goverment response (by prof jerry skees)

Income Stabilisation In European Agriculture

Design and economic impact of risk management tools

The Role of Government and Markets in Ex Ante Crisis Risk Management in Agriculture

Dr. Jerry SkeesThe H.B. Price Professor of Policy and RiskUniversity of Kentucky andPresident of GlobalAgRisk, Inc.


Research Suggests:

Decision makers tend to spend too much time on small but common losses that, while unpleasant, can be coped with ...

But the same decision maker doesn’t pay enough attention to protecting against large truly disastrous, low probability events.


Two classes of risk to be considered 1) Technology Risk in a Modern Food

SystemFood SafetyContagious Animal Disease Environmental Risk

2) Weather hazard risk in agricultureDrought, floods, extreme wind, freeze


Let’s be clear – the risk for this part of my presentation are linked to industrial farming systems … Small farms require early detection – quick payoffs to clean it up and then much lower payout rates as more losses are exposed

For financing problems on small farms a check off system is likely superior to insurance – bad information hurts the entire industry – it is an industry collective good problem (Sumner)

Risk in Industrial Food Systems


Risk Characteristics Food Safety, Contagious Disease, Environmental As more sophisticated techniques are used, safety

protocols (HACCP-like) solutions become essential for both risk-mitigation and risk crisis management

Society will be involved in regulating to assure that safety standards are followed or litigating to provide incentives to assure that when problems do emerge everyone in society can become the regulator through the courts

Risk in Industrial Food Systems


A Typical HACCP Protocol

1) Conduct a Hazard Analysis2) Identify Critical Control Points3) Establish Critical Limits4) Establish Procedures to Monitor CCP5) Establish Corrective Action6) Establish Effective Record Keeping7) Establish Verification Systems


Market-based instruments can be regulations that encourage behavior through market signals rather than through explicit directives regarding how well a safety protocol is followed

… can we ‘harness market forces’ that are well designed and implemented to encourage firms to undertake control efforts that are both in the interest of the firm and the collective society?

Stavins on Market-Based Instruments


Core Problem –Why Share Information?Hidden Information and Hidden Action Hidden information causes adverse

selection Hidden action becomes moral hazard The agents (producers) have significant

incentives to protect and hide information Systems are needed to change the

incentive structure for early disclosure – principle-agent literature can be very helpful


Will agents (producers) be more willing to share information with a principle that is a risk sharing partner or with a principle that is the government regulator?

Puzzle and Challenge


Players

Agent – Industrial Producers – Large farmers, food processor

Principle – Private sector risk-sharing partner (insurer or reinsurer)

Without clear rules and regulations about penalties if the agents creates a problem there is little derived demand for paying for risk-transfer..

Government sets the rules and establishes property rights


Blending Choices

Regulation

Litigation

Markets


Challenges in Regulating

Low Risk - High Consequence Risk Asymmetric information Cost of discovery of very low risk rise

exponentially Regulators can be co-opted Relations between regulator and firm is

adversarial Litigation by individuals who are damaged

is largely ineffective (Buzby and Frenzen)


Response to Regulation

Speeding Ticket storyOdds of getting a ticket x cost of ticket.01 x $100 = $1 … I think I will speedFine are low / chances of getting a fine lowFarmer response: Fines are a cost of doing

business and these cost are much less than improving my management to reduce the risk


Still regulation that increases penalties for repeat offenders can cause changes in behavior Getting caught once puts you on a list to be

monitored more closely No one wants to get caught even once Yet, some things are difficult to catch Agents (producers) adopt the minimum

standards set by government Incentives to adopt most advanced

technology are missing


Why the legal systems fail

• Lack of a uniform laws on liability Particularly problematic across country-states Ambiguity about the science Weak incentives • Due to low probability of being sued• Low expected damages that they will pay• Low probability of negative media attention


Can the Insurance Underwriter Replace the Government Regulator?

