This document provides an overview of a course on Risk Management and Insurance in Agribusiness. The course will cover topics such as the risks farmers face from unpredictable weather, prices, labor availability, and policy changes. It will teach skills in risk management and the role of insurance in protecting against losses. Key terms are defined, such as risk, uncertainty, peril, hazard, and different types of risks including static, dynamic, physical, moral, and morale hazards. The course aims to help farmers better understand and manage the risks within their operations.

1. Debremarkos University Burie Campus
Department of Agribusiness & Value Chain
Management
Course Title : Risk Management & Insurance in
Agribusiness (5 ECTS)
By Wubalem G.(Assistant Professor)
Period
Tuesday-------- 2:00-4:00 LT
Thursday------ 4:00-6:00 LT
2015 E.C.

2. Farming is a risky business.
 Farmers live with risk and make decisions every day that
affect their farming operations.
 Many of the factors that affect the decisions that farmers
make cannot be predicted with 100% accuracy with:
 Weather conditions change;
 Prices could drop;
 Hired labour may not be available at peak times;
 Machinery and equipment could break down when most
needed;
 Draught animals might die; and
 Government policy can change overnight.
Chapter One: General overview of Risk Mgt & Insurance

3. Con’t
 All of these changes are examples of the risks that
farmers face in managing their farm as a business.
 Farmers need to acquire more professional skills, not
only in basic production but also in farm business
management.
 Among these are risk management skills
 Skillful farmers and other business people generally do
not become involved in risky situations
 Higher profits are usually linked with higher risks.
 Good risk management involves anticipating potential
problems and
 Planning to reduce their detrimental effects.

4. Con’t
 Simply reacting to unfavorable events after they occur
is not good risk management.
 Extension workers can help farmers improve their risk
Mgt skills.
 They can help farmers recognize and understand their
problems and
 Assist them in making better farm management decisions
 Hence, at the start of a season, farmers decide to grow
different crops.
 They decide what to plant, how much to plant and
when to plant.
 These decisions may appear simple, but for each decision
there are many possible consequences.

5. Con’t
 There will be only one outcome; only one result.
 But at the time the decision is made, the outcome is
uncertain.
 When the chance or probability of an outcome is
known in advance this is called risk.
 When the chance of an outcome is not known in
advance this is called uncertainty.
“Risk management” can be defined as an organized
approach to identify possible or probable financial harm
and
 take steps to minimize the financial impact to
acceptable levels.

6. Con’t
 Agricultural insurance protects against loss
of or damage to crops and livestock
 It has great potential to provide value
to low income farmers and their communities, both
 by protecting farmers when shocks occur and
by encouraging greater investment in agriculture

7. 1.1. Concept and Meaning of risk
There is no single definition of risk.
 The term “risk” is used by people in the insurance industry
to mean something very different
 The property is at “risk”—there could be a fire
 A person is at “risk” or a “risk”—a young driver may be
considered a “risky” insured to the insurance company.
 To further compound the problem, the term “risk” is used
by people in the insurance business
 to mean a peril insured against, Fire, Earthquake, Flood ,
Crop loss, livestock loss.
 For purposes of this class the general meaning of the word
“risk” will indicate a situation where an exposure to loss
exists.

8. Con’t
Risk is a condition in which there is a possibility of an
adverse deviation from a desired outcome that is expected
or hoped for.
 Chance of harm from an activity
 Risk is uncertainty regarding loss.
 The individual hopes that adversity will not occur, and
 it is the possibility that this hope will not be met that
constitutes risk.
 If you own a house, you hope that it will not catch fire.
RISK VS UNCERTAINTY
 Uncertainty refers to a state of mind characterized by
doubt, based on a lack of knowledge about what will or
will not happen in the future.

9. Con’t
 Uncertainty is simply a psychological reaction to the absence
of knowledge about the future.
 Uncertainty is imperfect ability to assign a character state to
an entity or activity; a form or source of doubt.
 Uncertainty is the doubt a person has concerning his or her
ability to predict which of the many possible outcomes will
occur. For this definitions
 ‘Imperfect’ refers to qualities such as incomplete, inaccurate,
imprecise, inexact, insufficient, error, vague, ambiguous,
under-specified, changeable, contradictory or inconsistent;

10. Con’t
 Ability’ refers to capacities such as knowledge,
description or understanding;
 ‘Character state’ refers to properties such as time,
number, occurrences, dimensions, scale, location,
magnitude, quality, nature, or causality;
 ‘Entity’ refers to things such person, object, property or
system;
 ‘Activity’ refers to actions and processes such as
assessment, calculation, estimation, evaluation,
judgment, or decision; ‘a form or source of doubt’ is an
informal definition of uncertainty

11. RISK VS PROBABILITY
 Probability refers to the long-run chance of occurrence,
or relative frequency of some event.
 Insurers are particularly interested in the probability or
chance of loss, or accurately,
 the probability that a loss will occur to one of insured
objects.
 Actually, probability has little meaning if applied to the
chance of occurrence of a single event.
 It has meaning only when applied to the chance of
occurrence among a large number of events.
 Risk, as differentiated from probability, is a concept in
relative variation.

12. Con’t
 We are referring here particularly to objective risk, which is the
relative variation of actual from probable or expected one
 Objective risk can be measured meaningfully only in terms of a
group large enough to analyze statistically.
 Probability has both objective and subjective aspects.
 Objective Probability: Refers to the long-run relative frequency
of an event based on the assumptions of an infinite number of
observations and of no change in the underlying conditions.
 It can be determined in two ways. First, they can be determined
by deductive reasoning.

13. Con’t
 These probabilities are called a priori probabilities
 For example, the probability of getting a head from the
toss of a perfectly balanced coin is ½ because there are
two sides, and only one is a head.
 Second, objective probability can be determined by
inductive reasoning. For example, the probability that a
person age 21 will die before age 26 cannot be logically
deductive.
 However, by a careful analysis of past mortality
experience, life insurers can estimates the probability of
death
 and sell a five year term insurance policy issued at age 21.

14. Con’t
 Subjective probability: It is the individual’s personal
estimate of the chance of loss.
 For example, people who buy a lottery ticket on their
birthday may believe it is their lucky day and overestimate
the small chance of winning.
 RISK DISTINGUISHED FROM PERIL AND HAZARD
 Peril: is defined as a cause of loss.
 It is a contingency that may cause a loss.
 Example, if your house is burns because of a fire, the
peril, or cause of loss, is the fire.
 If your car is damaged in a collision with another car,
collision is the peril, or the cause of the loss.
 Hazard: is a condition that may create or increase the
chance of a loss arising from a giver peril.

15. Con’t
 A hazard is a condition that introduces or increases the
probability of loss from a peril.
 For example, one of the perils that can cause loss to an
auto is collision.
 A condition that makes the occurrence of collisions more
likely is an icy street.
 The icy street is the hazard and the collision is the peril.
There are basic types of hazards
 Physical hazard: is a condition stemming from the
physical characteristics of an object that increases the
probability and severity of loss from a given perils.

16. Con’t
 For example, the existence of dry forests (hazard for fire),
earth faults (hazard for earthquakes), icy road (hazard for
auto accident).
 Moral hazard: is dishonesty or character defects in an
individual that increase the frequency or severity of loss.
 Moral hazard refers to increase in the probability of loss
that result from dishonest tendencies in the character of the
insured person.
 Example of moral hazard includes intentionally burning
unsold merchandise that is insured

17. Con’t
 Morale hazard: is carelessness or indifference to a loss
because of the existence of insurance.
 Some insured are careless or indifferent to a loss because
they have insurance.
 Examples of morale hazard include leaving car keys in
the ignition of an unlocked car and
 Thus, increasing the chance of theft, leaving a door
unlocked that allows a burglar / theft, etc.

18. CLASSIFICATION OF RISK
 1. Static and Dynamic Risks
 Dynamic risks are those resulting from changes in the
economy.
 Changes in the price level, consumer tastes, income and
output, and technology may cause financial loss to
members of the economy.
 These dynamic risks normally benefit society over the
long run, since they are the result of adjustments to
misallocation of resources.
 Although these dynamic risks may affect a large number
of individuals,
 they are generally considered less predictable than static
risks, since they do not occur with any precise degree of
regularity

19. Con’t
 Static risks involve those losses that would occur even if
there were no changes in the economy.
 If we could hold consumer tastes, output and income, and
the level of technology constant, some individuals would
still suffer financial loss.
 These losses arise from causes other than the changes in
the economy, such as the perils of nature and the
dishonesty of other individuals.
 Unlike dynamic risk, static risks are not a source of gain
to society.
 Examples of static risks include the uncertainties due to
random events such as fire, windstorm, or death.

20. Con’t
 Static losses involve either the destruction of the asset or a
change in its possession as a result of dishonesty or human
failure.
 Static losses tend to occur with a degree of regularity
overtime and, as a result, are generally predictable.
 Because they are predictable, static risks are more suited to
treatment by insurance than are dynamic risks.
 2. Fundamental and Particular Risks
 The distinction between fundamental and particular risks is
based on the difference in the origin and consequences of the losses.

21. Con’t
 A fundamental risk is a risk that affects the entire
economy or large numbers of persons or groups within
the economy.
 Fundamental risks involve losses that are impersonal in
origin and consequence.
 They are group risks, caused for the most part by
economic, social and political phenomena,
 Although they may also result from physical
occurrences.
 They affect large segments or even all of the population.
 Examples of fundamental risks include high inflation,
war, drought, earthquakes, floods and other natural
disasters.

22. Con’t
 A particular risk is a risk that affects only individuals and
not the entire community.
 Particular risks involve losses that arise out of individual
events and are felt by individuals rather than by the entire
group.
 They may be static or dynamic.
 Examples of particular risks are the burning of a house,
the robbery of a bank, and the damage of a car.
 3. Objective and Subjective Risks
 Objective risk is defined as the relative variation of actual
from expected loss. Objective risk, or statistical risk,
 applicable mainly to groups of objects exposed to loss,
refers to the variation that occurs when actual losses
differ from expected losses.

23. Con’t
 For example assume that a property insurer has 10.000
houses insured over a long period and, on average, 1
percent, or 100 houses, burn each year.
 However, it would be rare for exactly 100 houses to burn
each year.
 In some years, as few as 90 houses may burn, while in
other years, as many as 110 house my burn.
 Thus, there is a variation of 10 houses from the expected
number of 100, or a variation of 10 percent.
 This relative variation of actual loss from expected loss is
known as objective risk.
 Subjective risk is defined as uncertainty based on a
person’s mental condition or state of mind.

24. Con’t
 A subjective risk is a psychological uncertainty that stems
from the individual’s mental attitude or state of mind.
 Some writers have used the word “uncertainty” to be
synonymous with subjective risk as defined here.
 Subjective risk has been measured by means of different
psychological tests,
 but no widely accepted or uniform tests of proven
reliability have been developed.
 Thus, although we recognize different degrees of risk-
taking willingness in persons,
 It is difficult to measure these attitudes scientifically and
to predict risk-taking behavior,
 such as insurance-buying behavior, from test of risk-taking

25. Con’t
 Degree of Risk: is the range of variability around the
expected losses, which are calculated using the chance of
loss concept by means of the following formula:

Objective risk=
(𝑷𝒓𝒐𝒃𝒂𝒃𝒍𝒆 𝒗𝒂𝒓𝒊𝒂𝒕𝒊𝒐𝒏 𝒐𝒇 𝒂𝒄𝒕𝒖𝒂𝒍 𝒇𝒓𝒐𝒎 𝒆𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒍𝒐𝒔𝒔𝒆𝒔)/
(𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑠𝑠𝑒𝑠)
 Consider the possibility of fire losses to buildings in
towns A and B.
 There are 100,000 buildings in each town and, on
average; each town has 100 fire losses per year.
 By looking at historical data from the towns, statisticians
are able to estimate that in town A
 The actual number of fire losses during the next year will
very likely range from 95 to 105.

26. Con’t
 In town B, however, the range of probably will be greater,
with at least 80 fire losses expected and possibly as many
as 120.
 The degree of risk for each town is computed as follows
 〖𝑅𝑖𝑠𝑘〗_𝐴 = (105 − 95 )/100 = 10 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
 〖𝑅𝑖𝑠𝑘〗_𝐵 = (120 − 80 )/100 = 40 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
 As shown, the degree of risk for town B is four times that
for town A, even though the chances of loss are the same.
 Chance of loss is expressed as the ratio of the number of
losses that are likely to occur compared to the larger
number of possible losses in a given group.
 “0” The outcome will not occur (event is impossible)
 “1” The outcome will occur (absolute certainty).

27. Con’t
 4. Pure and Speculative Risks
 Pure risk is defined a situation in which there are only the
possibilities of loss or no loss.
 The only possible outcomes are adverse (loss) and neutral
(no loss).
 A pure risk exists when there is a chance of loss but not
chance of gain.
 For example, the owner of an automobile faces the risk
associated with a potential collision loss.
 If a collision occurs, the owner will suffer a financial loss.
 If there is no collision, the owner does not gain.
 The owner’s position remains unchanged.

28. Con’t
 Other examples of pure risks include premature death,
job-related accidents, and damage to property from fire,
lighting, flood, or earthquake.
 Speculative Risk is defined as a situation in which either
profit or loss is possible.
 A speculative risk exists when there is a chance of gain as
well as a chance of loss.
 For instance, investment in a capital project might be
profitable or it might prove to be a failure.
 If you purchase 100 shares of common stock, you would
profit if the price of the stock increases but would lose if
the price declines.

29. Con’t
 Other examples of speculative risks are betting on a football match,
investing in real estate, and going into business for yourself.
 In these situations, both profit and loss are possible.
 Classifications of Pure Risk
 The major types of pure risk that can create great financial
insecurity include personal risks, property risks, liability risks, and
risks arising from failure of others.
 A. Personal Risks
 Personal risks are risks that consist of the possibility of loss of
income or assets as a result of the loss of the ability to earn
income.

30. Con’t
 Personal risks are risks that directly affect an individual;
they involve the possibility of the complete loss or
 Reduction of earned income, extra expenses, and the
depletion of financial asset.
There are four major personal risks:
 Risk of premature death
 Risk of insufficient income during retirement
 Risk of poor health
 Risk of unemployment
 Risk of premature death: is defined as the death of a
household head with unfulfilled financial obligations.

31. Con’t
 These obligations can include dependents to support, a
mortgage to be paid off, or children to educate.
 If the surviving family members receive an insufficient
amount of replacement income from other sources, or
 have insufficient financial assets to replace the lost income,
they may be financially insecure.
 Premature death can cause financial problems only if the
deceased has dependents to support
 or dies with unsatisfied financial obligations.
 Thus, the death of a child at the age of 10 is not “premature”
in the economic sense.

32. Con’t
 There are at least four costs that result from the
premature death of a household head.
 First, the human life value of the family head is lost
forever.
 The human life value is defined as the present value of the
family’s share of the deceased breadwinner’s future
earnings.
 Second, additional expenses may be incurred because of
funeral expenses, uninsured medical bills and others.
 Third because of insufficient income, some families will
experience a reduction in their standard of living.
 Finally, certain non-economic costs are also incurred,
including emotional grief/heartache , loss of a role model,
and counseling and guidance for the children.

33. Con’t
 Risk of insufficient income during retirement
 Risk of insufficient income during the retirement is
another major risk associated with old age.
 The majority of workers in America retire before age 65.
 When they retire, they lose their earned income. Unless
they have sufficient financial assets, or
 have access to other sources of retirement, they will be
exposed to financial insecurity during retirement
 Risk of poor health
 The risk of poor health includes both the payment of
catastrophic medical bills and the loss of earned income.

34. Con’t
 Unless a person has adequate health insurance, private
saving and financial assets, or other sources of income to
meet medical expenditures, he or she will be financially
insecure.
 The loss of earned income is another major cause of
financial insecurity if the disability is severe.
 In cases of long-term disability, there is a substantial loss
of earned income, medical bills are incurred,
 employee benefits may be lost, or reduced, savings are
often depleted/exhausted and
 someone must take care of the disabled person.
 The loss of earned income during an extended disability
can be financially very painful.

35. Con’t
 Risk of Unemployment
 It is another major threat to financial security.
 Unemployment can cause financial insecurity in at least
three ways.
 First, the worker loses his or her earned income.
 Unless there is adequate replacement income or past
savings on which to draw,
 the unemployed worker will be financially insecure.
 Second, because of economic conditions, the worker may
be able to work only part-time.
 The reduced income may be insufficient in terms of the
worker’s needs.

36. Con’t
 Finally, if the duration of unemployment is extended over
a long period, past savings may be exhausted.
 B. Property Risks
 Anyone who owns property faces property risks simply
because such possessions can be destroyed or stolen.
 There are two major types of loss associated with the
destruction or theft of property: direct loss and indirect
or consequential loss.
 Direct Loss: is defined as a financial loss that results from
the physical damage, destruction, or theft of the property.
 Direct loss is the simplest to understand; if a house is
destroyed by fire, the owner loses the value of the house.
This is called a direct loss.

37. Con’t
 Indirect Loss: However, in addition to losing the value of
the building itself,
 the property owner no longer has a place to live, and
during the time required to rebuild the house,
 it is likely that the owner will incur additional expenses
living somewhere else.
 This loss of use of the destroyed asset is an “indirect,” or
“consequential,” loss.
 An indirect loss is a financial loss that results indirectly
from the occurrence of a direct physical damage or theft
loss.
 An even better example is the case of a business firm.

38. Con’t
 When a firm’s facilities are destroyed, it losses not only
the value of those facilities but also the income that would
have been earned through their use.
 Property risks, then, can involve two types of losses:(a)
the loss of the property and (b) loss of use of the property
resulting in lost income or additional expenses.
 C. Liability Risks
 The basic peril in the liability risk is the unintentional
injury of other persons or
 Damage to their property through negligence or
carelessness;
 However, liability may also result from intentional
injuries or damage.

