Weather Insurance 101, Part I
Arbol focuses on disrupting insurance, specifically weather insurance. Before we discuss the specifics of weather insurance it is important to understand the concept in its simplest terms which will help set the stage for why we need to disrupt it.
In this three-part series, we will take you through the basics of insurance, different types of weather insurance, some of the pitfalls with the current solutions as well as cost analysis.
Concept of insurance
In its simplest form, insurance costs a certain payment amount often on a recurring payment by a policyholder in return for compensation of certain damages by the insurer. The specific type of damage is specified in advance of the policy being activated and can be as varied as sickness, a flood, or a loss of a ship in a storm. If the damage event occurs, the insurance company assesses the loss damage and makes payment to the insured. The damage assessment is conducted by an assessor and within the constraints of various legal restrictions, the assessment tends to be fairly subjective if there is not a clear market price of the damage cost.
The Importance of Insurance
Insurance is fundamental to the financial infrastructure of a society. From its early days in the Netherlands facilitating insurance against floods and selling life insurance to fund building dikes, insurance has grown to encompass every facet of life, especially in developed countries. We have life insurance to reduce financial risks stemming from an untimely death. Health insurance to reduce financial risks stemming from unexpected health problems. Car or home insurance and many other more esoteric policies. Beyond individuals, businesses insure against a multitude of risks from worker injury to loss of cargo at sea. The common thread here is to reduce unexpected risk enabling the individual or business to focus on their chief source of income whether it is earning a wage or moving cargo from point A to point B. The importance of risk reduction should not be underestimated, as setbacks from unexpected damages can be insurmountable. If such damages can occur every few years there is little chance to build wealth consistently. Even if damages are not catastrophic, they inevitably lead to wealth depletion and prevent investment into future capital and stunt growth. For example, hundreds of years ago, for a ship carrying spices, the cargo risk was carried by the company partners and a ship sinking due to a storm often resulted in the sinking of the company as well. With such high levels of risk only the most well-capitalized entities moving the highest value cargoes, such as spices, could hope to ensure sufficient reward for risk. Insurance allows far greater amounts of capital to be risked to grow a business and allows a larger set of individuals and businesses to partake in intelligent risk taking. Indeed, financial products such as insurance have been a key piece of infrastructure allowing economic development to speed up.
Weather as a major source of risk
Weather is one of the chief sources of risk on the planet directly affecting the livelihoods of over 2.5 billion people and 70% of all businesses. Although inclement weather can affect nearly any business in agriculture, the ebb and flow of seasons leading to cycles of crop planting and harvesting are highly dependent on weather patterns. Unusual temperature or precipitation patterns can be devastating to crop growth and in turn, have a major effect on the livelihoods of farmers. Nearly all commercially cultivated crops are affected by weather and especially unexpected rainfall patterns resulting in floods or drought. Although irrigation systems can alleviate some of the sensitivity to weather, the vast majority of crops are cultivated using rain sourced water as irrigation systems are expensive to construct and maintain. Beyond farmers, weather touches almost all aspects of agriculture including livestock and a multitude of agribusinesses. For livestock, drought is especially harmful as depleted pastures and feed lead to forced culling of animals at low prices with extended periods of time needed to rebuild flocks or herds. For processor businesses such as biofuels, flour mills, sugar mills, coffee grinders, and many others, input costs are dependent on a local supply of feed products. For example, a sugar mill dependent on sugar from local farms will have to pay much higher prices or face a business interruption in the event of a local drought reducing the sugar crop. For such agribusinesses, weather risk is not as obvious as in the case of the farmer growing the crop but it is quite exposed nonetheless.
Energy markets also have numerous points of exposure to weather. Traditional energy products such as natural gas or heating oil are used extensively in the winter months for heating leading to demand being linked to local temperatures. For distributors of such fuels, unexpected local temperatures can lead to disruptions in demand causing losses as they are expected to maintain consistent supply. Similar issues can arise for the power sector in the summer as power companies can be caught off guard when there are unexpected heat waves leading to sharp increases in air conditioning demand. Finally, renewables are a growing sector in the energy space with new forms of weather risk. For wind farms, in particular, wind speed is of growing importance in terms of risks to their business.
Although weather risk is pervasive, insurance for weather risk is not a unified concept as it is for medical or life. This is partly because of the high variety of weather exposures and difficulty in assessing damages for weather in different industries. For many insurers, without government subsidies, it is difficult to source clients and serve the needs of the wide variety of entities exposed to weather. In agriculture, the extensive source of insurance is crop insurance, which can be thought of as a close proxy for weather insurance. This is because for agriculture, as shown in the chart below, weather tends to form the bulk of risk to crops leading to crop insurance being closely correlated to weather risk.
Agricultural Insurance Basics
Agricultural insurance products come in a number of different varieties. The first major division tends to be between indemnity products, index products, or revenue products. Within these broader categories, there are a number of sub-category of products that highlight the different methods by which payouts are triggered for damage and the nature of such payouts.
Indemnity based insurance products determine claim payment based on the actual loss incurred by the policyholder. If an insured event occurs, an assessment of the loss and a determination of the indemnity are made at the level of the insured party. The classification is often divided into further sub-classes called named peril and multiple peril agricultural insurance.
Named peril insurance provides indemnity against specific adverse events that are explicitly listed in the policy. This subclass has a number of distinctive features. First, the sum insured is agreed at the inception of the contract and may be based on production costs, or on the expected crop revenue. Second, the loss is determined as a percentage of the damage incurred by the insured party as established by a loss adjuster as soon after the damage occurs. Third, the indemnity is calculated as the product of the percentage of the damage and the sum insured. Finally, deductibles and franchises are normally applied to reduce the incidence of false claims and to encourage improvements in risk management. Named peril is a popular type of insurance and accounts for a significant portion of the agricultural premiums worldwide. For the insured parties, it appeals where firms are located in areas frequently subjected to one of the perils covered while from the insurer’s point of view it is suitable to situations where the damages caused by the named perils are both measurable and have a sudden impact. Such insurance contracts are used extensively to protect against hail damage and are used in horticulture and floriculture in addition to crops and fruit but are also used in livestock, bloodstock aquaculture, forestry and greenhouses insurance.