Premiums will be based on risk Mitigation can reduce the risk and the premiums Discounts for agents adopting the most modern

systems that reduce risk Underwriters have greater incentives to help

processors with the latest information and technologies

The adversarial relationship may change The incentives to come clean quicker may

change


HACCP Like Regulator Environment coupled with Market-Based Risk Transfer With gov’t regulatory in charge, producer

has incentives to file a minimum HACCP plan and then do better

With insurance regulator, producer has incentives to file a maximum HACCP plan to get lower insurance premiums


Kunreuther: Overtime Using the Insurer Create Signaling for the Regulator

In the ideal world.. Those who take the insurance demonstrate that they have the best risk mitigation systems in place

This is a signal to the regulators who have few resources to focus their limited resources on those who do not take the insurance


Example: Food Recall Insurance (Skees, Zeuli,

and Botts, 2001 International Food and Agribusiness Management Review)

First party recall expenses (communications, added labor, transportation, disposal, etc.)

Third party recall expenses Expenses to rehabilitate and re-establish

product on the market Public relations campaigns Business interruption for up to 1 year


Example: Option to Haul Manure from Large Animal Producers Based on Weather RiskLarge CAFOs in the US have large storage systems for Manure

Problem.. If they have bad weather (excess rain) they can’t empty these systems adequately

Solution .. Organize a hauling option with a trucking company to move the manure to public sewer systems when a simulation model says that the system is exceeding capacity

What was missing?


Example: Insuring Contagious Animal Disease

Limited cases under special conditions Significant care must be taken – this may not

be the right approach for society – certainly you must not subsidize this type of insurance – this could cause an increase in risky behavior

The missing element here – government regulations and penalties for bad performers


Issues and Challenges

More hazard and adverse selection -- firms still have incentives to hide information

Improved underwriting requires more monitoring and more cost

Must use principles of co-insurance and deductibles so that agent still has risk of being hurt if they cause a problem

Some past experience suggest that some insurance companies still do a very poor job of monitoring and underwriting


Conclusion for Insuring Food Safety, Animal Disease, and Environmental

Problems Insurance markets can change behavior in a positive fashion – or they can create more risk taking and even more problems

Challenge for insurers is to insure only random risk and not BAD management

Pressures from Government in changing property rights and imposing regulations can complement both the demand and the use of appropriate insurance solutions


Natural Hazard Risk Sharing for Agricultural: Product Design for Weather and Index-Based InsuranceTraditional response to natural hazard risk and resulting income vulnerability in agriculture has been either post hoc disaster aid or ex ante multiple peril crop insurance.

Heavily subsidized – the mixing of market and social goals has made crop insurance budget intensive and the target of criticism in trade negotiations.

And yet, crisis risk management usually implies a role for government.

Needed: Innovation in our risk sharing models


Problems with Traditional Crop Insurance

Large financial losses due to correlated risk – the justification for government support.

Adverse selection – the most risky farmers buy; less risky farmers stay out.

Moral hazard – people change their behavior after they are insured: their risk is greater.

Controlling these problems requires high monitoring and administrative cost.


Problem Statement for Innovation

Premise: Markets are not complete for sharing output/yield agricultural risk

Low probability - high consequence natural disasters present particular challenges: At the core of the problem is cognitive failure and correlated losses!

Is there a market failure problem? Are there ways to mix government and

markets that might be more efficient and more equitable?


Thinking about Markets for Different Types of Risk

0% 100%No Correlation In-between risk Correlation

Examples:Auto Accidents Natural Disasters

Commodity PricesHeart Attacks Rainfall/crop yields Interest

Rates

Institutions:Insurance Markets Gov’t/Capital Mkts?? Futures Markets


Reframing the Problem: Is there a Cognitive Failure?

Difficulty in interpreting and reacting to probabilities (Morgan & Henrion, 1990; Kunreuther & Pauly, 2001)

Aversion to ambiguous risk and loss estimates (Schade et all, 2002; Kunreuther et al., 1995)

Decision makers tend to spend too much time on small but common losses that, while unpleasant, can be coped with.

But the same decision maker doesn’t pay enough attention to protecting against large truly disastrous, low probability events.


Cognitive issues for insurers

Averse to uncertain risk estimates

Tail risk is necessarily ambiguous Asymmetry around best estimate due to

measurement error, differences in record length, record reliability and completeness

Asymmetric information (moral hazard) contributes to loss probability ambiguity for insurance products

Result: Higher premium loads relative to well specified risk (Kunreuther et al., 1995)


Expectations of Loss Function Vary Between Buyer and Seller

0.00 0.50 1.00 1.50 2.00 2.50 3.00

Classic problem in pricing -- Both buyers and sellers of risk management instruments must agree about underlying risk for a market to evolve


Can cognitive failure be addressed by removing the tail risk?