39. Con’t
 Under our legal system, you can be held legally liable if
you do something that result in bodily injury or property
damage to someone else.
 Liability risks therefore involve the possibility of loss of
present assets or future income as a result of damages
assessed or legal liability arising out of either intentional
or unintentional torts, or invasion of the rights of others
 Liability risks are of great importance for several reasons.
 First, there is no maximum upper limit with respect to the
amount of the loss.
 You can be sued for any amount.

40. Con’t
 In contrast, if you own property, there is a maximum limit
on the loss.
 Second, a lien can be placed on your income and financial
assets to satisfy a legal judgment.
 For example, assume that you injure someone, and a court
of law orders you to pay substantial damages to the
injured party.
 If you cannot pay the judgment, a lien may be placed on
your income and financial assets to satisfy the judgment.
 Finally, legal defense costs can be enormous/huge.
 If you have no liability insurance, the cost of hiring an
attorney to defend you can be staggering.

41. Con’t
 D. Risks Arising from Failure of Others
 When another person agrees to perform a service for you,
he or she undertakes an obligation that you hope will be
met.
 When the person’s failure to meet this obligation would
result in your financial loss, risk exists.
 Examples of risks in this category would include failure
of a contractor to complete a construction project as
scheduled, or
 failure of debtors to make payments as expected.
 1.2. Producers‟ Attitude towards Risk
 Farmers may be divided into three types: risk-neutral; risk-
takers and risk-averse. The risk-averse farmers try to
avoid taking risks.

42. Con’t
 They tend to be more cautious individuals with
preferences for less risky sources of income.
 In general, they will sacrifice some amount of income to
reduce the chance of low income and losses.
 A risk averter does not refuse to accept any risk at all.
 However, the risk averse farmer would seek to be
compensated. So they minimize risk
 For the risk taken by receiving a higher return than
would normally be obtained if there were no risk.

43. Con’t
 Risk-takers are people who are open to more risky
business options. Also called risk seeker. Max return
 The risk-takers prefer to take a chance to make more
profit.
 Unlike the risk-averse, risk takers choose the alternative
that gives some chance of a higher outcome,
 even though they may have to accept a lower outcome.
 When faced with the choice, risk-taking farmers tend to
prefer to take the chance to make gains rather than
protecting themselves from potential losses.
 Even so, risk-taking farmers are still influenced by the
return they could receive.
 Risk-neutral lies between the risk-averse and risk-
taking positions. Invest with certainity.

44. Con’t
 It is useful for the farmers and those who provide support
services to know their attitudes towards risk.
 In this way, they are more conscious of the motivation
behind the risk management decisions made.
 While most farmers tend to be risk averse, attitude
concerning risk is not fixed. Many factors influence it.
 Thus, in one situation a farmer may be risk averse, and in
another situation the same farmer may be a risk-taker.
 The following are some of the factors that may
influence a farmer’s attitude towards risk
 Farmers who operate under subsistence conditions tend
to be the most risk-averse

45. Con’t
 The provision of food for their dependent is an
overriding priority for many of them.
 Activities with a monetary reward are frequently
sacrificed in favor of meeting the objective of producing
their own food.
 Market-oriented farmers who are not willing or able to
withstand the possible financial losses associated with a
risk also tend to be more risk-averse.
 This is often true for smallholder farmers.
 In effect the relationship between the input costs and the
value of output from the farm influences the farmer’s
attitude toward risk.
 Family commitments and responsibilities can also play a
role in attitudes toward risk.

46. Con’t
 A person without family commitments may be more
willing to take risks. Similarly, older people are likely to
take less risk.
 Past experience may also influence a farmer’s decisions.
 The effects of particularly good or bad years in the past
influence decisions to be made today.
 Again, this may be related to age; a younger person may
not yet have had many experiences on which to base
decisions.
 An example of decision-making in risk management, A
farmer needs to decide how to cope with a possible
infestation of pests.
 Should he spray early as an “insurance” against the
infestation occurring?

47. Con’t
 Or should he wait for indications of infestation before
deciding when to spray?
 When market prices are low and the cost of pesticides is
high,
 The net benefit from using pesticides in years when there
is high pest infestation will be lower.
 In this case the farmer will be reluctant to buy
expensive inputs
 Risk-taking choices: Risk Mgt refers to farmers take
actions to increase the chances of success of the farm
business.
 Farmers can do this by influencing events in the future
and by limiting the negative effect of those events.

48. Con’t
 Many farmers try to do both.
 A good risk Mgt strategy will try to act on both events and
their consequences.
 Farmers are often willing to accept higher risks to obtain
higher incomes.
 The main aspects of risk management are:
 1.Anticipating that an unfavorable event may occur and
acting (where possible) to reduce the chances of it
happening;
 2.Taking actions that will reduce the adverse consequences
should the unfavorable event occur.
 An important aspect of risk Mgt is that all responses to
risk involve a cost.

49. Con’t
 This cost is expressed by the amount of resources tied up
in order for the farmer to manage his risks more
effectively.
 In some cases the cost is easy to identify, in other cases
the cost is less obvious.
 Examples of risk Mgt costs: A farmer may keep a stock
of spare parts for the farm machinery to minimize risks
of breakdowns.
 The spare parts are tied-up resources.
 The cost is the value of the spare parts.
 Insurance is a common way to manage risk.
 In this case the cost is obvious and easily identified: the
insurance premium.

50. Con’t
 A farmer may decide to grow a drought-resistant crop
instead of one that is more drought prone.
 But the market price of the drought-resistant crop may
be lower than the market price of the drought-prone
crop.
 The cost to the farmer is the possible higher price that is
given up by growing the drought-resistant crop.
 A farmer may decide to use a more complex production
system. In this case, the cost is in the form of additional
time required in management.
 Whatever its form, the cost of a response to risk will also
influence a farmer’s choice of strategies to manage risk.
 An example of reducing adverse consequences: A
cassava farmer in West Africa has heard on the radio
that there is blight in his area.

51. Con’t
 What should be done about the risk that his crop might be
attacked by the blight?
 First he needs to know how likely it is that his farm will
be affected.
 He knows that one way to avoid the potential problem is
to harvest his crop early. But to do this means he will have
a smaller crop that will possibly attract a lower price.
 There is a risk in taking this action.
 He does not like taking risks. He is risk averse.
 The cost of this action is the potential loss of income.
 But failure to do it may lead to a total crop failure.
 So a lower income may be better than the risk of no
income.

52. Con’t
 He decides to harvest his crop early.
 This way he knows he will have some income, which is
better to him than the possibility of no income at all.
 He decides to harvest his crop early.
 This way he knows he will have some income, which is
better to him than the possibility of no income at all.
 When risk is viewed as the chance either of gains or losses,
 the decision changes from seeking to remove all risk to
trying to find the balance between the potential income that
the farmer is willing to accept and the amount the farmer is
willing to pay to reduce the risk.
 That balance depends on: the riskiness of the action itself;
 the farmer’s attitude towards risk;

53. Con’t
 the resources tied up; the gains that must be given up to
cover the risk.
 The decision is complex and related to the farmer’s ability
to take risk.
 In order to assess the cost of risk and the effect on
potential income,
 the farmer will need to have at least a basic
understanding of farm economics.
 An example of avoiding potential problems: At the
beginning of every season a farmer worries that his old
tractor could break down.
 To reduce the likelihood of this happening
 he may: overhaul/ repair the tractor before he starts using

54. Con’t
 Keep some spare parts for the tractor ready;
 Service the tractor regularly in an attempt to avoid the
risk completely.
 While these actions may not prevent a breakdown, the
farmer reduces the chances of one happening.
 1.3. Quantifying Risk
 Quantifying risk is a process to evaluate identified risks
to produce data that can be used in deciding a response to
corresponding risks.
 The objective of risk quantification is to prepare
contingencies in terms of costs, time, or HRs and
prioritize them in terms of their severity and likelihood,
 So that appropriate action can be taken accordingly.

55. Con’t
 In order to quantify risk, it needs to be identified first.
 Once risk is identified then it is analyzed in terms of
probability of occurrence and impact that it could print
on the outcome.
 The probability is assigned either based on intuition or
the previous data of failure rates available for similar
events in datasheets.
 Once probabilities of all events are calculated, a
criterion for the likelihood of all the events is defined.

56. Con’t
 .For example, if a specific event may occur in exceptional
circumstances, like for example less than 3% chance of
occurrence,
 Then its likelihood can be assigned as “Rare”.
 In a similar way, severity or consequence of the events on a
project is also classified.
 For example, if an event may result in abandonment/stop of
project then it can be classified as “Catastrophic”
 or if it may result in a delay of 50% of schedule or 50% of
additional cost then it may be classified as “Major”.
 The risk(R) is calculated by multiplying probability (P) with
the impact (I) or severity.
 Farmers’ risk-taking abilities are determined by their
financial obligations.

57. Some key indicators of risk taking ability are:
 Gross margin: is the difference between the income of an
enterprise or farm and the variable costs.
 The higher the gross margin, the more income the farmer
can generate and the greater the risk-taking ability.
 Cash flow: All farmers need cash to meet family living
expenses, loan repayments and other expenses requiring
cash payment.
 The farm is expected to generate an income to cover
expenses.
 Cash flow is the expected sales minus expenses.
 The smaller the cash flow, the lower the cash reserve and
the risk-taking ability of the farmer.
 In the event of a shock occurring, such as a sudden increase
in costs, or an outbreak of disease leading to a high
mortality of livestock,
 or drought and a failed crop,

58. Con’t
 An example of cash flow
 Assume there are three farmers each operating 20-ha
farms with the same type of machinery.
 All three farmers have outstanding debt from a
purchase of improved seed and fertilizer.
 Farmer 3 borrowed $100 to cover the cost of hired labour
when the farmer was in hospital.
 A comparison of the three respective financial situations
is outlined below.

59. Con’t

60. Con’t
 Here we see that Farmer 1 has the highest gross margin and
the largest cash flow.
 Farmer 1 can assume more risk than either Farmers 2 or 3
and has higher risk-taking ability.
 A quick demonstration of this can be seen if the gross
income is reduced by $60.
 In this situation, Farmer 1 would still have a positive cash
flow, but Farmers 2 and 3 would have negative cash flows.
 This again shows that Farmer 1 is able to absorb greater
risk.

61. Chapter Two : Risk Analysis
 Risk analysis is the overall process of risk assessment,
risk management and risk communication.
 Risk assessment identifies risks from plausible sets of
circumstances that may result in harm to people or
 to the environment and estimating the level of risk on the
basis of the seriousness and chance of harm.
 Risk management evaluates, selects and implements
plans or actions to ensure that risks are appropriately
managed.
 Risk communication is the exchange of
information, ideas and views between the stakeholders.
 Risk communication also conveys the rationale for
decisions made by the stakeholders.

62. Con’t
 Risk Mgt is evaluating the risks that may warrant contro
l measures and determines the appropriate conditions to
manage farming risk.
 The purpose of risk Mgt is to protect the
health and safety of people and the environment by
controlling or mitigating the farming risks.
 Risk Mgt may be described as answering the questions:
 Does anything need to be done about the risks?
 What can be done about it?
 And what should be done about it?
 Risk Mgt involves prudent/careful judgments about
which risks require management (risk evaluation).

63. Con’t
 The risk assessment and risk Mgt plan forms the basis
upon which the Regulator decides whether to issue a
license or not.
 To issue a license the Regulator must be satisfied that
risks can be managed the farming activities to protect
human health and safety and the environment.
 Riskcommunicationestablishes an interactive dialogue
between the regulator and stakeholders
 to provide open, transparent and consultative risk-
based regulation of farming business.
 It is integral to the processes of risk assessment and risk
management and
 involves development of an interactive dialogue between
the Regulator and stakeholders of farming business.

64. Con’t
 The Regulator undertakes extensive consultation with a
diverse range of expert groups and authorities and
 Key stakeholders, including the public, before deciding
whether to issue a license or not.
 In many instances differing perceptions of risk can
influence the approach of stakeholders to particular issues.
 The Regulator endeavors to provide accessible
information to interested parties on applications, licenses,
and dealings with farming business.
 The Risk Analysis Framework is part of the Regulator’s
commitment to clarity, transparency and
accountability of decision-making processes and is
supported by a risk communication.

65. Con’t
 The Risk Analysis Framework is a key document for
informing applicants, stakeholders and the public about
the Regulator’s approach to applying risk analysis of
farming business.
 The purpose of this Risk Analysis Framework is to:
 Provide a guide to the rationale and approach to risk
analysis used by the farming activities
 Enable a consistent and rigorous risk analysis approach to
evaluating the farming business
 Ensure that the use of risk analysis in the decision-making process
is transparent to the farming businessmen and other stakeholders.
 This version of the Risk Analysis Framework incorporates recent
advances in risk analysis methodology and increased scientific
knowledge, as well as regulatory experience gained from farming
activities.

66. 2.1. Sources of Risk
The most common sources of risk in farming can be
divided into five areas:
Production and technical risk: - Crop and livestock
performance depend on biological processes that are
affected by the weather, and by pests and diseases.
 Low rainfall or drought may lead to low yields.
Hail or heavy rains could damage or even wipe out crops.
Outbreaks of pests or diseases could also cause major
yield losses in crops and livestock.
It include low rainfall, drought, hail or heavy rains, pests
and disease, breakdown or unavailability of equipment
and spare parts.
When farmers plant seeds and fertilize their land they do
not know for certain how much rain will fall, or whether

67. Con’t
 They do not know if there will be a problem with pests or
diseases.
 But still they must decide whether they are going to plant
their crops or raise their livestock.
 The resources they spend to plough, plant and fertilize
their crops or to care for their livestock may not be
recovered.
 This is why there is risk.
 Farmers produce without complete certainty about what
will happen to their production.
 Another source of production risk is equipment.
 A farmer’s tractor may break down during the
production season resulting in an inability to harvest in
time, thus affecting yields.

68. Con’t
 Similarly, if the farmer uses shared or hired traction or
other equipment, will it be available when needed?
 If the farmer is using a new technology, will it perform as
expected?
 Will it actually reduce costs and/ or increase yields?
 If seeds do not germinate and day old chicks die what will
be the impact on production and farm family income?
 The farmer can never be completely certain.
 Production risk stems from the uncertainty regarding the
factors that affect the quantity and quality of farm produce
(e.g. weather, disease, pests).
 It also arises with the introduction of new technologies.
 Several strategies can be used to reduce production risk.

69. Con’t
 Risk-reducing inputs:- are production inputs that improve
the chances of better quantity or quality of farm products.
 Fertilizers and compost are used to reduce the risk of
low yields.
 Pesticides and Integrated Pest Management (IPM)
practices are used to reduce the risk of crop damage.
 Irrigation is used to reduce the risk of low rainfall.
 Not all inputs necessarily reduce risk.
 For example, even if fertilizer is used, the crop still
depends on rainfall, which may or may not be favorable.
 When soil moisture levels are low, using fertilizer can still
result in low yields.

70. Con’t
 Farmers, however, do not experience only one kind of
production risk at a time.
 They often experience the risk of unfavorable weather,
pests and weeds at the same time.
 Using a single risk-reducing input, such as drought-
resistant seed will not prevent low yields caused by pest
and insect damage.
 To determine whether an input will reduce the risk of low
yields, farmers must look at a number of factors at the
same time.
 They should think about the effect the input is most likely
to have on their crop, given other factors that also affect
production.

71. Con’t
 For example, hybrid seeds may increase yields in years
of good rainfall but produce poorer yields than traditional
varieties in years when the rain is poor.
 Farmers must ask themselves whether the income
expected by using the input is high enough to compensate.
 For the increased risk involved.
 Essentially, farmers must weigh up the costs and
benefits of using an input as a risk reducing strategy.
 Risk-reducing technologies:-
 Farmers can reduce risk by learning about and applying
new technologies and
 Practices designed to address specific risks common to
their area of production.

72. Con’t
 For example, new varieties of seed are being developed
and livestock are being bred with certain characteristics,
including the following:
 Drought-resistant seed for maize;
 Bird-resistant seed for sorghum;
 Disease- and pest-resistant seed species;
 Decease -resistant livestock species;
 Livestock bred to provide better productivity;
 Irrigation for high-value crops;
 Crops and livestock bred specifically to improve
marketability
 Risk-reducing technologies may be difficult to implement
but could be beneficial if successful.

73. Con’t
 In many countries there are examples of how genetic
technology has created an economically viable opportunity
to address some of the risks in livestock production.
 For example, programs have been developed to provide
higher quality cattle to local farmers to make it possible for
them to access markets that offer higher prices.
An example of introducing new technologies:
 A farmer in Swaziland received imported milk cows from a
technical assistance project.
 The cows faced production risks as they could not easily
adapt to the environmental conditions of Swaziland.
 To reduce these production risks the farmer decided to
cross-breed the imported animals with local breeds, as a
way to improve their disease resistance.

74. Con’t
 Risk is a way of describing the chance a farmer takes when
making decisions. Risk can often encourage positive cha
nge. Risk can lead to gains or losses.
 The greater the risk, the greater the potential for loss or
gain.
 Selecting low-risk activities: One way to reduce
production risk is to choose a farm enterprise that has a
lower risk.
 In these situations farmers choose reliability over
potential profitability.
 A farmer may forego an enterprise that has a high potential
for income but also carries a high risk for loss,
 and choose instead an enterprise which is less profitable
but also less risky.

75. Con’t
 For example, some smallholder farmers may prefer a
drought-resistant variety of sorghum or millet to high
yielding varieties that could fail in a drought.
 Farmers often prefer to continue with familiar crops and
production activities with low risk.
 Risk is often associated with a lack of familiarity with a
variety.
 Although the yield of an improved variety may be more
stable than those of local varieties,
 farmers may not have the knowledge and experience of
growing the improved variety.
 This lack of experience could lead the farmer to assess the
risk of cultivating the new variety as being too high.

