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Goverment response (by prof Jerry Skees)
 

Goverment response (by prof Jerry Skees)

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Goverment response (by prof Jerry Skees) Goverment response (by prof Jerry Skees) Presentation Transcript

  • The Role of Government and Markets in Ex Ante Crisis Risk Management in Agriculture Dr. Jerry Skees The H.B. Price Professor of Policy and Risk University of Kentucky and President 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
    • Technology Risk in a Modern Food System
    • Food Safety
    • Contagious Animal Disease
    • Environmental Risk
    • Weather hazard risk in agriculture
    • Drought, 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
    • Conduct a Hazard Analysis
    • Identify Critical Control Points
    • Establish Critical Limits
    • Establish Procedures to Monitor CCP
    • Establish Corrective Action
    • Establish Effective Record Keeping
    • 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 story
    • Odds of getting a ticket x cost of ticket
    • .01 x $100 = $1 … I think I will speed
    • Fine are low / chances of getting a fine low
    • Farmer 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 Risk
    • Large 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 Insurance Traditional 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 Prices
    • Heart 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 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 Innovations
    • Weather markets
    • Index based insurance
    • Catastrophe bonds
    • Blending 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 frequency 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 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