Multiple peril yield based insurance (MPCI) provides insurance against all perils that affect production unless specific perils have been explicitly excluded in the contract of insurance. Under this type of insurance, the sum insured is defined in terms of the expected yield to the producer. Cover is normally set in the range of 50 % to 70 % of the expected yield. In turn, the expected yield is determined on the basis of the actual production history of the producer or the area in which the producer operates. The sum insured can be based on the future market price of the guaranteed yield if the producer has an insurable interest or alternatively if the producer has taken a loan to finance the crop, the sum insured may be based on the amount of the loan if the financier has an insurable interest in the crop. The calculation of the payout is based on the extent to which the actual yield falls short of the guaranteed yield at the agreed price or as the shortfall in yield as a percentage of the guaranteed yield applied to the sum insured. This subclass of insurance offers comprehensive cover to the producers but comes at a significantly higher cost compared with named peril insurance. Rates for MPCI insurance contracts offered to individual producers range between 5 % and 20 % of the sum insured, depending on the crop, the region where the crop is located and the level of coverage. The premium reflects not only the additional cover but the costs of minimizing the chances of adverse selection and moral hazard through risk inspections, enforcing sales deadlines and overall monitoring of the insured. The cost generally makes this form of cover unattractive to marginal or small producers.
Revenue agricultural insurance products protect insured parties from the consequences of low yields, low prices or a combination of both. These products combine the MPCI coverage with price protection. Revenue insurance products are newer and less available globally with the USA being most prevalent of this form of insurance (see below for more details). For revenue insurance, a relatively liquid and transparent market price is needed for the crop, which can be difficult for specialty or smaller crops.
Index based agricultural insurance products payout based on the value of an “index”, not on losses measured in the field. They are also referred to as parametric insurance. The index is a variable that is highly correlated with losses and that cannot be influenced by the insured. Indexes can include rainfall, temperature, regional yield, satellite vegetation indices or a host of other data. The precondition for the successful implementation of this subclass is that both parties to the contract have confidence in the objectivity and transparency of the index. To achieve the necessary degree of objectivity and transparency, there must be sufficient data, a strong correlation between the index and the losses at the producer level and freedom from influence by either the insurer or the insured party. There are significant advantages to this subclass. It avoids the issues of moral hazard and adverse selection found in other classes as individual producers are only one of a large number of producers whose output determines the index or the data used to construct the index, physical phenomena such as rainfall are observable and cannot be affected by either party. Because the payment of the indemnity is based on deviations from the index not individual losses, no assessment of losses at the individual insured party level is needed. The indemnity process is quick and inexpensive to administer. Again, the design features of the product lessen administrative and operational expenses. Lastly, due to the objectivity in constructing the index, insurers are able to obtain reinsurance more easily. On the other hand, index insurance tends to have some drawbacks. The chief one is basis risk whereby the insured’s outcome varies from the outcome of the index. For example, if the insurance policy is paying off based on rainfall measured by a station, the farmer’s farm may experience differing rainfall than the weather station records. This can be the case especially if the nearest weather station is far away from the farm being insured. For index insurance to operate effectively, data quality is key and ideal data sets have high granularity and consistency to reduce basis risk. Index insurance is often more cost-effective once a suitable index has been agreed upon. This is because the marginal cost of a policy is low as there is no need for on-the-ground verification of damage or customized loss estimation. The benefit is especially important for smaller farmers or growers of specialty or customized crops.
Within index insurance, there are many common flavors with area-yield and weather index insurance being the two most common ones. For the area-yield insurance, the insurance contract defines an area referred to as the “insured unit”. The insurer constructs an index based on a guaranteed yield for the insured unit, normally in the range of 50% to 90% of the expected yield. The insurer pays out if the actual yield of the insured crop in the insured unit falls below the guaranteed yield, irrespective of the actual yield of the particular policyholder. The payout is determined as the product of the shortfall in production in the insured unit and the sum insured. An example would be a contract that pays out on the official county yield as determined by an objective third party such as a Government agency. For such a contract, trustworthy yield measurements across history would be necessary.
Weather index insurance contracts using weather data as their underlying index. The product is designed around the construction of an index that is highly correlated with loss experiences. The most common index in agriculture is rainfall since crop yields tend to be most sensitive to rainfall variation. Typically, an insurer will offer a contract that will specify the index (for example, rainfall), over what period and where it will be measured, the threshold, the sum insured and any indemnity limits. If the rainfall is less than the index at the specified measurement point and over the period specified in the contract, the insurer will payout under the contract irrespective of the actual losses of the policyholder. The quantity of the payout is determined according to the provisions of the contract. A simple payout may be the total sum insured under the contract. Alternatively, contracts are written so that the proportion of the sum insured that is paid out is determined by how far the actual production observed in the insured unit deviates from the index.
Arbol’s initial contracts on its platform will be weather index contracts focused on rainfall. The payout will be the total sum insured for the sake of simplicity. Over time, Arbol will add new data sources such as temperature, satellite vegetation indices (NDVI), or yields depending on the location’s data quality. Additionally, new variations of payout structures will be added to serve client needs. The different types of insurance are summarized in the table below:
Stay tuned for Part II of this series as we dig deeper into weather and agriculture insurance in the United States….
Arbol makes automated payments based on weather outcomes using smart contracts and third-party weather data.
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