76. Con’t
 Farmers are usually aware of the differences in the yield
variability of crops associated with the different soils,
husbandry practices and other factors on their farm.
 Because of the many differences, one farmer may consider
a particular activity high-risk while another may consider
it a low-risk activity.
 System flexibility: Farming system flexibility is an
important strategy for risk management.
 A flexible farming system makes it possible for the farmer
to make quick or short-term changes in production and
sales.
 Farmers who sell cash crops may also reduce risk by
using available funds to enable them to change to another
enterprise if the price of the main cash crop falls.

77. Con’t
 By keeping their farm systems flexible, farmers are able to
make decisions in response to changing circumstances.
 While working with general production plans, they should
keep their options as open as possible in order to respond
to opportunities and risks as they occur.
 EXAMPLES OF FLEXIBLITY: Vary area of land under
cultivation and/or the number of livestock kept, as a
response to market changes.
 Keep land fallow (unplanted) in times of low rainfall in
order not to risk unnecessary expenditure on inputs.
 Intensify the farming system by increasing an already
 existing enterprise (e.g. small stock such as pigs, sheep,
poultry) if future prices are likely to be good.

78. Con’t
 Utilize labor rather than purchasing or hiring farm
machinery.
 Spread the time of planting and increase the area under
cultivation.
 If an early planted food crop fails the farmer may replant
with a more drought-resistant variety.
 If farmers feel that neither will be successful they may
decide to increase the area under another staple crop for
food security purposes.
 It should be noted, however, that flexibility is not
possible with all enterprises.
 For example, tree crops are generally inflexible.
 The enterprise cannot be changed easily and quickly.
 However, coffee farmers, for example, can respond to low
prices by heavy pruning – hoping that yields will be good
when prices are again high.

79. Con’t
 Production diversification: is a successful risk
management strategy because not all farm enterprises
and
 operations are likely to be affected in the same way by
changing situations.
 Some techniques include managing multiple farm
enterprises together at any one time
 (or in the same season); engaging in the same farm
enterprise in different physical locations;
 engaging in the same farm enterprise over successive
periods of time (or seasons);
 generating income from off-farm activities.

80. Con’t
 Managing multiple enterprises together at any one
time (or in the same season).
 There are many forms of this kind of risk management
strategy.
 For example, farmers concerned that their normal crop
may fail because of pests may decide to produce more
than one crop (i.e. multiple enterprises) over the same
season.
 They will choose crops that are more resistant to pests and
diseases.
 Another example is intercropping, which is a common
form of crop diversification.
 Crops that are more resistant to drought may be planted
together with food crops to ensure that some return is
obtained from the effort put into land preparation.

81. Con’t
 In many countries, sorghum and maize are grown together;
sorghum is drought resistant
 but susceptible to bird damage, whereas maize is liable
to fail in a drought but is more resistant to bird damage.
 Mixed broadcast farming, which is a traditional practice in
low rainfall areas of Southern Africa, is an example of
intercropping.
 In this case, the farmer literally mixes the seeds of three or
four different crops (e.g. maize, sorghum, pumpkin) in a
single bag and plants them simultaneously in the same
field.
 This was designed specifically to protect the household food supply
in case of drought. Even if two crops fail, there are at least one or
two other crops that will provide food for the family.

82. Con’t
 Essentially, diversification is a practical application of
the saying “Don’t put all your eggs in one basket”
 Many farmers around the world – particularly smallholder
farmers – integrate crops and livestock to reduce risk and
 improve their efficiency in resource use and sustainability
of the natural resource base.
 Engaging in the same enterprise in different physical
locations.
 This risk management strategy works on the understanding
that the same crops grown in different areas will not meet
the same fate.
 Perhaps a crop grown in the area surrounding the house is
more likely to be infested by rodents than the same crop
grown elsewhere

83. Con’t
 One piece of land may have marginally better protection
against frost than another.
 Also, by planting crops on different soil types the farmer
diversifies to avoid risk:
 in a dry year the crop on sandy,
 upland soils may fail;
 in a wet year the crop on wet,
 river-valley land may fail.
 Land close to a river can possibly be irrigated.
 By taking advantage of these differences, farmers can
spread their risks and
 Can be more assured that at least one of their production
sites will succeed.

84. Con’t
 Engaging in the same enterprise over successive
periods of time (or seasons).
 Farmers also diversify over time. Staggered planting can
be used to manage household food supply and also to
reduce the risk of water stress.
 If an early-planted crop does not receive sufficient rain at
the flowering stage,
 the crop planted later may not be affected in the same
way.

85. Con’t
 An example of phased livestock production A farmer in
the Manica province of Mozambique, decided to develop
a commercial broiler enterprise of 1 000 units.
 Owing to limited capital for housing and a concern over
the market, he decided to spread production and rear his
broilers in batches of 250 units.
 By so doing he was able to spread sales and sell his
chickens at competitive prices.
 As part of his business strategy, the farmer increased
production towards one of the festival days to meet the
increased demand for poultry at that time.

86. Con’t
 General considerations: Diversification of production
can be used to manage price, yield, and income risk.
 Unlike risk-reducing inputs, the effects of which are
shown on a field-by-field or enterprise-by-enterprise basis,
 the effects of production diversification are seen only by
observing the farm as a whole.
 But by diversifying production practices or engaging in
alternative farm enterprises,
 the farmer no longer uses the optimum combination of
resources that gives the highest possible yield.
 Using different production practices on different fields
may require more Mgt time and possibly different types
of farm equipment.

87. Con’t
 In this way production diversification, while minimizing
risk, often reduces potential farm income.
 Risk-averse farmers will more likely be prepared to
accept the lower income because their primary concern is
to avoid risk.
 It is unlikely that risk-neutral or risk-taking farmers will
accept the lower income
 because they will go for a production plan that will
probably deliver the highest expected net income (over
one or several seasons) regardless of risks involved.
 Indeed, the risk-taker might seek out more risky
enterprises to gain a higher income.

88. Con’t
 An example of enterprise mix. A farmer has been
debating the most appropriate mix of enterprises on his
farm.
 In particular he is considering switching 0.5 ha from
maize to beans.
 In adding this new crop he is not worried about the risk of
a lower income, because in his area income from beans
varies less than income from maize.
 Also, the pattern of price changes for produce sold is not
the same.
 When the price of maize falls, the price of beans often
stays the same.
 One thing he has realized though is that he has to consider this risk
reduction against the expected income from beans.

89. Con’t
 Reserves of inputs and produce: The most common
reserves are stores of farming inputs and farm products.
 As a risk-reducing strategy, these goods are set aside to
reduce the impact of unfavorable events.
 Reserves of inputs such as feed for livestock, fertilizer
and other chemicals can protect farmers from the risk
of short-term input price changes.
 Food storage on the farm can also provide security
against the risk of crop failure, although losses of stored
grain due to pests can be considerable.
 As is the case with all risk management strategies input
and product reserves come at a cost.
 One obvious cost of holding reserves is their actual value.

90. Con’t
 Resources held in reserve are tied up and do not earn a
return.
 This can affect both the net income and cash flow
negatively.
 Grain storage provides security against the risk of crop
failure for both family needs and future market sales.
 Share leases: In some countries where land tenure
arrangements permit (e.g. among small-scale farmers in
Latin America),
 Share leases for crop and livestock production are a
common risk management strategy.
 Under such schemes the landowners usually pay part of
the operating expenses and,

91. Con’t
 in return, receive a portion of the crop or livestock
produced instead of a cash rental payment.
 In this way the risks of low production, low selling prices,
or high input costs are shared between the tenant and
the owner.
 Under share-lease arrangements tenants require less
working capital for farm operations and credit may
consequently be more readily available.
 With share lease agreements production and sales risks
are borne by both tenant and owner
 Custom farming: it involves a farmer entering into an
agreement with a custom operator to carry out various
farm operations.
 It is also sometimes referred to as “contractor” farming.

92. Con’t
 The advantage (or risk saving value) of this strategy is that
operational costs can be fixed.
 Instead of facing the risk of high equipment costs, the
farmer contracts someone else to do this work.
 Custom farming can also be applied to livestock feeding.
 Under such arrangements livestock producers feed cattle
or small stock owned by other farmers on their own plots
for a fixed price.
 In either case, some farmers may undertake only part of
a production activity as a means of reducing risk.

93. Con’t
Farmers can either contract operators to work their
land or be contracted as an operator to work the land
of other farmers.
Contracting an operator can reduce the risk of high
equipment costs.
A farmer with equipment, contracted as an operator,
receives alternative income and makes more efficient
use of equipment.
 Custom cattle feeding and custom farming allow
farmers to focus on production.
The advantage of custom farming is that operating
costs can be fixed in advance

94. B. Marketing risk
 Marketing risk – prices and costs changes in prices are
beyond the control of any individual farmer.
 The price of farm products is affected by the supply of a
product, demand for the product, and the cost of
production.
 Supply of a product is affected by a combination of
production decisions made by farmers as a group and by
the weather and other factors that influence yields.
 Demand for a product is affected by consumer
preference, consumers’ level of income, the strength of the
general economy, and the supply and price of competing
products.
 Cost of production of a unit of product depends on both
input costs and yield.

95. Con’t
 This makes it highly variable.
 Although input costs tend to be less variable than output
prices, when combined with yield variations, the cost of
production becomes a serious source of risk.
 Sometimes price movements follow seasonal or cyclical
trends that can be predicted.
 Many times, however, supply or demand will change
unexpectedly and, in turn, affect the market price.
 When farmers plant crops or commit resources to raising
livestock, they do not know for certain what prices they
will obtain for their products.
 In situations of low rainfall, production of crops is often
reduced and, as a result, prices rise.

96. Con’t
 Factors affecting marketing risk include supply, demand
and cost of production
 Marketing risk exists because of the variability of product
prices and the uncertainty of future market prices that
the farmer faces when making the decision to produce a
commodity.
 Several methods can be used to reduce price variability
or to set a satisfactory price before the crops or livestock
are ready for sale.
 These are discussed below.
 Spreading sales: If the farmer is producing a crop that
can be easily stored after harvest, parts of the crop can be
sold at different times during the year.

97. Con’t
 The farmer can watch for changes in the market and sell
when prices are most favorable.
 This particularly applies to food grains and for seasonal
produce that can be stored (e.g. apples, potatoes and
onions).
 However, storing produce has risks, entails high costs
and sometimes loss.
 Livestock sales can also be spread throughout the year if
managed properly in terms of feeding, calving and other
livestock husbandry operations.
 This strategy may or may not increase income for the
farmer but it reduces risk and
 Provides the added benefit of ensuring a regular cash flow
throughout the year.

98. Con’t
 Again, in all cases farmers need to balance the costs and
benefits.
 It is important that farmers realize both costs and benefits
of storage and on-farm primary processing and ensure that
income generated covers the costs involved.
 Produce that can be stored, can be sold later on in the
season.
 An example of adding value by drying: A farmer decided
to process vegetables by solar drying and to selling them
at times of short supply.
 By so doing he avoided having to sell his produce at times
where the market was flooded and prices were low.

99. Con’t
 This marketing strategy increased his farm income.
 Primary processing can be a way of avoiding losses in
storage or low market prices.
 Direct sales: For some farmers, selling directly to final
consumers may be a way to enhance profitability and
reduce risk.
 Small scale farmers near population centers may
especially benefit from direct sales to final consumers.
 However, the farmers need to be sure that they can sell
everything taken to market.
 Otherwise they may end up worse off than selling to
traders.
 They also need to be sure that the higher prices they will
get from retail sales will cover the extra costs they will incur.

100. Con’t
 Contractual agreements to sell produce and buy
inputs:
 Price uncertainty could be greatly reduced if farmers could
make advance contracts with buyers of products.
 Contractual agreements can be made with a private
individual or company.
 The farmer often knows in advance the prices that will
be received.
 For example, a livestock feed-mill may contract to buy a
farmer’s grain at an agreed price or a tobacco company
may do the same for the tobacco crop.
 Some companies that buy produce from farmers at
harvest time also sell inputs to farmers.

101. Con’t
 An example of a contract agreement
 A farmer runs a small-scale commercial chicken broiler
operation.
 He is considering whether to enter into a production
contract with an integrated broiler company.
 The company would supply the farmer with chicks and
technical advice on feeds, health and housing
throughout the production cycle.
 In return for handing over management decisions, his
income risk is greatly reduced, market access is
guaranteed and access to capital ensured.
 The farmer has to weigh up these potential benefits against
his reduced managerial freedom and the risk that the
contract might be terminated after he has made

102. Con’t
 considerable investment in broiler facilities.
 Marketing contracts can be either verbal or written
agreements between farmers and buyers.
 The contracts often set the price for produce sold and the
quality of the produce expected.
 Forward pricing: is a practice where the buyer and
producer agree on a price for the sale of crops or livestock
in advance of delivery.
 An agreement is reached to deliver the crop at an agreed
price, quantity, quality and time.
 This practice enables farmers to reduce the risk that the
price they receive for their output might not cover
production costs.

103. Con’t
 An example of forward pricing for vegetables
 In the case of vegetable production, it is sometimes
possible for a farmer to negotiate a predetermined price
with a buyer.
 The price is often set at a level below the expected market
price at harvest time.
 The farmer has to guarantee that supplies are delivered to
the buyer according to the agreement; at the volume,
quality and time set.
 This provides the farmer with a guarantee of the price to be
received.
 In this way the risk of low prices is reduced.

104. Con’t
 However, such agreements do not allow farmers to enjoy
the advantages of possible price increase that may occur
over the harvest period.
 Forward pricing is particularly relevant for highly
specialized or perishable products, and is also common
for “niche” products although it is not widely used by
small-scale farmers at present.

105. Advanced Pricing Arrangements
 Cash forward contracts: Agreements that are based on
an exchange of produce at a specified future time.
 They allow farmers to establish a price for later delivery.
 The contract specifies the price, quantity and quality of
produce to be delivered at an agreed post-harvest date.
 The contract also indicates the penalty to be paid if the
farmer fails to deliver.
 Deferred pricing contracts: Contracts where the price is
determined later at some specified date.
 Ownership is transferred before the price is set.
 Deferred payment contracts: Contracts where the current
price and delivery of the produce is set but there is delay in the
receipt of payment. It transfers ownership to the buyer at delivery
but allows the seller to set the price later.

106. Con’t
 Minimum price contracts: Provide farmers with a floor
price for duration of the contract.
 They offer the farmer protection against a drop in price
below a minimum level, while still leaving the final
pricing until a later date.
 Futures contracts: Agreements that are made for a
specified future time.
 The risks are transferred to another business that is more
willing to accept them.
 Here the contract is sold and bought instead of the actual
produce.

107. Con’t
 Building trust: For farmers involved in contractual
relationships the most critical issue is agreeing on the
price with the buyer and developing trust.
 The nature of the business relationship is that both buyers
and sellers try to obtain the best deal.
 Farmers aim at negotiating the highest possible price to
maximize their profits and buyers try to ensure that low
prices are paid so that they can also maximize their profits.
 Farmers need skills in negotiating contracts in order to
arrive at an acceptable agreement.
 Even though agreement can be reached there are still risks
involved for both the farmer and buyer.

108. Con’t
o Problems are often related to:
agreement on the weight of the crop;
agreement on the quality of the produce;
calculating the money owed to farmers;
failure of buyers to buy agreed quantities;
failure of farmers to supply agreed qualities.
 Both parties need to build trust and realize that the long-
term advantages of a fair relationship should outweigh any
short-term benefits of failing to honor the agreement.
 Although there are likely to be periods when products are sold
at a loss, a sustainable production marketing relationship is
one in which both parties involved make a profit.
 For arrangements to continue for a long time they need to be
financially sustainable.
 Both parties must benefit. The long-term success of such an
arrangement depends on the capacity of farmers to negotiate
with buyers and to ensure that they work well together.

109. Con’t
o The position of farmers during negotiations with buyers
can be improved by extension staff by:
 informing the farmers of the range of buyers available;
 encouraging the farmers to grow crops for which there
is a strong demand;
 ensuring that farmers are aware of prevailing market
prices and the conditions of purchase;
 advising farmers to calculate the break-even cost of
production and marketing.
 Market price information: A key element in managing
price risk, especially price information.
 Farmers should track price information relevant to their
products.

110. Con’t
 They should try to establish if there are seasonal, annual
or other cyclical price trends for those products.
 Sound knowledge of market prices alone is not a risk
management strategy.
 However, having such information strengthens a farmer’s
position to be able to forecast more accurately future
price events.
 It will help farmers make basic decisions about their farm,
including decisions about the level of inputs, production
and choice of market.
 It will help farmers to better assess the risk of various
products, production programs, and market options.
 Market information can be divided into short- and long-
term

111. Con’t
 Short-term market information helps farmers make
instant/prompt marketing decisions on selling their
products.
 This includes: up-to-date price information; up-to-date
information on supply and demand.
 Longer-term market information can be used to make
planting decisions and plan marketing strategies.
 This includes: quarterly or annual price reports from
market Information services;
 contacts of companies providing services (e.g. transport,
storage), and
 inputs (e.g. seeds, fertilizers and packaging); descriptions
of the marketing chain.

112. C. Financial Risk
 Financial risk occurs when money is borrowed to finance
the operation of the farm business.
 This risk is caused by uncertainty about future interest
rates and repayment schedules, changes in the loan
collateral, and the ability of the farm to generate the cash
flow necessary for credit repayments.
 In some countries small farmers have become bankrupt
as a result of indebtedness.
 Farmers may purchase expensive inputs on credit, but
with the failure of rainfall and consequent low yields
may be unable to repay their loans.
 The failure to assess the financial risks associated with
lending has a direct impact on their livelihoods.

113. Con’t
In some cases, farmers have even committed
suicide.
This emphasizes the risk of farming and the need for
extension workers and farmers to be aware of the
need for appropriate financial risk Mgt.
The three aspects that need to be considered in
managing financial risk are:
a. The availability and cost of credit and the repayment
schedule,
b. The farmer’s liquidity or ability to generate cash flow
and
c. The farmer’s ability to maintain and increase capital.

