What is Crop Insurance – Risks and Its Future

Agriculture is a prehistoric occupation. In fact, it is said that human beings only started building civilizations after they discovered agriculture. But agriculture has always been an inherently risky business. Thousands of years have passed between the discovery of agriculture and the modern society that we live in today. However, the modern farmers are exposed to the same natural risks as their ancestors. Weather, plays the most significant part in the prosperity of farmers and they do not have any control over it!

Insurance companies have been able to help people mitigate risks for centuries now. However, the products that they offer to mitigate agricultural risks are substandard to say the least. In this article, we will first understand what crop insurance is and why it is still unable to provide relief to the members of the agricultural community.

What is Crop Insurance ?

Crop insurance is an insurance product that is meant to protect farmers from risks that arise in due course of the business of agriculture. The risks must be beyond the control of farmers. Crop insurance includes clearly identified risks such as lack of rainfall. The adverse outcome of such risk factors must necessarily lead to an adverse economic impact. Also, the relationship between the risks and the loss must be clear and irrefutable.

For instance, if crop insurance is taken to protect against the adverse effects of rainfall, then it must be possible to ascertain whether the fall in yield is because of a drop in rainfall or whether there are other factors at play as well.

Low Frequency High Severity

Insurance risk factors can be classified into several types. Most risk factors pertaining to crop insurance have a low chance of occurring. In places where drought and floods are common, insurance companies will typically not offer these products at all!

However, if the risk factors do occur, they have a huge impact on the lives of the farmers. Hence, people who purchase crop insurance expect speedy settlement of claims.

Concept of Reference Yield

The whole concept of crop insurance is tacitly based on the concept of reference yield. Let’s understand how this works with the help of an example. All farms in one particular geographical area are considered to be homogenous. The data pertaining to historical yields of these farms is collected. Statistical processes are run on this data to arrive at an average yield. This is the benchmark number based on which the sum to be paid out as insurance claims is calculated.

Deviation From Reference Yield

Farmer’s loss is defined as a deviation from the reference yield. Suppose the reference yield was 5 kgs per hectare and a farmer has an actual yield of 3 kgs per hectare, then they have incurred a loss of the balance 2 kgs. Insurance companies will pay the minimum sales price that has been set by the government for the lost 2 kgs per hectare. This loss is derived on the basis of deviation from an assumed yield.

Risks Inherent in Crop Insurance

1. Basis Risk: Basis risk refers to the possibility that the insured person may not receive any payout even though they have faced a loss. Alternatively it could also refer to the possibility that a farmer who has not suffered any loss will receive a payout. Therefore, basis risk refers to the errors made by the insurance company.

2. Spatial Risk: Crop insurance is prone to spatial risk. This is because one farm in every particular area is considered to be the reference farm. Hence, there might be spatial differences in the weather conditions in the reference farm as compared to the actual farm. This leads to wrong interpretation of the yields at the ground level and leads to the two incorrect possibilities as mentioned in basis risk.

3. Design Risk: Every insurance company has a cause effect relationship which has been mapped between identified causal factors and crop yield. For instance, rainfall may be considered a risk factor. Therefore a variation in the level of rainfall should ideally have a 100% correlation to the crop yield. Well, sometimes it does not. Hence even if the rainfall was poor, there may be a good crop or vice versa. Such scenarios are covered in design risk.

4. Other Factors Ignored: Crop insurance considers all farms in a given area to be homogenous units. In reality, this is not the case. The yield would widely differ from farm to farm even if there were no human interference. This difference would be caused by an differences in the availability of irrigation, the soil type of the farm etc.

Future of Crop Insurance

Crop insurance has a lot of scope to grow and develop. At the moment, only a fraction of farmers in developing countries opt for crop insurance because of its irregular payouts. New techniques need to be developed so that crop insurance becomes a regular business practice. A bad crop should just be a normal part of business. It shouldn’t be a life threatening event causing mass farmer suicides.