressure and you can’t afford a significant loss it could be the difference between surviving or having to sell up.

What situations would favour the use of this insurance product?

A low equity position

If your equity position is 75% or less, then your bank loan to value ratio would be close to 50 per cent (or higher) of land value. In this situation, the risk of experiencing financial pressure is higher if a very poor year is experienced. You may be more inclined to seek insurance cover to minimise the downside and protect the business from being in an unsustainable position.

High percentage of lease land to area owned

If you lease a high proportion of the land you farm, even at average to good equity levels, you are more likely to have a shortage of bank security. Like the lower equity scenario, you may be in a weaker position to wear a disastrous season because of the debt gearing. This position might encourage you to take some risk cover from this type of product.

Where you need to take a higher risk agronomy strategy

You may want to share the risk where you are fully committed to a large dry seeding program, which includes a significant area of canola.

Your farm has an above average exposure to frost

You know early seeding will provide a greater return over the longer term but you can’t afford to take the hit of a severe frost which may only happen once in 10 years.

You need to replace your airseeder but are concerned that the purchase and a bad year will put your business under too much pressure

You use the insurance to prevent the double problem of a bad year and extra machinery repayments knowing the better machinery will cover the cost of the insurance through better productivity over the next ten years.

Parametric/weather index products

In 2011 Farmanco modelled the likely outcomes of using the CBH Mutual Cost of Production Cover which was  a Weather Certificate Product that offered protection through derivatives for a number of seasonal events, and the Primacy ‘Yield Shield’ which was based on a crop model.

The CBH Model only lasted a year. This demonstrates the difficulty of getting a MPCI product that costs less than $10/ha and returns a profit to the provider that is sufficient enough to be viable over the long term.

The Yield Shield product used a crop model to calculate the expected yield at the start of the season using average rainfall. The model was run again at the end of the year based on the actual rainfall. A payout was made if a lower yield was calculated at the end of the year. You could select the level of cover and what excess you would pay. Our study selected the maximum payouts calculated in the CBH Product as the level of cover to give a valid comparison. Primacy has now moved to a more typical MPCI Product using an Agreed Yield.

Our study selected the Weather Pro cover (similar products are being offered by Celsius Pro and SRG Corporate) for seasonal rainfall and set our target amounts as 200mm at Dalwallinu and 250mm at Wickepin. Dalwallinu and Wickepin were selected to cover the northern and southern parts of the wheat belt.

The analysis covered a 20 year period from 1991 to 2010 and the results are show in Table 6 and 7 below

Results and discussion

This analysis proved useful to compare the ‘good’ decade of the 1990s versus the ‘poor’ decade of the 2000s. In the good years all the products had little or no payouts so the cost of the product had the biggest bearing on the overall cost. The very poor decade experienced in Dalwallinu, which included very low rainfall years in 2002, 2006, 2007 and 2010, meant all the products that were modelled paid out more then what was collected in premiums. In hindsight, we should have all been using Weather Pro and Yield Shield in this decade. The good thing about using derivatives is that it doesn’t influence what you would normally do in managing adverse seasons. Your best outcome is still to try and reduce your losses as much as possible and utilise the payout on your derivatives to help reduce the loss further. The other main advantage is that the derivatives are low cost to run and easy to use. It is revealing that the weather derivatives are the only products out of the three that were looked at that are still being offered in the same format, albeit by different companies.

The other interesting result from this analysis was the advantage of using the Weather Derivative product in Wickepin compared with Dalwallinu. This result reinforces the need to do some sort of historical analysis on any new product and to continue to track their performance as changes in method of payout calculation can make a huge difference in the effective cost and usefulness of the product for different locations and objectives (Table 8). In other words, you need to understand the products well and read the fine print!

Table 6. Analysis for Dalwallinu clients.

Table 7. Wickepin analysis

Table 8. Historical comparison of performance of a number of different products.

Conclusion

Insurance companies provide a range of products that may be useful to your business. There are many MPCI products which have different advantages and disadvantages. The best long-term insurance is to have a profitable farm business and maintain strong levels of equity. This will provide resilience in your business to cope with adverse seasons and poor prices. If your business is not in a strong equity position due to aggressive expansion or taking advantage of favourable opportunities and is very profitable then it can afford to reduce its risk by giving away some profit, and a number of MPCI products may be used to good effect. MPCI won’t help to rescue poor performing businesses from the inevitable run down of equity, which then leads to restricted cashflow, and ultimately low or negative profits.

Insurance needs to be used to reduce risk when needed. It shouldn’t be used to try and sustain cashflow. If you can use the insurance to increase long term profitability, in some situations it could make a substantial difference. If you are just trying to reduce your exposure to the normal variability in the weather and prices it will reduce your profitability over the long term.

Useful resources

Managing Risk using Multi-Peril Crop Insurance. A Review of 2017 MPCI products for use in cropping operations
Graingrowers policy resources

Contact details

Rob Sands
mundaring@farmanco.com.au

Richard Brake
richard@farmanco.com.au

James Macfarlane
james@farmanco.com.au