114. Con’t
o In the face of this, there are a number of strategies to
manage financial risk.
 Credit: Many factors influence a farmer’s decision to
borrow money, including:
 Attitude towards risk;
 The size and type of farm operation;
 The farmer’s relationship with input suppliers and output
purchasers;
 The willingness of lenders to provide loans at conditions
acceptable to the farmer.
 Increasing the capital available lenders for farm expansion
 But this, in turn, obliges them to repay outstanding
debts and creates the risk of loan default.

115. Con’t
 Increased debt raises the likelihood that farmers would be
unable to meet their financial obligations in a year of
low returns.
 Highly indebted farmers operate in an environment of
greater financial risk.
 Savings with high liquidity are most easily converted to
cash assets that are easily converted should be sold first.
 Liquidity: is the ability of the farmer to raise cash.
 What can a farmer do if an unfavorable event happens?
 Does the farmer have ready cash or other assets that can be
easily converted to cash to cover his or her financial
obligations?

116. Con’t
 Assets tied up in land and machinery are the most
difficult to convert to cash, while stored inputs or
products are easier to convert.
 Cash held at home or in a bank provides the best
protection.
 In the case of non-cash assets, conversion to cash is
generally done by selling the asset.
 High liquidity means that the farmer can fairly easily
convert assets to cash without the assets losing much
value in the transaction.
 It is often very useful to maintain high levels of
liquidity to provide a financial obligation against the risk
of low income or increased debt.

117. Con’t
 However, if all farmers in an area have to sell stored crops
at the same time, the price will fall and the liquid assets
will be less valuable.
 As a risk management strategy, the farmer should start by
selling assets that are most easily converted to cash.
 Less liquid assets should be sold only if and when
additional cash is needed.
 Managing the phasing of investments: This refers to
decisions made by some farmers about the timing of the
purchase of assets.
 Rather than buying all the necessary equipment at one time,
 The farmer may spread the purchases out over time – over
the year or even over several years.
 In this way, farmers can limit (or perhaps even avoid) debt and at the same
time build equity.

118. Con’t
 Contingencies: are often included in farm enterprise
budgets as a way of building risk into the business
decisions of the farmer.
 They are a deliberate overestimation of costs to account
for the risk of unexpected increases in the cost of inputs,
materials and capital items.
 Contingencies can generally be used in three ways when
drawing up an enterprise budget:
 To cover cost increases;
 To cover costs (often a variety of small items) that have
not been specifically identified but which the farmer
knows are likely to arise;
 To cover the cost of unexpected items that may have
been overlooked in the original estimation.

119. Con’t
 In each case, the farmer knows from experience that there
is a possibility (therefore a risk) that this additional cost
will occur.
 Based on that experience, the farmer can add some
cost as a contingency to those costs anticipated over a
growing season or year.
 In practice, in the case of cost increases, a contingency
allowance is calculated as a percentage of the
specifically identified cost
 (e.g. labour, ploughing, fertilizer) and is then added to that
cost.
 The other contingency items are often included as a
separate cost entry calculated as a percentage of the total
costs.

120. Con’t
 The amount included is usually determined by the
experience of the individual farmer.
 It is not usually just a random amount. Including a
contingency item in a farm budget is a useful planning
tool that shows the direct impact of an unfavorable event
such as product price decreases,
 Yield failure and cost increases on farm profit.
 If the calculation shows that the impact of the
unfavorable event is too great,
 The farmer may not want to take the risk and will have to
make some other plan for the farm.
 If the farmer goes ahead as planned, including the
contingency and the unfavorable event occurs the farmer
is covered.

121. Con’t
 The farmer knows what to expect. If the event does not
occur, the farmer enjoys additional gains.
 Crop insurance is a simple risk Mgt strategy what is
covered is clear and the cost is immediately known.
 Insurance: is an agreement that is designed to provide
protection in the form of compensation against the
consequences of significant risks.
 Some farmers, usually the “better off” more commercial
farmers, can insure their farms against major risks,
 which have a low chance of occurrence but may have very
adverse consequences.
 Such events include: the death of a farmer or a family
member; sickness and accidents that disable the farmer;
fires or other hazards that destroy capital items;

122. Con’t
 loss of crops by hail, storms and floods.
 The farmer usually pays an insurance company
(private or public) to provide protection against the
consequences of these major risks.
 If the unfavorable event occurs, the insurance pays out
compensation in terms of the insurance agreement.
 Crop or weather insurance is a simple risk Mgt strategy.
 What is covered is clear and the cost is immediately
known.
 However, farmers need to make careful calculations to
determine the impact of the cost of the insurance (i.e. the
premium) on their net income.
 It is rare that insurance is offered to smallholder farmers
and affordable for them to use.

123. D. Human and personal risk
 Human risk refers to the risks to the farm business caused
by illness or death and the personal situation of the farm
family.
 Accidents, illness and death can disrupt farm performance.
 In many countries labour migration away from rural areas is
a common occurrence.
 Migration can cause labour shortages for the farm.
 Political and social unrest can also limit labour availability.
 The spread of HIV/AIDS has had a serious impact on
labour availability and productivity in some areas.
 When farmers plant their crop or commit resources to raise
livestock,
 They cannot be certain whether they will have enough
labour to manage the farm enterprises.

124. Con’t
 Strategies to guard against unexpected changes in
availability and productivity of labour
 An aspect of managing risk for larger farmers is good
human resource management(HRM).
 This includes: selecting casual workers with suitable skills
and experience; ensuring workers are employed according
to the relevant law (including fair pay);
 Regular communication; ensuring the safety of workers;
providing adequate supervision and discipline.
 Labour planning: Another aspect of human risk
management involves strategies to guard against
unexpected changes in the availability and productivity
of labour.

125. Con’t
 Careful labour planning, such as using a seasonal labour
calendar, ensures that farmers know exactly what and how
much labour is needed at various times during the
production season.
 Labour productivity: To address labour productivity
risks larger farmers may replace hand labour with
animal power, tractors or motorized implements.
 Different production program including changing farm
enterprises and enterprise mixes may also be looked at.
 Intercropping, improving farm layout, introduction of
labour-saving technologies and similar actions can all
contribute to a risk management strategy.

126. E. Institutional risk
 Institutional risk refers to unpredictable changes in the
provision of services from institutions that support
farming.
 Such institutions can be both formal and informal and
include banks, cooperatives, marketing organizations,
input dealers and government extension services.
 Part of institutional risk is the uncertainty of
government policy affecting farming, such as price
support and subsidies.
 The risks farmers face are often a result of decisions taken
by policy-makers and managers.
 Subsidies, food quality regulations for export crops,
rules for animal waste disposal and the level of price or

127. Con’t
 Income support payments are examples of decisions
taken by government that can have a major impact on the
farm business.
 There are a number of strategies to manage
institutional risk.
 Traditional institutions and social arrangements.
 The customs and organization of traditional societies tend
to provide the individual family with a measure of
security against risk.
 As part of a survival strategy the close bonds between
community members have resulted in mutual
assistance and self-help when required.
 Generally, the more fortunate and able members of the
community are obliged to help their kinsmen or

128. Con’t
 neighbours in times of need.
 This may relieve the situation in cases of sickness, injury
or death of an individual member;
 However, it is less effective in situations where the
entire community suffers. For instance, failure of
rainfall or an attack of crop pests may affect all
community members in the same way.
 Producer groups: When farmers have sufficient trust in
each other there is scope for them to work together
 Informally in order to reduce some of the risks
associated with credit mobilization,
 The purchase of inputs and marketing.
 Groups for credit and marketing purposes can produce:
economies of scale in input procurement,

129. Con’t
 Loan administration and marketing of produce;
 Capital accumulation through savings and credit
mobilization; timely delivery of services.
 The risk reducing function of farmer groups comes
from the pooling of capital of individual farmers into a
common fund,
 Collecting and disseminating information to its
members, and bulk buying and marketing.
 Producer groups also serve to provide information to
their members on the sources of additional financing,
 The potential prices of produce sold, the cost of inputs
purchased, and the quality of those inputs and final
products.

130. Con’t
 Information of this kind shared with their members
enables them to better cope with the many risks affecting
the farm household system.
 The first step in the process of group formation is for
farmers to understand the benefits of working together
and to show commitment to coordinate their activities.
 Producer groups can reduce some of the risks associated
with credit mobilization, the provision of inputs and
marketing.
 Cooperatives: Forming and participating in more formal
cooperative organizations also provides farmers the
opportunity to benefit from volume sales of produce,
 Bulk purchases of inputs and supplies

131. Con’t
 And the mobilization of credit.
• Cooperative marketing involves:
 Consolidating loads to facilitate bulk buying by traders
or bulk transport; sharing transport to reduce costs;
 Negotiating jointly with buyers;
 Purchasing inputs collectively to reduce costs;
 Mobilizing savings and credit, with members providing
mutual guarantees.
 Credit for individual farmers is more easily accessible
through cooperatives and at lower transaction costs.

132. Con’t
 Loan default and the costs of collecting delinquent loans
can similarly be reduced when individuals are jointly
liable for group loans.
 However, cooperatives and similar groupings are
sometimes the source of risk for farmers, (e.g. when the
managers or officers misappropriate the funds).

133. Ch- 3: Risk management in the dynamic world
 3.1. Definitions and basic concepts
 Risk management is defined as a systematic process for
the identification and evaluation of pure loss exposures
faced by an organization or individual.
 And for the selection and implementation of the most
appropriate techniques for treating such exposures.
 It is a scientific approach to dealing with pure risks by
anticipating possible accidental losses
 And designing and implementing procedures that
minimize the occurrence of loss or the financial impact of
the losses that occur
 Risk Mgt focuses on a part of the total bundle of risks,
those that are classified as “pure risk.”

134. Objectives of risk management
 Risk management has several important objectives that
can be classified into two categories:
 Pre-loss Objectives : Economy, Reduction in anxiety,
Meeting external obligations
 Post-loss Objectives: Survival, Continuity of operation ,
Earnings stability ,Continued growth, Social responsibility
 Pre loss Objectives:
• The first objective means that the firm should prepare
for potential losses in the most economical way.
 This involves an analysis of safety program expenses,
insurance premiums, and the costs associated with the
different techniques for handling losses

135. Con’t
• The second objective is the reduction of anxiety:
 Certain loss exposures can cause greater worry and
fear for the risk manager,
 key executives, and stockholders than other exposures.
 For example, the threat of a catastrophic lawsuit/sue
from a defective product can cause greater anxiety and
concern than a possible small loss forms a minor fire,
• The third objective is to meet any externally imposed
obligations:
 This means the firm must meet certain obligations
imposed on it by outsiders.
 For example, government regulations may require a firm
to install safety devices to protect workers from harm

136. Con’t
 Post loss Objectives: The first and most important post
loss objective is survival of the firm.
 Survival means that after a loss occurs, the firm can at
least resume/start again partial operation
 Within some reasonable time period if it chooses to do so.
 The second post loss objective is to continue operating.
 For some firms, the ability to operate after a sever loss is
an extremely important objective
 Example: X company
 Stability of earnings is the third post loss objective
 The firm wants to maintain its earnings per share after a
loss occurs
 Earnings per share can be maintained if the firm continues to operate

137. Con’t
 The fourth post loss objective is continued growth of the firm
 A firm may grow by developing new products and markets or by
acquisitions(when a company absorbs another, but no new
organization is created) and mergers(the combining of two
organizations into an entirely new entity)
 Finally, the goal of social responsibility is to minimize the
impact that a loss has on other persons or society
 A server loss can adversely affect employees, customers,
suppliers, creditors, taxpayers, and the community in general.
 The Risk Management Process: There are four steps in the risk
management process:
1. Identifying potential losses: it is the process by which a
business systematically & continuously identifies property,
liability, and personnel exposure as soon as or before they
emerge

138. Con’t
 Unless the risk manager identifies all the potential losses
confronting the firm,
 He or she will not have any opportunity to determine the
best way to handle the undiscovered risks
 Risk identification is a very difficult process because the
risk manager has to look into all operations of the
company,
 So as to identify where exactly risks emanate from.
2. Evaluating Potential Losses: The second step in the risk
Mgt process is to evaluate and measure the impact of losses
on the firm
• This involves an estimation of the potential frequency
and severity of loss

139. Con’t
 Loss frequency refers to the probable number of losses
that may occur during some given period of time
 Loss severity refers to the probable size of the losses that
may occur
 Both the maximum possible loss and maximum probable
loss must also be estimated
 The maximum possible loss is the worst loss that could
possibly happen to the firm during its lifetime
 The maximum probable loss is the worst loss that is
likely to happen
 For example, if a plant is totally destroyed in a flood, the
risk manager may estimate that replacement cost,
demolition/destruction costs and other costs will total
Birr10 million

140. Con’t
 Thus, the maximum possible loss is 10million Birr
 The risk manager also estimates that another flood causing
more than 8 million Birr of damage to the plant
 Thus, for this risk manager, the maximum probable loss
is 8 million Birr
 Catastrophic losses are difficult to predict because they
occur infrequently
 However, their potential impact on the firm must be given
high priority
 In contrast, certain losses such as physical damage losses to
automobiles and trucks, occur with greater frequency, but are
usually relatively small

141. Con’t
 This can be predicted with greater accuracy
3. Selecting the Appropriate Technique
 The major techniques for treating loss exposures are the
following:
 Risk control techniques
 Risk control techniques attempt to reduce the frequency
and severity of accidental losses to the firm
 Avoidance- means that a certain loss exposure is never
acquired, or an existing loss exposure is
abandoned/discarded.
 One way to control a particular risk is to avoid the
property, person,

142. Con’t
 or activity giving rise to possible loss by either refusing to
assume it even momentarily or by abandoning an
exposure to loss assumed earlier.
 For example, a pharmaceutical firm that produces a drug
with dangerous side effects may stop manufacturing that
drug
 Loss Control- activities are designed to reduce both the
frequency and severity of losses.
 Loss-control measures attack risk by lowering the
chance that a loss will occur or by reducing its severity if
it occurs.
 The purpose of loss-control activities is to change the
characteristics of the exposure so that it is more
acceptable to the firm;

143. Con’t
 The firm wishes to keep the exposure but wants to reduce
the frequency and severity of losses
 Separation /Diversification/- Another risk control tool is
separation of the firm’s exposures to loss
 instead of concentrating them at one location where they
might all be involved in the same loss.
 For example, instead of placing its entire inventory in
one warehouse, a firm may elect to separate this exposure
 by placing equal parts of the inventory in ten widely
separated warehouses.
 If fire destroys one warehouse, the firm will have others
from which to draw needed supplies

144. Con’t
 Combination-Combination or pooling makes loss
experience more predictable by increasing the number of
exposure units.
 One way a firm can combine risk is to expand through
internal growth.
 Risk Financing Techniques: provide for the funding of
accidental losses after they occur
 Retention/Assumption/- The source of the funds is the
organization itself, including borrowed funds that the
organization must repay.
 Retention may be passive or active, unconscious or
conscious, unplanned or planned.

145. Con’t
 Retention is passive or unplanned when the risk manager
is not aware of that the exposure exists and consequently
does not attempt to handle it.
 Retention is active or planned when the risk manager
considers other methods of handling the risk and
 consciously/deliberately decides not to transfer the
potential losses
 Retention can be effectively used in a risk Mgt program
when three conditions exist:
 When no other method of treatment is available
 When the worst possible loss is not bankrupt the firm
 When losses are highly predictable

146. Con’t
 Self-insurance: is a special form of planned retention by
which part or all of a given loss exposure is retained by
the firm.
 Self-insurance is a special case of active or planned
retention.
 Self-insurance is not insurance, because there is no
transfer of the risk to an outsider.
 A better name for self-insurance is self-funding, which
expresses more clearly the idea that losses are funded and
paid by the firm.
 Non-insurance Transfers: are methods other than
insurance by which a pure risk and its potential financial
consequences are transferred to another party

147. Con’t
 Insurance: Commercial insurance is also used in a risk
management program
 From the risk manger’s viewpoint, insurance represents
a contractual transfer of risk
 Insurance is appropriate for loss exposures that have a low
probability of loss but the severity of loss is high
 If the risk manager uses insurance to treat certain loss
exposures, five key areas must be emphasized.
 Selection of insurance coverage,
 Selection of an insurer,
 Negotiation of terms,
 Dissemination of information concerning insurance coverage,
 Periodic review of the insurance program

148. Con’t
 Which method should be used?
 In determining the appropriate method or methods for
handling losses,
 a matrix can be used that classifies the various loss
exposures according to frequency and severity
 The matrix can be useful in determining which risk Mgt
method should be used

149. 4.Implementing and Administering the Risk Mgt Program
 At this point, three of the four steps in the risk Mgt process
have been discussed.
 The fourth step is implementation and administration of
the risk management program.
3.2. The changing scope of risk management
 Traditionally, risk Mgt was limited in scope to pure loss
exposures, including property risks, liability risks, and
personnel risks.
 An interesting trend emerged in the 1990s, however, as
many businesses began to expand the scope of risk
management to include speculative financial risks.
 Recently, some businesses have gone a step further,
expanding their risk Mgt programs to consider all risks

150. Con’t
 A. Financial Risk Management: Business firms face a
number of speculative financial risks.
 Financial risk Mgt refers to the identification, analysis,
and treatment of speculative financial risks.
 These risks include commodity price risk, Interest rate
risk and currency exchange rate risk.
 Commodity Price: is the risk of losing money if the price
of a commodity changes.
 Producers and users of commodities face commodity
price risks. For example, consider an agricultural
operation that will have thousands of bushels of grain at
harvest time.
 At harvest, the price of the commodity may have increased or
decreased, depending on the supply and demand for grain.

151. Con’t
 Because little storage is available for the crop, the
grain must be sold at the current market price, even if
that price is low.
 In a similar fashion, users and distributors of
commodities face commodity price risks.
 Consider a cereal company that has promised to deliver
500,000 boxes of cereal at an agreed-upon price in six
months.
 In the meantime, the price of grain of a commodity
needed to produce the cereal may increase or decrease,
altering the profitability of the transaction.
 Hence, to minimize this futures contracts can be used
to hedge a commodity price risk.