Leads to decision errors in risk management and creates a wedge between supply and demand for insurance and insurance-type products, especially for risk that are infrequent.

Parametric disaster assistance for low probability events: Reduce/remove ambiguity Lower load over the remaining distribution Larger probabilities are easier for consumers to

grasp Lower search cost


How should we begin?

Build effective insurance programs to remove the strongly correlated risk of hurricanes, excess rainfalls, high wind speed, droughts, etc. will take time and careful thinking.

Get the big risk out of the way first.

Index insurance and carefully layering risks can offer an excellent beginning


Financial and Technological Innovations Pave the Way

Financial InnovationsWeather marketsIndex based insuranceCatastrophe bondsBlending capital markets with reinsurance markets

Technological Innovations Satellites are measuring weather Satellites images on vegetative cover Ground level real-time weather Computer models to give early warning (LEWS)


Index-Based Insurance Products as a possible beginning

Indemnities based on an objective, transparent measure that is beyond the control of individual management decisions. Average yield across a region. Mortality rates for a region Precipitation. Temperature. Flood levels.


Index-Based Insurance Products

Advantages: Significantly lower moral hazard. Significantly lower adverse selection. Low administrative costs (no individual farm

loss adjustments). Easy to understand. Protects against correlated risk Structured rules / avoids the politics of

disaster payments


Index-Based Insurance Products

Disadvantage Basis Risk Research is required to structure a proper

contract Optimal hedging rules apply for

considering risk transfer from index insurance products (Critical Beta).

Tailored products are important for agriculture.


Insurance Product Development

What is the peril of concern? What can be used as the index? What can I

measure? One can’t insure what can’t be measured! Can an objective third party determine whether

the realized value of the index has exceeded the threshold?

Can an objective third party accurately measure the magnitude by which the realized value of the index has exceeded the threshold?


Potential Applications

Index insurance can be sold to: individual farmers (US, Canada, India, Brazil – area

yield insurance / India – rainfall insurance ) Microfinance / rural banks (Peru – COPEME) Importers for food security (WFP – Food security) governments for disaster aid (Mexico- Fonden) Irrigators in a irrigation valley (Mexico IDB project) Herders based on mortality in an area (Mongolia) agribusinesses traditional crop insurance providers to serve as

localized reinsurance Banking institutions to protect their loan portfolios


Blending Exchange Markets and Insurance Markets Are weather trades real enough to obtain

efficient pricing? Or have we moved to a world of tailored insurance products where the risk are retained by large reinsurers?

The market trades would give more efficient pricing in theory

Without counterparty risk, hard to swap the risk

However, with tail risk, one is still looking at heavy loads for ambiguity and traditional methods for pricing an insurance product!


Layering Risk for Effective Policy

severity

freq

uenc

y

Retained by the Individual and Banks!

Insurance Sector offers layer with Global

Reinsurance for Pooled Country Risk

Government offers ‘Free Catastrophe Insurance’

to cover ambiguity risk layer


Layering the Risk with Index Products

CapxStrike

Strikex

Capx

Let x = the weather or indexed event

The individual retains and manages the risk

An insurance market holds this risk

Government pays for this level; social solution


Layering Risk

Severity

Frequency

Self-retained

Insurance

Reinsurance

Gov’t Assistance

NGO/Donor Community


Fixing Basis Risk

Risk aggregators can still add value to many index contracts

Facilitates forms of formal and informal mutual insurance

Case Study – India Loan-Link flood insurance with consequential

loss feature and flat fee for delivery costs

Recommendation: Allow Innovators of new risk products to use the index insurance as a form of local reinsurance


Steps to Getting Equity Markets to Agricultural Insurance 1) Use Index to remove big risk – pool as

much risk inside the country as possible 2) Allow competition via delivery cost and

innovation that enhances the index products 3) Prepaid indemnity pool to aggregate and

hold all premiums + reinsurance cost + excess exposure

4) Prepaid indemnity pool is a ready made equity fund for any investors


Conclusions on Natural Disaster Risk Must separate market and social function

more distinctly.. Using flat premium subsidies or gov’t to share risk of products that require diligent underwriting of individuals will be subject to significant abuse and cost

Key – pool risk with index insurance inside the market --- sell off the tail risk --- allow for dynamic trading of the pooled index risk

goverment response (by prof jerry skees)

Documents