152. Con’t
 Interest Rate Risk: Risk Financial institutions are
especially susceptible to interest rate risk.
 Interest rate risk is the risk of loss caused by adverse
interest rate movements.
 For example, consider a bank that has loaned money at
fixed interest rates to home purchasers under 15- and 30-
year mortgages.
 If interest rates increase, the bank must pay higher interest
rates on deposits while the mortgages are locked-in at
lower interest rates.
 Similarly, a corporation might issue bonds at a time when
interest rates are high.
 For the bonds to sell at their face value when issued, the coupon
interest rate must equal the investor- required rate of return.

153. Con’t
 If interest rates later decline, the company must still pay
the higher coupon interest rate on the bonds.
 Currency Exchange Rate Risk: is the value for which
one nation’s currency may be converted to another
nation’s currency.
 For example, one Canadian dollar might be worth the
equivalent of two-thirds of one U.S. dollar.
 At this currency exchange rate, one U.S. dollar may be
converted to one and one-half Canadian dollars.
 U.S. companies that have international operations are
susceptible to currency exchange rate risk.
 Currency exchange rate risk is the risk of loss of value
caused by changes in the rate at which one nation’s
currency may be converted to another nation’s currency.

154. Con’t
 For example, a U.S. company faces currency exchange
rate risk when it agrees to accept a specified amount of
foreign currency in the future as payment for goods sold
or work performed.
 Likewise, U.S. companies with significant foreign
operations face an earnings risk because of fluctuating
exchange rates.
 When a U.S. company generates profits abroad, those
gains must be translated back into U.S. dollars.
 When the U.S. dollar is strong (that is, when it has a high
value relative to a foreign currency), the foreign currency
purchases fewer U.S.
 dollars and the company’s earnings therefore are lower.

155. Con’t
 A weak U.S. dollar (that is, when it has a low value
relative to a foreign currency)
 means that foreign profits can be exchanged for a larger
number of U.S. dollars, and consequently the firm’s
earnings are higher.
 Managing Financial Risks: The traditional separation of
pure and speculative risks meant that different business
departments addressed these risks.
 Pure risks were handled by the risk manager through
risk retention, risk transfer, and loss control.
 Speculative risks were handled by the finance division
‘through contractual provisions and capital market
instruments.

156. Con’t
 A variety of capital market approaches are also
employed, including options contracts, forward contracts,
futures contracts, and interest rate swaps.
• Forward contract: A legally binding agreement between
two parties calling for the sale of an asset or product in the
future at a price agreed upon today.
• The terms of the contract call for one party to deliver the
goods to the other on a certain date in the future, called the
settlement date. The other party pays the previously
agreed-upon forward price and takes the goods.
• Swaps are an agreement b/n two parties to exchange cash
flows in the future according to a prearranged formula.
Two types swaps

157. Con’t
• Interest rate swaps is swapping only the interest related
cash flows b/n the parties in the same currency.
• Currency swaps is swapping both principal & interest b/n
the parties with the cash flow from different currency.
• Future contract: A forward contract with the feature that
gains and losses are realized each day rather than only on
the settlement date
• An option contract: An agreement that gives the owner the
right, but not the obligation, to buy or sell a specific asset at
a specific price for a set period of time.
 The second part shows how options can help to manage the
risk of a decrease in the price of common stock.
 During the 1990s, some businesses began taking a more
holistic view of the pure and speculative risks faced by the
organization,

158. Con’t
 Hoping to achieve cost savings and better risk treatment
solutions by combining coverage for both types of risk.
 In 1997, Honeywell became the first company to enter
into an “integrated risk program” with American Inter-
national Group (AIG).
 An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks in
the same contract.
 At the time, Honeywell was generating more than one
third of its profits abroad.
 Its integrated risk program provided traditional property
and casualty insurance, as well as coverage for currency
exchange rate risk.

159. Con’t
 In recognition of the fact that they are treating these
risks jointly, some organizations have created a new
position.
 The chief risk officer (CRO) is responsible for the
treatment of pure and speculative risks faced by the
organization.
 Combining responsibilities in one area permits treatment
of the risks in a unified, and often more economical way.
 For example, the risk manager may be concerned about a
large self- insured property claim.
 The financial manager may be concerned about losses
caused by adverse changes in the exchange rate.
 Either loss, by itself, may not harm the organization if the
company has a strong balance sheet.

160. Con’t
 The occurrence of both losses, however, may damage the
business more severely.
 An integrated risk management program can be designed to
consider both contingencies by including a double- trigger
option.
 A double-trigger option is a provision that provides for
payment only if two specified losses occur.
 Thus, payments would be made only if a large property claim
and a large exchange rate loss occurred.
 The cost of such coverage is less than the cost of treating
each risk separately.

161. B. Enterprise Risk Management:
 Enterprise risk management is a comprehensive risk
management program that addresses an organization’s
pure risks, speculative risks, strategic risks, and operational
risks.
 Pure and speculative risks were defined previously.
 Strategic risk refers to uncertainty regarding the
organization’s goals and objectives, and the organization’s
strengths, weaknesses, opportunities, and threats(SWOTs).
 Operational risks are risks that develop out of business
operations, including such things as manufacturing
products and providing services to customers.

162. Con’t
 By packaging all of these risks in a single program, the
corporation offsets one risk against another, and in the
process reduces its overall risk.
 As long as the risks combined in the program do not
exhibit perfect positive correlation, the combination of
exposures reduces risk.
 Indeed, if some of the risks are negatively correlated, risk
can be reduced significantly.
 To what extent have enterprise risk management (ERM)
programs actually been adopted?
 Early studies estimated that 30 to 35% of U.S. and North
American companies had adopted ERM.

163. Con’t
 Usage of ERM was most prominent in the financial services
sector (the largest adopters being global insurers), followed
by energy and mining, manufacturing, and telecommunications
companies.
 Organizations adopting ERM programs did so for several
reasons.
 Holistic treatment of risks facing the organization, advantage
over competing businesses,
 Positive impact upon revenues, reduction in earnings volatility,
and compliance with corporate governance guidelines.
 Some barriers cited by survey respondents included:
organization culture,
 Management’s perception that ERM is not a priority, lack of
a formal process, and deficiencies in intellectual capital and
technology.

164. 3.3. Insurance Market Dynamics
 When property and liability loss exposures are not
eliminated through risk avoidance, losses that occur
must be financed in some other way.
 The risk manager must choose between two methods of
funding losses:
 Risk retention and risk transfer.
 Retained losses can be paid out of current earnings, from
loss reserves, by borrowing,
 Risk transfer shifts the burden of paying for losses to
another party, most often a property and liability
insurance company.
 Decisions about whether to retain risks or to transfer them
are influenced by conditions in the insurance market place.

165. Con’t
 Three important factors influencing the insurance market are:
1. The Underwriting Cycle: Underwriting means determining
risk related to something, whether related to securities in
financial market and related to insurance policies.
 For many years, a cyclical pattern has been observed in a number
of underwriting results and profitability measures in the property
and liability insurance industry.
 This cyclical pattern in underwriting stringency/ severity,
premium levels, and profitability is referred to as the
underwriting cycle.
 Property and liability insurance markets fluctuate between
periods of tight underwriting standards and high premiums,
called a “hard” insurance market, and
 Periods of loose underwriting standards and low premiums,
called a “soft” insurance market.

166. Con’t
 A number of measures can be used to ascertain the status
of the underwriting cycle shows the combined ratio for
the property and liability insurance industry over time.
 The combined ratio is the ratio of paid losses and loss
adjustment expenses plus underwriting expenses to
premiums.
 If the combined ratio is greater than 1 (or 100 percent),
underwriting operations are unprofitable.
 For example, the combined ratio of 107 for 2002 indicates
that for every $1.00 that insurers collected in premiums,
they paid out $1.07 in claims and expenses.
 If the combined ratio is less than 1 {or 100 percent),
insurance companies are making money on
underwriting operations.

167. Con’t
 Risk managers must consider current premium rates and
underwriting standards when making their retention
and transfer decisions.
 When the market is “soft,” insurance can be purchased
at favorable terms (for example, lower premiums, broader
coverage, removal of exclusions).
 In a “hard” market, more retention is used because
some insurance coverages are limited in availability or
may not be affordable.
 The continued soft market of the late 1990s, for example,
led some risk managers to purchase multiple-year
insurance contracts in an effort to lock in favorable terms.
 What causes these price fluctuations in property and
liability insurance markets?

168. Con’t
 Two factors affecting property and liability insurance
pricing and underwriting decisions are: Insurance
industry capacity and Investment returns.
 Insurance Industry Capacity: In the insurance industry,
capacity refers to the relative level of surplus.
 Surplus is the difference between an insurer’s assets and
its liabilities.
 When the property and casualty insurance industry is in a
strong surplus position, insurers can reduce premiums
and loosen
 Underwriting standards, because they have a cushion to
draw on if underwriting results prove unfavorable.

169. Con’t
 Given the flexibility of financial capital and the
competitive nature of the insurance industry, other insurers
often follow suit if one insurer takes this step.
 As competition intensifies, premiums are reduced further,
and underwriting standards are applied less stringently.
 Underwriting losses begin to mount for insurers, because
inadequate premiums have been charged.
 Underwriting losses reduce insurers’ surplus, and at
some point, premiums must be raised and underwriting
standards tightened to restore the depleted surplus.
 These actions will lead to a return to profitable
underwriting, which helps to replenish the surplus.

170. Con’t
 When adequate surplus is restored, insurers once again are
able to reduce premiums and loosen underwriting
standards, causing the cycle to repeat.
 External factors (such as earthquakes, hurricanes, and
large liability awards) may also increase the level of
claims, reducing surplus.
 The World Trade Center disaster produced what in the
insurance industry is called a “clash loss.”
 A clash loss occurs when several lines of insurance
simultaneously experience large losses.
 The WTC disaster created large losses for life insurers,
health insurers, and property and liability insurers.

171. Con’t
 Investment Returns: Would you sell insurance if, for
every dollar you collected in premiums, you expected to
pay 78 cents in losses and 30 cents in expenses?
 That payout rate would lead to a loss of 8 cents per dollar
of premiums collected.
 Property and casualty insurance companies can, and often
do, sell coverages at an expected loss, hoping to offset
underwriting losses with investment income.
 In reality, insurance companies are in two businesses:
underwriting risks and investing premiums.
 If insurers expect favorable investment results, they can
sell their insurance coverages at lower premium rates,

172. Con’t
 hoping to offset underwriting losses with investment
income.
 This practice is known as cash flow underwriting.
2. Consolidation in the Insurance Industry: While
changes were occurring in insurance product markets,
 Changes were also occurring among the organizations
operating in this sector of the economy.
 In the financial services industry, the consolidation trend is
continuing.
 Consolidation means the combining of business
organizations through mergers and acquisitions.
 Acquisitions (when a company absorbs another, but no
new organization is created) and mergers(the combining
of two organizations into an entirely new entity)

173. Con’t
 A number of consolidation trends have changed the
insurance market place for risk managers:
 Insurance company mergers and acquisitions, Insurance
brokerage mergers and acquisitions and Cross-industry
consolidations.
 Insurance Company Mergers and Acquisitions: Given
the market structure of the property and liability insurance
industry
 (numerous companies, relatively low barriers to entry
given the flexibility of financial capital, and relatively
homogenous products),
 Insurance company consolidations do not have severe
consequences for risk managers.”

174. Con’t
 Risk managers may notice, however, that the market
place is populated by fewer but larger, independent
insurance organizations as a result of consolidation.
 An excellent recent example is the merger of Travelers
Property Casualty Insurance Company and The St. Paul
Companies in 2004, forming St. Paul Travelers.
 Insurance Brokerage Mergers and Acquisitions: Unlike
the consolidation of insurance companies, consolidation of
insurance brokerages does have consequences for risk
managers.
 Insurance brokers are intermediaries who represent
insurance purchasers.
 Insurance brokers offer an array of services to their
clients, including attempting to place their clients’
business with insurers.

175. Con’t
 Clearly, a risk manager wants to obtain insurance
coverage's and related services under the most favorable
financial terms available.
 Periodically, risk managers Contact several insurance
agents and insurance brokers in an effort to obtain
competitive insurance coverage bids.
 The number of large, national insurance brokerages has
declined significantly in recent years because of
consolidation.
 For example, before the consolidation of recent years, a
risk manager could obtain coverage bids from the
Sedgwick Group, Johnson SC Higgins, and Marsh SC McLennan.

176. Con’t
 As a result of consolidation, these three large, independent
brokerages are now a single entity Marsh and McLennan
Companies, Inc.
 Other large insurance brokerages have merged with or
been acquired by other insurance brokerages as well.”
 Cross-Industry Consolidation: Consolidation in the
financial services arena is not limited to mergers between
insurance companies or between insurance brokerages.
 Boundaries separating institutions with depository
functions, institutions that underwrite risk, and securities
 businesses were enacted in Depression-era legislation.
 The divisions between banks, insurance companies, and
securities firms began to blur in the 1990s.

177. Con’t
 The U.S. Congress formally struck/ hit down the barriers
with passage of the Financial Services Modernization Act
of 1999 (also known by the names of the bill’s sponsors,
Gramm—Leach-Bliley).
 The 1998 merger between Citibank and Travelers, which
created Citigroup, provides an excellent example of an
integrated financial services company.
 The consolidated company included Citibank, Travelers
Insurance Group, Smith Barney, and several other financial
services operations.
 In 2002, Citigroup decided to spin off Travelers Insurance.
A second example is the announcement in 2001 by Wells

178. Con’t
 Fargo that it would acquire ACO Brokerage, parent firm
of Acordia Inc., a large insurance brokerage.
 In addition to mergers and acquisitions between different
types of financial institutions, some financial services
companies are simply diversifying their operations by
expanding into new sectors.
 State Farm Insurance, for example, has its own bank,
offers mortgages, and sells mutual funds.
 Securitization of Risk: Another important development
in insurance and risk management is the accelerating use
of securitization of risk.
 Securitization of risk means that insurable risk is
transferred to the capital markets through creation of a financial

179. Con’t
 instrument, such as a catastrophe bond, futures
contract, options contract, or other financial instrument.
 The impact of risk securitization upon the insurance
marketplace is an immediate increase in capacity for
insurers and re-insurers.
 Rather than relying upon the capacity of insurers only,
securitization provides access to the capital of many
investors.
 Insurers were among the first organizations to experiment
with securitization. USAA Insurance Company, through a
subsidiary, issued a catastrophe bond in 1997 to protect the
company against catastrophic hurricane losses.

180. Con’t
 Catastrophe bonds are corporate bonds that permit the
issuer to skip or defer scheduled payments if a catastrophic
loss occurs.
 Under the terms of the USAA bond, investors were paid
principal and interest provided that hurricane losses
during a time period did not exceed a specified level.
 Principal and interest would be lost, however, if
hurricane claims exceeded a trigger point.”
 Catastrophe bonds are not the only way in which risk can
be securitized.
 The profitability of many businesses is determined, in
large part, by weather conditions.
 Utility companies, agricultural enterprises, resorts, and
other businesses face weather- related risk and uncertainty.

181. Con’t
 More and more of these businesses are turning to the
weather derivatives market, the fastest growing segment of
the derivatives market, for assistance in managing this risk.
 A weather option provides a payment if a specified weather
contingency (e.g., temperatures higher or lower than
normal) occurs.
 3.4. Loss Forecasting: The risk manager must also
identify the risks the organization faces, and
 Then analyze the potential frequency and severity of
these loss exposures.
 Although loss history provides valuable information,
there is no guarantee that future losses will follow past
loss trends.

182. Con’t
 Risk managers can employ a number of techniques to
assist in predicting loss levels, including the following:
 1. Probability Analysis: Chance of loss is the probability
that an adverse event will occur.
 The probability (P) of such an event is equal to the
number of events likely to occur (X) divided by the
number of exposure units (N).
 Thus, if a vehicle fleet has 500 vehicles and on average
100 vehicles suffer physical damage each year,
 The probability that a fleet vehicle will be damaged in any
given year is: P(physical damage) =100/500 = .20 or 20%.

183. Con’t
 Some probabilities of events can be easily deduced (for
example, the probability that a fair coin will come up
“heads” or “tails”).
 Other probabilities (for example, the probability that a
male age 50 will die before reaching age 60) may be
estimated from prior loss data.
 The risk manager must also be concerned with the
characteristics of the event being analyzed.
 Some events are independent events the occurrence does
not affect the occurrence of another event.
 For example, assume that a business has production
facilities in Louisiana and Virginia, and that the
probability of a fire at the Louisiana
 plant is 5% and that the probability of a fire at the Virginia plant is 4 %.

184. Con’t
 Obviously, the occurrence of one of these events does
not influence the occurrence of the other event.
 If events are independent, the probability that they will
occur together is the product of the individual
probabilities.
 Thus, the probability that both production facilities will be
damaged by fire is: P(fire at Louisiana plant) X P(fire at
Virginia plant) = P(fire at both plants) = .04 X .05 = .002
or 2%.
 Other events can be classified as dependent events the
occurrence of one event affects the occurrence of the
other.
 If two buildings are located close together, and one building catches on
fire, the probability that the other building will burn is increased.

185. Con’t
 For example, suppose that the individual probability of a
fire loss at each building is 3 percent.
 The probability that the second building will have a fire
given that the first building has a fire, however, may be
40 percent.
 Then what is the probability of two fires? This probability
is a conditional probability that is equal to the
probability of
 the first event multiplied by the probability of the second
event given that the first event has occurred:

186. Con’t
 Events may also be mutually exclusive. Events are
mutually exclusive if the occurrence of one event
precludes the occurrence of the second event.
 For example, if a building is destroyed by fire, it cannot
also be destroyed by flood. Mutually exclusive
probabilities are additive.
 If the probability that a building will be destroyed by fire
is 2% and the probability that the building will be
destroyed by flood is 1%,
 then the probability the building will be destroyed by
either fire or flood is:

187. Con’t
 If the independent events are not mutually exclusive,
then more than one event could occur.
 Care must be taken not to “double count” when
determining the probability that at least one event will
occur.
 For example, if the probability of minor fire damage is
4% and the probability of minor flood damage is 3%, then
the probability of at least one of these events occurring is:
 P(minor fire) + P(minor flood) = P(minor fire and flood)
= P(at least one event) .04 + .03 ~ (.04) X (.03) = .0688 or
6.88%.
 Assigning probabilities to individual and joint events and
analyzing the probabilities can assist the risk manager in
formulating a risk treatment plan.

188. Con’t
 2. Regression Analysis: is another method for forecasting
losses. Regression analysis characterizes the relationship
between two or more variables and then uses this
characterization to predict values of a variable.
 One variable the dependent variable is hypothesized to
be a function of one or more independent variables.
 It is not difficult to envision relationships that would be of
interest to risk managers in which one variable is
dependent upon another variable.
 For example, consider workers compensation claims.
 It is logical to hypothesize that the number of workers
compensation claims should be positively related to some

189. Con’t
 Variable representing employment (for example, the
number of employees, payroll, or hours worked).
 Likewise, we would expect the number of physical
damage claims for a fleet of vehicles to increase as the
size of the fleet increases or as the number of miles
driven each year by fleet vehicles increases.
 Regression analysis provides the coordinates of the line
that best fits the points in the chart.“
 This line will minimize the sum of the squared deviations of the
points from the line.
 Our hypothesized relationship is as follows:

190. Con’t
 The regression results provided at the bottom of fig 3.1,
coefficient of determination, R-square, ranges from 0 to
1 and measures the model fit.
 An R- square value close to 1 indicates that the model
does a good job of predicting Y values.
 By substituting the estimated payroll for next year (in
thousands),
 The risk manager estimates that 509 workers
compensation claims will occur in the next year.
 Fig 3.1. Relationship Between Payroll and Number of
Workers Compensation Claims.

191. Con’t

192. Con’t
 3. Forecasting Based on Loss Distributions:Another
useful tool for the risk manager is loss forecasting based
on loss distributions.
 A loss distribution is a probability distribution of losses
that could occur.
 Forecasting by using loss distributions works well if losses
tend to follow a specified distribution and the sample
size is large.
 Knowing the parameters that specify the loss
distribution (for example, mean, standard deviation,
and frequency of occurrence) enables
 the risk manager to estimate the number of events,
severity, and confidence intervals.
 Many loss distributions can be employed, depending on the pattern of losses.

193. Con’t
 Several distributions are available, including the normal,
binomial, exponential, Poisson, and others.
 Selection of the distribution is often based upon loss
history, especially when the number of losses is large.
 We will examine application of the normal distribution,
which is used in many situations.
 The normal distribution is a symmetric bell curve
summarized by two parameters: m and s, respectively
 The area under the curve is equal to one, with 50% of the
either side of the expected value. Based on the values of m
and s, and an “Areas Under a Normal Curve”(See Z table),
 the probability of any event (x) can be estimated based on the standard variant, Z:

194. Con’t
 For example, assume that the number of weather- related
property losses is normally distributed with a mean (m)
equal to 16 and standard deviation (s) equal to 3.
 What is the probability that the number of weather-related
property losses will be between 16 and 22?
 Substituting values into the formula, we can solve for the
standard variant, z, which equals 2.00.
 The area corresponding to a standard variant of 2.00,
according to Z-table, is 0.4772.
 Therefore, the probability that between 16 and 22
weather—related losses will occur is almost 48%.
 1. Assume the number of physical damage losses for a
large fleet of vehicles is normally distributed with a mean
of 400 and a standard deviation of 80.

195. Con’t
a. What is the probability that More than 440 losses will
occur?
b. Between 320 and 480 losses will occur?
c. Between 460 and 520 losses will occur?
 The standard variant can also be used to determine “X
values” corresponding to a given probability.
 Based on the previous information (normally-
distributed losses, mean of 400, standard deviation of
80),
 above what number of physical damage claims do the
highest 10 percent of x values fall?
 We know that the area to the right of the value of x is
10 percent.

196. Con’t
 As the table shows probabilities between the expected
value and x, we need to look in the table for a z value
corresponding to .40.
 This z value is approximately 1.28. By substituting all of
the known values back into our expression for z, we can
solve for x:

197. 3.5. Financial Analysis in Risk Management Decision Making
 Risk managers must make a number of important
decisions, including whether to retain or transfer loss
exposures,
 which insurance coverage bid is best, and whether to invest
in loss control projects.
 The risk manager’s decisions are based on economics
weighing the costs and benefits of a course of action to see
whether it is in the economic interests of the company and
its stockholders.
 Financial analysis can be applied to assist in risk
management decision making.
 To make decisions involving cash flows in different time
periods, the risk manager must employ time value of
money analysis

198. Con’t
 1. The Time Value of Money
 Means that when valuing cash flows in different time
periods, the interest-earning capacity of money must be
taken into consideration.
 A dollar received today is worth more than a dollar
received one year from today,
 Because the dollar received today can be invested
immediately to earn interest.
 Therefore, when evaluating cash flows in different time
periods, it is important to adjust dollar values to reflect
the earning of interest.
 A lengthy discourse on the time value of money is beyond
the scope of this text.”

199. Con’t
 Instead, we will limit our treatment to the valuation of
single cash flows. Suppose you open a bank account today
and deposit $100.
 The value of the account today, the present value is $100.
 Further assume that the bank is willing to pay 4%
interest, compounded annually, on your account.
 What is the account balance one year from today?
 At that time, you would have your original $100, plus an
additional 4% of $100, or $4 in interest: $100 + ($100 X
.04) = $104. Factoring, you would have $100 X (1 + .04)
= $104.
 Thus, if you multiply the starting amount (the present
value, or PV) by 1 plus the interest rate (i), it will give you
the amount one year from today ( FV): FV = PV(1+i)

200. Con’t
 If you want to know the account balance after two years,
simply multiply the balance at the end of the first year
by 1 plus the interest rate.
 In this way, we arrive at the simple formula
for the future value of a present amount:
 In the second year, not only will you earn interest on the original
deposit, but you will also earn interest on the $4 in interest you
earned in the first period.
 Because you are earning interest on interest (compound
interest), the operation through which a present value is converted
to a future value is called compounding.

201. Con’t
 Compounding also works in reverse. Assume that you
know the value of a future cash flow,
 but you want to know what the cash flow is worth
today, adjusting for the time value of money.
 Dividing both sides of our compounding equation by (1 +
i)n yields the following expression:
 Thus, if you want to know the present value of any
future amount, divide the future amount by 1 plus the
interest rate, raised to the number of periods.
 This operation bringing a future value back to present
value is called discounting.

202. 3.5.1. Financial Analysis Applications
 In many instances, the time value of money can be
applied in risk management decision making.
 We will consider two applications
a. Analyzing Insurance Coverage Bids: Assume that
Susan Carley would like to purchase property
insurance on a building.
 She is analyzing two insurance coverage bids. The bids
are from comparable insurance companies, and the
coverage amounts are the same.
 The premiums and deductibles, however, differ.
 Insurer A’s coverage requires an annual premium of
$90,000 with a $5000 per claim deductible.
 Insurer B’s coverage requires an annual premium of
$35,000 with a $10,000 per claim deductible.

203. Con’t
 Susan is wondering whether the additional $55,000 in
premiums is warranted to obtain the lower deductible.
 Using some of the loss forecasting methods just
described, Susan predicts the following losses will occur.
Which coverage bid should Susan select, based on the number
of expected claims and the magnitude of these claims?
For simplicity, assume that premiums are paid at the start of
the year, losses and deductibles are paid at the end of the
year, and 5% is the appropriate interest (discount) rate.

204. Con’t
 With Insurer A’s bid, Susan’s expected cash out- flows in one
year would be the first $5000 of 20 losses that are each $5000
or more, for a total of $100,000 in deductibles.
 The present value of these payments is
 Pv =
Fv
1+𝑖 𝑛
Pv =
100000
1+0.5 1
=$95,238
 The present value of the total expected payments ($90,000
insurance premium at the start of the year plus the present
value of the deductibles) would be $185,238.
 With Insurer B’s bid, Susan’s expected cash out- flows for
deductibles at the end of the year would be
 ($5000 X 12) + ($10,000 X 6) + ($10,000 X 2) = $140,000. The
present value of these deductible payments is
 Pv =
Fv
1+𝑖 𝑛
Pv =
140000
1+0.5 1
=$ 133,333

205. Con’t
 The present value of the total expected payments ($35,000
insurance premium at the start of the year plus the present
value of the deductibles)
 Would be $168,333. Because the present values calculated
represent the present values of cash outflows,
 Susan should select the bid from Insurer B, because it
minimizes the present value of the cash outflows.
 b. Loss-Control Investment Decisions: are undertaken in
an effort to reduce the frequency and severity of losses.
 Such investments can be analyzed from a capital budgeting
perspective by employing time value of money analysis.
 Capital budgeting is a method of determining which
capital investment projects a company should undertake.

206. Con’t
 Only those projects that benefit the organization
financially should be accepted.
 If not, enough capital is available to undertake all of the
acceptable projects, then capital budgeting can assist the
risk manager in determining the optimal set of projects to
consider.
 A number of capital budgeting techniques are
available.” Methods that take into account time value of
money, such as NPV and IRR, should be employed.
 The NPV of a project is the sum of the present values of
the future cash flows minus the cost of the project.”
 The IRR on a project is the average annual rate of return
provided by investing in the project.

207. Con’t
 Cash flows are generated by increased revenues and
reduced expenses.
 To calculate the NPV, the cash flows are discounted at an
interest rate that considers the rate of return required by
the organization’s capital suppliers and the riskiness of the
project.
 A positive NPV, represents an increase in value for the
firm; a negative NPV, would decrease the value of the firm
if the investment were made
 For example, Susan Carley has noticed a distressing trend
in premises related liability claims from several of NPP’s
service stations.

208. Con’t
 Patrons claim to have been injured on the premises (for
example, slip-and faIl injuries near gas pumps), and they
have sued NPP for their injuries.
 Susan has decided to install camera surveillance systems
at several of the “problem” service stations at a cost of
$85,000 per system.
 She expects each surveillance system to generate an after-
tax net cash flow of $40,000 per year for three years.
 The present value of $40,000 per year for three years
discounted at the appropriate interest rate (we assume 8%)
is $103,084.
 Therefore, the NPV of this project is NPV = PV of future
cash flows - Cost of project = $103,084 — $85,000 =
$18,084.

209. Con’t
 As the project has a positive net present value, the
investment is acceptable.
 Alternatively, the project’s internal rate of return could
be determined and compared to the company’s required
rate of return on investment.
 The IRR is the interest rate that makes the net present
value equal zero.
 In other words, when the IRR is used to discount the future
cash flows back to time zero, the sum of the discounted
cash flows is the cost of the project.
 For this project, the IRR is 19.44%. As 19.44% is greater
than the required rate of return, 8%, the project is
acceptable.

210. Con’t
 Although the cost of a project is usually known with some
certainty,
 the future cash flows are merely estimates of the benefits
that will be obtained by investing in the project.
 These benefits may come in the form of increased
revenues, decreased expenses, or a combination of the
two.
 Although some revenues and expenses associated with the
project are easy to quantify,
 other values- such as employee morale, reduced pain and
suffering,
 public perceptions of the company, and lost productivity
when a new worker is hired to replace an injured
 experienced worker can prove difficult to measure.

211. Ch- 4: Risk Management Strategies
 4.1. Enterprise Diversification and Vertical Integration
 The diversification of agricultural activities/enterprises is o
ne of the important traditional risk management, self-
insuring mechanisms adopted by farmers.
 Agricultural diversification is defined ‘‘re-
allocation of some of a farm's productive resources
 (land, capital, farm equipment, paid labour, etc.) into new a
ctivities to reduce risk.
 The primary objective of agricultural diversification is to
 spread the risk while maintain the highest possible level
of income.
 Examples:1 Sorghum and maize may be grown together because
sorghum is drought resistant but susceptible to bird damage,

212. Con’t
 whereas maize is liable to fail in a drought but
is more resistant to bird damage.
 2.Mixed broadcast farming traditionally practiced in low ra
infall areas, such as the intercropping
of maize, sorghum, and pumpkin.
 3. Crop diversification including grains and nitrogen fixing
legumes either in a rotation or mixed/intercropping.
 4. Maize and beans to protect the income as their market pr
ices are likely not correlated with each other
 5. Do not put all eggs in one basket
 Why Agricultural diversification?
 To reduce Climate variability,
 To reduce Agricultural price volatility

213. Con’t
 It is suitable for all farmers, especially those that have suff
icient land to cultivate different crops
and/or undertake livestock activities.
 The sustainability and resilience of the farm family livelih
ood is increased.
 It is primarily useful to manage farm production risk.
 Many smallholder farmers, integrate crops and livestock
 to reduce risk and to improve their
efficiency in resource use and sustainability of the natural
resource base
 Other factors at the same time as generating additional inc
ome.’’
 If there are greater profit opportunities than in its present
product market.

214. Con’t
 Firms may explore diversification possibilities if the
information available does not permit a
conclusive comparison between expansion and diversificati
on.
 Firms diversify to avoid dependence on one product line,
to achieve greater stability of profits, to make greater use
of an existing distribution system and to acquire know
how.
 Firms diversity because it helps them avoid the danger of
over specialization, helps in balancing the vulnerabilities
due to one’s own wrong size.
 Further, the firm’s technology research and development
may also help in finding our products which appear to have
promise.

215. Vertical integration:
 This tries to increase the number of chain activities the farmer
undertakes from farming into processing, transport, and
trading.
 The preferred strategy of farmers because it “shorten the
chain” by cutting out traders or other intermediary agents.
 They think that adding activities to their businesses will
provide them a lot of added value and extra income.
 This, however, is not always true. Vertical integration
requires a new set of assets and skills.
 Some of these are:
Technology: using appropriate technologies for the value-
adding activities (grading, processing, transport, etc.).
Finance: Securing access to (a) credit or investment in
facilities for processing, marketing and distribution, and (b)
working capital to run the operations.

216. Con’t
 Human resources: Building up managerial competence
and appropriate human resources to operate.
 Organization making: sure that the farmer organization
has the organizational discipline to get involved in joint
value-adding activities.
 Vertical integration allows the firm to enlarge its scope of
operations within the same overall industry.
 It takes place when one firm acquires another that is
involved either in an earlier stage of the production
process (backward or upstream) or a later stage of the
production process (forward or downstream).
 Backward vertical integration occurs when the
companies acquired supply the firm with products,
components or raw materials.

217. Con’t
 The main reason for backward integration is to gain a
firm grip over supply and quality of raw materials.
 Backward integration is quite common in industries where
low cost and certainty of supply are important to
maintaining the firm’s competitive advantage in its end
markets.
 Forward integration on the other hand helps a firm gain
control over sales and prices of its existing products.
 However, increased risks are inherently present in both
types of integration.
 It is not easy to share the additional burden and diverse
responsibilities are thrust upon the managers in the
changed scenario.

218. Con’t
 The longer chain increases the costs of coordination and
bureaucracy.
 At times, a technological innovation in the vertical
channel may compel all of the vertically linked businesses
to modify their operations.
 In a dynamic setting where changes in technology and
demand are highly unpredictable outsourcing may be a
better option.
 Apart from forward or backward integration firms can
vertically integrate in varying degrees.
 Full integration occurs when the firm seeks to control all
stages of the value chain related to the final end product
or service

219. Con’t
 At the same time, a firm can also have a limited form of
vertical integration known as partial integration.
 Partial integration here refers to a selective choice of those
value adding stages that are brought in-house.
 5.1. Hedging, Leasing and Off-farm Employment
 Many producers use strategies such as hedging, options,
and forward contracting to
protect themselves against price changes.
 Hedging on the futures market allows farmers to
establish now the prices of products they intend to buy or
sell on some future date.
 While hedging reduces the chances of lower prices, it also
eliminates any chance to gain from an
increase in market prices or a decline in input prices.

220. Con’t
 Commodity options offer sellers and buyers
an opportunity to insure against adverse price movements
without eliminating the possible gains
from favorable price movements.
 Risk related to certain aspects of farming (production and
marketing) can be shared
 by farmers with other firms, under contractual arrangements.
 The system of agreements, arrangements and contracts that
improves links between farmers and
 consumers, typically through one or more intermediaries,
has the potential to reduce price and
marketing risks for small farmers.

221. Con’t
 Hence, the objective of this tool is to explain how various
types of contract farming schemes can be used as
 an instrument of agricultural risk management along with
their pros and cons and applicability.
 USDA’s Risk Management Agency (RMA) defines a mar
keting contract as a contract between
a farmer and a processor or handler that establishes a mark
eting outlet and formula for
determining the price of a commodity before harvest or
before the commodity is ready to be marketed.
 Similarly, a production contract is defined as an agreeme
ntbetweenthefarmeranda processor.

222. Con’t
 It usually details the production inputs supplied by the far
mer and the processor, the
quality and quantity of a particular commodity that is to be
 delivered, and compensation that the farmer will be paid.
 Contract farming or marketing contracts are generally
suitablefor cash commodities such as vegetables, fruits, c
otton, tobacco, sugarcane, dairy and poultry.
 They are less practiced for staples food crops such as cerea
ls, root crops and pulses.
 Many products desired by large supermarket chains are
ideal for marketing contracts.
 Generating income from off-farm activities. It is difficult to
separate the risks of farming from the risks of the household,
particularly among smallholder farmers.

223. Con’t
 In many cases, the farm and the household are a single
unit. Therefore, although it is not a farming strategy, many
farmers sustain their income with earnings from activities
off their farm.
 Farmers may take part-time work in towns or on
commercial farms or one of their family members may
have a full-time job.
 Many farm families sustain their income with earnings
from activities off their farm
 Leasing assets: Assets are hired or rented out to another
farmer for a specified period and at a specified price.
 The asset Savings with high liquidity are most easily
converted to cash assets that are easily converted should be
sold first.

224. Con’t
 The asset remains the legal property of the owner.
 Farmers can lease land, machinery, equipment or
livestock.
 Leasing assets generates additional income and spreads the
cost of paying for and maintaining the asset.
 It also allows farmers to use equipment that might
otherwise not be profitable to buy
 5.2. Risk Management Alternatives and Information Technology
 Having first become aware of a risk and then having
assessed it, the next issue is how the party (or parties) at
risk can seek to manage that risk.
 It should first be noted that risk management should be
planned on an ex-ante basis (that is, before realization of an event).

225. Con’t
 Some ex-ante plans provide (financially or otherwise) for
actions on an ex-post basis (for example, insurance
payouts and government relief programs).
 Managing realized risks on an ex-post basis only is not
considered to be risk management after all,
 if something has already happened, it is no longer a risk
(although a future reoccurrence might be).
 There are four clear approaches to agricultural risk
management.
 1. Mitigation is the lessening or limitation of the adverse
impacts of hazards and related
disasters.
 Risk mitigation options are numerous and varied including
,for instance,

226. Con’t
a. crop and livestock diversification,
b. income diversification,
c. soil drainage,
d. mulching,
e. use of resistant seeds,
f. Avoidance of risky practices, and
g. crop calendars
 2. Risk Transfer/Sharing
 Transfer refers to the transfer of the potential financial
consequences of particular risks from one
party to another.

227. Con’t
 While insurance is the best-known form of risk transfer, in
developing countries the use of informal risk transfer
within families and communities is extremely important.
 When the likelihood of a risk materializing is low but the
potential is high, the organization will wish to transfer that
risk.
 Insurance is a well-established mechanism for transferring
the financial impact of losses arising from hazard risks and
(to a lesser extent) control risks.
 In some cases, risk transfer is closely related to the desire
to eliminate or terminate the risk.
 However, many risks cannot be transferred to the insurance market,
either because of prohibitively high insurance premiums or because
the risks under consideration have (traditionally) not been insurable.

228. Con’t
 Risk transfer can be achieved by conventional insurance
and also by contractual agreement.
 It may also be possible to find a joint-venture partner, or
some other means of sharing the risk.
 Risk hedging or neutralization may therefore be considered
to be a risk transfer option, as well as a risk treatment
option.
 There is another issue of terminology with the use of the
phrase ‘risk transfer’.
 ISO 31000 recommends that risk sharing should be used in
preference to risk transfer.
 The argument is that a risk can never be fully transferred
and whatever the intentionof the parties, the risk will
always be, to some extent, shared.

229. Con’t
 This is an accurate analysis, but the choice of terminology
used within an organization will also be
influenced by other factors.
 In relation to risk sharing, the insurance industry uses
the terminology risk transfer.
 This makes it easier to measure or quantify an operational
risk, which facilitates their transfer through the use, for
example, of risk transfer techniques such as crop
insurance and hedging.
 Risk transfer can also occur in situations in which the
“cost” of the transfer is more disguised or vague.
 For example, grain farmers can transfer price risk
through forward contracts. Likewise, a contract producer
of vegetables may be able to transfer price risk to the contractor.

230. Con’t
 The monetary and non-monetary costs of such risk transfer
are often in the form of lost opportunities (the unexpected
price rise) and are less clear.
 Industrialized agriculture tends to alter the mechanisms for
managing risk.
 Producers who operate under contract may have better
opportunities for yield and price risk avoidance,
 Reduction, and transfer than do traditional independent
producers.
 However, these opportunities may be offset by increases in
less traditional risks such as relationship risks and strategic
risks.
 Integrators, on the other hand, have opportunities to assume
more risk in the new industrialized forms of agriculture.

231. Con’t
 Of course, higher returns are expected for accepting such
risks.
 Transfer refers to the transfer of the potential financial co
nsequences of particular risks from one party to another.
 While insurance is the best known form of risk transfer,
 Indeveloping countries the use of informal risk transfer wi
thin families and communities is extremely important.
 3. Risk Coping
 Coping refers to improving the resilience to withstand and
manage events, through ex-ante preparation and making
 use of informal and formal mechanisms in order to
sustain production and livelihoods following an event.

232. Con’t
 Although we have noted that coping is an ex-post activity,
it is possible to plan and to prepare for coping activities on
an ex-ante basis.
 This is often fiscally beneficial, as the ability to quickly
respond to events often reduces losses.
 Risk-coping strategies when uninsured shocks hit include
selling productive assets such as land
and livestock, cutting back on consumption, and reducing
investments in education among others.
 Risk Coping refers to improving the resilience to withstan
d and manage events, through ex ante preparation

233. Con’t
And
making use of informal and formal mechanisms in ord
er to sustain production and livelihoods following an event
.
 Although we have noted that coping is an ex-
post activity, it is possible to plan and to prepare for copin
g activities on an ex-ante basis.
 This is often fiscally beneficial, as the ability to quickly re
spond to events often reduces losses.
 4. Risk avoidance or risk prevention.
 This is rarely possible in agricultural production,
especially in developing countries where there are very
few alternative sources of nonfarm employment.
 Farmers and their associated supply chains in developing

234. Con’t
 approaches to manage risk, and these are evident at the
household, community, market, and government levels.
 At the producer end of the supply chain, there is generally
more reliance on informal approaches,
 Whereas the later links in the chain tend to rely on more
formal (and financially based) risk management
approaches.

235. Con’t
Severity of risk Households/Community Markets Governments
Non-specific Sharecropping
Farmer self-help groups
Water resource manageme
nt
New technology
Improved seed
Irrigation
infrastructure
Extension
Agricultural resear
ch
Weather data
systems
Low Crop diversification
Savings in livestock
Food buffer stocks
Formal savings
Moderate Labor diversification
Risk pooling (peers, family
members)
Money lenders
Formal lending
Risk sharing (in
put suppliers,
wholesalers)
State-sponsored
lending
High/Catastroph
ic
Sale of assets
Migration
Insurance Disaster relief
State-sponsored
insurance

236. Ch- Five: Agricultural Insurance
 5.1. Meaning and Scope of Agricultural Insurance
 There is no single definition of insurance.
 Insurance can be defined from the viewpoint of individual,
and social.
 From an individual point of view: Insurance is an
economic device whereby the individual substitutes a
small certain cost (the premium)
 For a large uncertain financial loss (the contingency
insured against) that would exist if it were not for the
insurance.
 From the social point of view: Insurance is an economic
device for reducing and eliminating risk through the
process of combining a sufficient number of homogeneous

237. Con’t
 exposures into a group to make the losses predictable for
the group as a whole
 Functional Definition: Insurance is a co-operative device
to spread the loss caused by a particular risk
over a number of persons,
 who are exposed to it and who agree to insure themselves
against the risk.
 Contractual Definition: Insurance contract may be
defined as a contract by which one party
 (the insurer/insurance company) agrees to pay to the other
party (the insured) or his beneficiary.
 A certain sum upon a given contingency (the risk) against
which insurance is sought.

238. Con’t
 According to the Commission on Insurance Terminology
of the ARIA, “Insurance is the pooling of fortuitous losses
by transfer of such risks to insurers,
 who agree to indemnify insured for such losses, to provide
other pecuniary benefits on their occurrence, or to render
services connected with the risk".
 A1though this definition may not be acceptable to all
insurance scholars,
 It is useful for analyzing the common elements of a true
insurance plan.
 FunctionsofInsurance:The functions of insurance can be
studied into two parts:
 A. Primary Functions: Insurance provides certainty-

239. Con’t
 Insurance provides certainty of payment at the uncertainty
of losses, the uncertainty of loss can be reduced by better
planning and administration.
 But, the insurance relieves the person from such difficult
task.
 There are different types of uncertainty in a risk.
 The risk will occur or not, when will occur?,
 how much loss will be there?,
 in other words, there are uncertainty of happening of time
and amount of loss.
 Insurance removes all these uncertainty and the insured is
given certainty of payment of losses.

240. Con’t
 B. Insurance provides protection
 The main function of the insurance is to provide protection
against the probable chances of loss.
 The time and amount of loss are uncertain and at the
happening of risk, the person will suffer loss in the absence
of insurance.
 The insurance guarantees the payment of loss and thus
protects the insured from sufferings.
 The insurance cannot check (or) control the happening of
risk but can provide for losses at the happening of the risk.
 C. Risk Sharing
 The risk is uncertain and therefore, the loss arising from
the risk is also uncertain.

241. Con’t
 When risk takes place, the loss is shared by all the persons
who are exposed to the risk.
 The risk sharing in ancient times was done only at the time
of damage or death.
 But, today, on the basis of Probability of risk, the share is
obtained from each and every
 insured in the shape of premium without which protection
is not guaranteed by the insurer.
SECONDARY FUNCTIONS
 A. Prevention of loss: The insurance joins hands with
those institutions which are engaged in preventing the
losses of the society
 Because the reduction in loss causes lesser payment to the
insured and

242. Con’t
 So more saving is possible which will assist in reducing
the premium.
 Lesser premium invites more business and more business
cause lesser share to the insured.
 Here, the insurance assist financially to health
organizations, fire brigade, educational institutions and
 Other organizations which are engaged in preventing the
losses of the masses from death and damage.
 B. It provides capital
 The insurance provides capital to the society. The
accumulated funds are invested in productive channels.
 The shortage of capital of the society is minimized to a
greater extent with the help of investment of insurance.

243. Con’t
 The industry, the business and the individual are benefited
by the investment and loans of the insurers.
 C. It improves efficiency
 The insurance eliminates worries and miseries of losses at
death and destruction of property.
 The carefree person can devote his body and soul together
for better achievement.
 It improves not only his efficiency, but the efficiencies of
the masses are also advanced.
 D. It helps economic progress
 The insurance by protecting the society from huge losses
of damage, destruction and death, provides an initiative to
work hard for the betterment of the masses.

244. Con’t
 The next factor of economic progress, the capital, is also
immensely provided by the masses.
BASIC CHARACTERISTICS OF INSURANCE
1. Pooling of losses: The other names for pooling are
sharing, spreading or combination.
 "Pooling is the spreading of losses incurred by the few
over the entire group,
 so that in the process, average loss is substituted for actual
loss".
 In addition, pooling involves the grouping of a large
number of homogeneous exposure units
 so that the law of large numbers can operate to provide a
substantially accurate prediction of future losses.

245. Con’t
 Homogeneous exposure unit means there is a large
number of similar (e.g., houses),
 but not necessarily identical exposure units that are
exposed to the same perils.
 Thus pooling implies: the sharing of losses by the entire
group and
 the prediction of future losses with some accuracy based
on the law of large numbers.
 a. Sharing of loss: The concept of loss sharing can be
explained with an example. Assume that there are 10, 000
houses in D/Markos.
 All the10, 000 households agree that if anyone of the
house is damaged or destroyed by a fire,

246. Con’t
 The other households will indemnify, or cover, the actual
costs of the household who has suffered a loss.
 Also assume that each home is valued at 100,000 birr, and,
on average, one house burns every year.
 In the absence of insurance, the maximum loss to each
household is 100,000 birr, if the house burns.
 However, by pooling the loss, it can be spread over the
entire group, and if one household has a total loss,
 the maximum amount that each household would have to
pay only 10 birr (100,000/ 10,000).
 Thus, the pooling technique results in the substitution of
an average loss of 10 birr for the actual loss of 100,000
birr.

247. Con’t
 b. Prediction of future losses: By pooling the loss
experience of a large number of units, an insurer may be
able to predict future losses with some accuracy.
 From the viewpoint of the insurer if future losses can be
predict, objective risk is reduced.
 Thus, another characteristic of insurance is risk reduction
based on the law of large numbers.
 The law of large numbers states that the greater the
number of exposures, the more closely will the actual
results approach the probable results that are expected from
an infinite number of exposures.
 For example, if you flip a balanced coin into the air, the
chance of getting a head is 0.5.

248. Con’t
 If you flip the coin only 10 times, you may get a head 8
times. Although, the observed probability is 0.8, the true
probability still 0.5.
 If the coin were flipped 1 million times, however, the
actual number of heads would be approximately 500,000.
 Thus, as the number of random tosses increases, the actual
results approach the expected results.
 2. Payment of accidental losses: An accidental loss is
one that is unforeseen and unexpected and occurs as
a result of chance.
 In other words, the loss must be accidental. For example,
a person may slip on an icy sidewalk and break his or her
leg.
 The loss would be accidental.

249. Con’t
 3. Risk Transfer: Risk transfer means that "a pure risk
is transferred from the insured to the insurer, who typically
is in a stronger financial position to pay the loss than the
insured."
 Examples: Premature death, Poor health, Disability,
Destruction, Theft of property, etc.
 With the exception of self-insurance, a true insurance plan
always involves risk transfer.
 4.Indemnification:Indemnification means that the insured
is restored to his or her approximate financial position
prior to the occurrence of the loss.
 Examples of insurance which cover the loss are, Home
owners policy, Automobile liability insurance policy,
Disability income policy, etc.

250. ELEMENTS OR REQUIREMENTS OF AN INSURABLE RISK
 Insurers normally insure only pure risks.
 However, not all pure risks are insurable. Certain
requirements usually must be fulfilled before a pure risk
can be privately insured.
 From the view point of the insurer, there are ideally six
requirements of an insurable risk.
1. There must be a large number of homogeneous exposure
units
2. The loss must be accidental and unintentional
3. The loss must be determinable and measurable.
4. The loss should not be the catastrophic
5. The chance of loss must be calculable
6. The premium must be economically feasible

251. Con’t
 1. Large number of Homogeneous Exposure units:
 The purpose of the first requirement is to enable the
insurers to predict losses based on the law of large
numbers.
 If a sufficiently large number of homogeneous exposure
units are present within a class, the insurer can accurately
predict both the average frequency and the average
severity of loss.
 The items in an insurance pool, or the exposure units,
need to be similar so that a fair premium can be
calculated.
 The fire damage done to brick homes will ordinarily be
less than that of suffered by wooden homes.

252. Con’t
 It would be unfair to combine them is the same insurance
pool and charge each insured the same premium rate based
on the combined losses of the pool.
 If such as attempt were made, the rate developed would
cause the owners of brick home (less susceptible to loss)
 To pay too high a premium and the owners of wooden
structures (more susceptible to loss) to pay too low a
premium.
 2. Accidental and unintentional loss: The loss should be
accidental and unintentional; ideally, the loss should be
accidental and outside the insured’s control.
 Thus, if an individual deliberately causes a loss, he or she
should not be indemnified for the loss.

253. Con’t
 The requirement of an accidental and unintentional loss is
necessary for two reasons.
 First, if intentional losses were paid, moral hazard would
be substantially increased, and premiums would rise as a
result.
 The substantial increase in premium could result in
relatively fewer persons purchasing the insurance, and
 The insurer might not have a sufficient number of
exposure units to predict future losses.
 Second, the loss should be accidental because the law of
large numbers is based on the random occurrence of
events.

254. Con’t
 A deliberately caused loss is not a random event because
the insured knows when the loss will occur.
 Thus, prediction of future experience may be highly
inaccurate if a large number of intentional or nonrandom
losses occur.
 3. Determinable and Measurable loss:
 Loss must be definite, measurable and of sufficient
severity to cause economic hardship.
 This means the loss must be definite to cause, time, place,
and amount.
 Life insurance in most cases meets this requirement
easily.

255. Con’t
 The cause and time of death can be readily determined in
most cases.
 It is difficult to determine and measure the losses in some
cases.
E.g. Disability income policy; there are chances of
dishonest claims, taking an illness or
 injury and collecting the insurance payment.
 It is also important that the losses insured against be
measurable.
 The company must determine whether the insured satisfies
the definition of disability as stated in the policy,
 Because sickness and disability are highly subjective.

256. Con’t
 The basic purpose of this requirement is that the insurers
must be able to determine if the loss is covered under the
policy, and
 If it is covered, how much the company will pay.
 4. No Catastrophic Loss: This means that ideally a large
proportion of exposure units should not incur losses at the
same time.
 The pooling technique breaks down if most or all of the
exposure units in a certain class simultaneously incur a
loss.
 Examples of catastrophic losses include, flood, storms,
earth quakes, wild fire, tsunami etc.
 Insurers ideally wish to avoid all catastrophic losses, but
still employ two approaches to handle this problem.

257. Con’t
 Reinsurance: Insurance companies are indemnified by re-
insurers for catastrophic losses.
 It is shifting of part or all of the insurance originally
written by one insurer to another.
 Dispersing coverage over a large geographical
area: This is a technique to reduce the burden of
catastrophic losses by dispersing the coverage area to
different geographic locations.
 5. Calculable Chance of Loss: The insurer must be able
to calculate both the average frequency and the average
severity of future losses with some accuracy.
 This is necessary so that a proper premium can be charged

258. Con’t
 That is sufficient to pay all claims and expenses and yield
a profit during the policy period.
 Certain catastrophic losses, however, are difficult to
insure because of the chance of loss cannot be accurately
estimated.
 6. Economically Feasible Premium: The insured must
be able to afford to pay the premium.
 Premium should be substantially less than the face value,
or amount, of the policy.
 Benefits of Insurance to the society: The existence of
insurance results in great benefits to society.
 The major social - economic benefits of insurance include
the following.

259. Con’t
 1. Indemnification for loss: The indemnification function
contributes greatly to family and business stability and
 Therefore is one of the most important social & economic benefits
of insurance.
 The following table lists the benefits to individuals and families and
also to business firms through the indemnification function of
insurance.
To individuals and families To business firms
Permits individuals & families to be
restored to their former financial
position that existed prior to the loss
occur.
Permits the firm to remain in business
even after the loss occurs
The families maintain their economic
security.
Employees of the firm would be able to
keep their jobs
They are less likely to apply for public
assistance or welfare.
Suppliers continue to receive orders
They are less likely to seek financial
assistance from relatives & friends.
Customers can still receive the goods
and services

260. Con’t
 2. Reduction of Worry and Fear: A second benefit of
insurance is that worry and fear are reduced.
 This is true both before and after a loss. For example, if
family heads have adequate amounts of life insurance,
 They are less likely to worry about the financial security of
their dependents in the event of premature death;
 persons insured for long-term disability do not have to
worry about the loss of earnings if a series illness or
accident occurs;
 and property owners who are insured enjoy greater peace of
mind because they know they are covered if a loss occurs.
 Worry and fear are also reduced after a loss occurs, because
the insured know that they have insurance that will pay for
the loss.

261. Con’t
 3. Source of Investment funds: Insurance provide funds
for capital investment and accumulation.
 Premiums are collected in advance of the losses and funds
not needed to meet the immediate losses can be loaned to
business firms. These investments:
 Increases society's stock of capital goods
 Promote economic growth
 Promote full employment
 Reduce cost of borrowings of business firm
 4. Loss prevention: Insurance companies are actively
involved in numerous loss prevention programs and also
employ a wide variety of loss prevention personnel.

262. Con’t
o (E.g. Safety Engineers, Specialists in fire prevention,
Occupational Safety and Health, etc.) Some of the loss
prevention activities are:
 High way safety & reduction of automobile death'
 Fire prevention
 Reduction of work related disabilities
 Prevention of automobile thefts
 Prevention and detection of arson losses
 Prevention of defective products that could injure the users
 Prevention of boiler explosions
 Educational programs on loss prevention
 The loss prevention activities reduce both direct and
indirect, or consequential losses.

263. Con’t
 5. Enhancement of Credit: Insurance makes a borrower a
better credit risk, because its gives greater assurance that
the loan will be repaid.
 For example, Property insurance is obtained while lending
for purchase of houses.
 Property insurance protects the lender's financial interest if
the property is damaged or destroyed.
 Temporary loan may obtained by insuring inventories of
business firms.
 Insurance on automobile’s required to get a loan for
purchasing any new automobile
 Thus, insurance can enhance a person's credit worthiness

264. Cost of insurance to society
 No institution can operate without certain costs.
 These are listed below so that one can obtain an impartial
view of the insurance institution as a social device.
 The major social costs of insurance include the following:
 1.Cost of doing the business: The main social cost of
insurance lies in the use of scarce of economic
resources land, labor, capital, and organization to operate
the business.
 In financial terms, an expense loading must be added to
the pure premium to cover the expenses incurred by
insurance companies.

265. Con’t
 An expense loading is the amount needed to pay all
expenses, including commissions, general administrative
expenses, state premium taxes, acquisition expenses, and
an allowance for contingencies and profit.
 The cost is justified from the insured's view point as
follows:
 Uncertainty concerning the payment of a covered loss is
reduced because of insurance.
 The cost of doing business is not necessarily wasteful,
because insurers engage in a wide variety of loss
prevention activities.
 The insurance industry provides jobs to millions of workers.
 However, because economic resources are used up in providing
insurance, a real economic cost is incurred.

266. Con’t
 2. Fraudulent claims: These are the claims made against
the losses that one caused intentionally by people in order
to collect on their policies.
 There always exists moral hazard in all forms of
insurance.
 Arson losses are on the increase.
 Fraud and vandalisms are the most common motives for
arson.
 Fraudulent claims are made against thefts of valuable
property, such as diamond ring or fur coat, and ask for
reimbursement.
 These claims results in higher premiums to all insured.
These social costs fall directly on society.

267. Con’t
 3. Inflated claims
 It is a situation where, the tendency of the insured to
exaggerate the extent of damages that result from purely
unintentional loss occurrences.
 Examples of inflated claims include the following.
a. Attorney for plaintiffs may seek high liability
judgments - Liability insurance
b. Physicians may charge above average fees – health
insurance
c. Disabled persons may malinger to collect disability
income benefits for a longer duration.

268. Con’t
 These inflated claims must be recognized as an important
social cost of insurance.
 Premiums must be increased to cover the losses, and
disposable income that could be used for the consumption
of other goods or services is thereby reduced.
 The social costs of insurance can be viewed as the
sacrifice that society must make to obtain the social
benefits of insurance.

269. 5.2. Types of Agricultural Insurance and
Insurability of Agricultural Risks
 Agriculture is without doubt one of the riskiest sectors of e
conomic activity.
 There are different options to manage agricultural risks,
agricultural insurance being one of them.
 Actions taken before the risk materializes are known as
ex-ante measures and actions taken after the fact as ex-
post.
 Agricultural insurance protects against loss of or damage
to crops and livestock.
 It has great potential to provide value to low-income
farmers and their communities, both by protecting farmers
when shocks occur and by encouraging greater investment
in agriculture.

270. Con’t
 Where available and affordable, agricultural insurance
(crop or livestock) can provide great
benefits to farm households:
 1. Insurance can (and should) be used to complement other
risk management approaches.
 Farmers can rely on informal household- and community-
level strategies such as crop and labor diversification to
manage small to moderate risks.
 In the event of a major weather shock, insurance can be
designed to protect against revenue or consumption losses.
 This enables households to avoid selling livelihood assets
or drawing on savings.
 2. Insurance can assist farmers in accessing new
opportunities by improving their ability to borrow either money or in-kind credits.

271. Con’t
 In doing so, farm households may potentially
experience safer and possibly higher returns.
 Ethiopian insurance corporation (EIC) is committed
 to provide adequate insurance covers agricultural projects
that are financed by financial institutions and
 individual farmers (commercial & small holder).
 Key challenges in agricultural insurance
 Moral hazard, adverse selection, fraud
 (insurance) literacy
 Trust
 Geography: Distribution, after-sales service, monitoring and claims
assessment…
 Covariant risks
 Information asymmetry: Lack of baseline: often no production data

272. Con’t
 Reasons for increasing demand for agricultural
insurance
• Increasing investment in Agro enterprises
• Increasing demand for agro- products.
• Increased movement across borders (imports and
exports)
• Increase in farm sizes
• Increased disease exposure
• New and aggressive viral & bacterial strains
• Specialized & intensive farm production
• Market fluctuations (input cost/market price)
 Role/Benefits of agricultural Insurance:
 Stabilization of farmers’ income, Risk management tool
for financial institutions, Collateral Adoption of innovative
technology, Loss prevention and minimization etc.

273. Con’t
 Agriculture Insurance cannot Compensate: For poor
management & cultivation practices, for inadequate
agricultural policy of government (infrastructure,
subsidies)
 Agricultural Insurance differ from other Insurances:
Risk sensitivity, Exposure to climate change and Land as a
production asset that cannot be relocated
 Requirements for a Crop Insurer: Experience and
Expertise, Infrastructure & Systems, Proven Assessment
Procedures, Financial Backing, Adequate Reinsurance –
Good securities
 There is an under supply of insurance: on insured
(demand) side:
 Lack of skills & inadequate/ inequitable access to support services

274. Con’t
 High costs of production / Cost price squeeze (cost of
insurance is one
such factor of production affecting our competitiveness)
 Premium rates are too high
 On insurers (supply) side:
– Asymmetry /irregularity of information brings adverse
selection
– Risks are hard to quantify as no sufficient data is
available
– Premium rates are high
 Importance of pre-risk assessment: Pre-risk assessment
entails surveys, physical assessment of a risk to establish if
the risk is suitable for admittance by Insurers:
 Crops and animals are growing risks – nature of risks is continuously changing.

275. Con’t
 Verifies that risks are of insurable stands.
 Validates risk management and husbandry practices.
 Enables determination of terms and conditions
 Acceptance/rejection of the risk.
 Note: Pre-risk assessment is very important for agro
risks.
 Risk evaluation includes –Soil, Climate, Husbandry
practices, Management skill, Variety, area of business,
Seed quality, location of the business etc.
 Perils in Crop Production is adverse weather
conditions such as
 Hail
 Storm,Wind,Sandstorm

276. Con’t
 Floods, excessive rainfall
 Drought, heat wave
 Fire & lightning, Uncontrollable disease and pets will be
discussed in the next session.
– Crop insurance products: can broadly be classified into two
major groups: indemnity-based insurance and index insurance.
 A. Indemnity -based crop insurance: There are two main
indemnity products: Damage-based
indemnity insurance (or named peril crop insurance) and yield-
based crop insurance (or multiple peril crop insurance (MPCI):

277. Con’t
 Damage-based indemnity insurance is crop insurance in
which the insurance claim is calculated
by measuring the percentage damage in the field soon
after the damage occurs.
 The damage measured in the field, less a deductible
expressed as a percentage, is applied to the pre-agreed
sum insured.
 The sum insured may be based on production costs or on
the expected revenue.
 Where damage cannot be measured accurately
immediately after the loss, the assessment may be
deferred until later in the crop season.
 Damage-based indemnity insurance is best known for hail,
but is also used for other named peril insurance products
(such as frost and excessive rainfall).

278. Con’t
 Yield-based crop insurance (or multiple peril crop
insurance (MPCI): is coverage in which an insured yield
(for example, tons/ha) is established as a percentage of the
farmer’s historical average yield.
 The insured yield is typically between 50 percent and 70
percent of the average yield on the farm.
 If the realized yield is less than the insured yield, an
indemnity is paid equal to the difference between the
actual yield and the insured yield, multiplied by a pre-
agreed value.
 Yield-based crop insurance typically protects against
multiple perils, meaning that it covers many different
causes of yield loss (often because it is generally difficult
to determine the exact cause of loss).

279. Con’t
 Index-based crop insurance: Currently there are two
types of index product: area yield index insurance and
weather index insurance (WII).
 In area yield index insurance, the indemnity is based on
the realized average yield of an area such as a county or
district, not the actual yield of the insured party.
 The insured yield is established as a percentage of the
average yield for the area.
 An indemnity is paid if the realized yield for the area is
less than the insured yield regardless of the actual yield on
a policyholder’s farm.
 This type of index insurance requires historical area yield
data.

280. Con’t
 In weather index insurance (WII), the indemnity is base
d on realizations of a specific weather parameter measured
over a pre specified period of time at a particular weather
station.
 The insurance can be structured to protect against index re
alizations that are either so high or so low that they are ex
pected to cause crop losses.
 For example, the insurance can be structured to protect aga
inst either too much rainfall or too little.
 An indemnity is paid whenever the realized value of the
index exceeds a pre-specified threshold (for
example, when protecting against too much rainfall) or
 when the index is less than the threshold (for example, when
protecting against too little rainfall).

281. Con’t
 Risk layering in weather-related agricultural
insurance
 For risk transfer products, risk layering is a vital part of
the risk management task, as it helps to determine who
carries which part and how much of a risk.
 This enables equitable risk sharing and also ensures that
correct levels of cover are taken out by the right parties
(especially based on ability to pay).
 Let us not forget, insurance is not a panacea (cure all)
that can cover 100 percent of risks at premium levels that
will be attractive to agricultural sector stakeholders.
 Insurance has a role to play as part of the solution, not as
the solution itself.

282. Con’t
 Figure 1 presents a simple risk-layering example in
relation to excess rainfall and the application of risk
transfer products.

283. Con’t
 Self-retention layer: Risk retention (by the farmer) is
needed for manageable, smaller,
 frequent risks that have to be either mitigated by the
farmer using standard farming practices or
 coped with by the farmer, household, or local community
mechanisms.
 This self-help and community approach is the first layer
for managing risks. Additionally, where inputs or credits
are concerned, arrangements may be needed to agree to
delayed repayment for inputs or rescheduling of interest or
principal of loans.
 These arrangements are quite similar to insurance, in that
the financing of negative impacts of risks are spread over
time.

284. Con’t
 Market risk transfer layer: Insurance is best suited to
infrequent but severe events.
 At an aggregated level, layering risk means that the
financial sector stakeholders may decide to retain or
transfer risks depending on their financial capacity and
appetite for risk.
 When insurers decide to transfer part of their risk to
another party, they generally rely on reinsurance
companies to achieve this.
 The existence of the reinsurance agreement effectively
boosts the insurer’s capital and enables them to underwrite
more risk than their own capital would otherwise enable
them to do.

285. Con’t
 In addition to traditional insurance companies, other
agriculture sector stakeholders do become involved in risk
transfer operations.
 They can be financial institutions lending to agriculture,
processors, or those dependent on agricultural production
for their turnover.
 Market ‘failure’ layer: Extreme losses from extremely
rare, highly catastrophic events are not suitable for
commercial insurance.
 For these types of losses governments or the broader
international community may be needed to aggregate and
transfer this risk layer out of the
domestic economy to the international markets.

286. Con’t
 This is also known as the “government intervention
layer,” as the fiscal responsibilities for reconstruction or
such interventions as social safety nets lie with the
affected government.
 Due to the risk that a government may decide to withdraw
support for budgetary or political reasons,
 it is important to maintain a distinct segregation between
the commercial layer described above and the social layer
reserved for extremely rare and highly catastrophic
events.
 This safeguards the commercial product from political
whim, by allowing it to continue even if the market
failure layer is no longer funded.

287. Explain the adverse weather conditions of Perils
in Crop Production are
 Hail: is solid precipitation – falling ice particles.
 These often cause visible and quantifiable damage on
plants.
 Severity of damage is influenced by size of pellet and
intensity when striking the plant.

288. Con’t
Fire: visible damage caused by fire
 Frost: Visible quantifiable damage caused by freezing of
the plant or parts of the plant.

289. Con’t
 Drought (Irrigation Excluded)
Excessive Rainfall

290. Con’t
 Flood: Where the water of a river and/or stream overflow
the river and/or stream bank due to excessive rain in the
catchment area and the overflow water cause damage to
the insured crops.

291. Con’t
Excessive Heat Waves (Irrigation excluded):
 An event where irreversible damage is caused to the
growth or developmental process in the crop resulting
 from a persistent hot temperature spells above the upper
lethal temperature threshold values of the crop/crop
development stage.

292. Application of insurance products vary for commercial
and smallholder farming:
 Basis of sum-insured are
 Yield base: 5years average yield x price (market price) x
cultivated land
 Cost Base; Production Cost, Production Credit And
Market Value
 Rating is based on: Susceptibility, Type of crop, Location
, Growth cycle, Spread and Loss experience.
 Ethiopia Insurance Corporation offers: A. Multi-peril
Crop Insurance which covers crop loss due to:-
 Fire and Lightning, hail and Storm, Excessive rainfall,
Frost, Flood and Uncontrollable disease & pests
(additional premium is needed).

293. Con’t
 General Exclusions:-The Insurance Does Not Cover
 Any crop which has been harvested prior to inspection by t
he Assessor
 Hay and Straw
 Theft except whilst in direct transit to the insured’s perma
nent storage
 Loss or damage occasioned by or through or in consequen
ce directly or indirectly of any of the
following occurrence namely:
• War, Invasion, act of foreign enemy, hostilities or warlike
operations.
• Volcanic eruption, subsidence, landslide, erosion, or other
convulsion of nature.

294. Con’t
• Infestation, vermin, pests animals, birds, insects and other
natural enemies or disease of every description whether
evident in the crop before or after an insured event
 Specific exclusions:
 Consequential loss due to delay, detention or confiscation.
 Weight losses unless due to theft or fortuitous circumstanc
es.
 Theft by the insured or its employees.
 Transit risks outside the borders of Ethiopia
 Theft of the crop whilst in or on a road vehicle which has
been left unattended.
 Unexplained disappearance or unaccountable losses of any
form or kind whatsoever or normal shrinkage or normal loss of weight.

295. Con’t
 Loss or damage due to bad state of roads or rail.
 Sum-Insured Calculation
 Example: Amhara seed enterprise notify to insure its seed mai
ze as follows:
Total Land -500ha
Cultivated Land-300ha
Yield -30ql/Ha
Market Price-1800/Ql
Premium Rate-3.2%
Deductible-25% of each & every loss
1. Pre
risk assessment = to decide whether it is insurable or not
2. Sum insured calculation SI=Cultivated Land*Yield /Ha*M
arket Price =100HA*30QL*1800 =5,400,000.00Birr
3. Premium= 5,400,000.00*3.2% =172,800.00Birr

296. Con’t
 Livestock Insurance: Like any insurance product, the
purpose of livestock insurance is to compensate clients
for the death of animals due to disease or accident.
 As a general rule all animals of the same group on the
farm must be insured because:
 Insurers obtain a better spread of risk, Minimization of
moral risks, Animals to be uniquely identified and Stock
values to be homogeneous
 Livestock Perils are
 Health factors: Mortality (death), Low production
 Climate: Drought, Lightning, Accident, Fire, Poison,
Swell

297. Con’t
 Types of animal: The major type of insured objects in the
Livestock Insurance policy is an
animal for domestic purposes.
 The animals’ types are: Fattening steer, Draft ox, Dairy co
w, Bulls/bullock, Draft horse, Sheep & Goats
 Rating considerations:
 Type of animal, Susceptibility, Location, Age (Growth
cycle), Overall Management, Spread, Loss Experience,
Normal Mortality, The excess structure
 EIC Offers: A Multi-peril Livestock Insurance
 Covers more than one peril.
 It covers livestock death due to disease or accident.
 Possibly extension be made to such risks of death

298. Con’t
 due to surgical, operations, breeding and parturition and
permanent total disability of draught animals ,Dairy and
Breeding animals.
 This does not cover: Injury, Loss of use, Emergency
slaughter
 Exclusions of Livestock by EIC:
 Moral hazard, Preexisting conditions, Theft ,Disappearanc
e, Sales
 Accumulations of :- Drought, Famine, War like risks
 Underwriting Conditions:
 Selection: the basic selection factor are age and state of
health of the animal; an animal to be considered for cover
should fall within the range specified.

299. Con’t
Vaccination: Vaccination at least three
communicable diseases of the area.
 It may be Anthrax, Black leg or pasteurellosis.
Ear–tagging or deep skin tag: Distinctive natural
mark and ear-tag number need to be registered.
Other considerations
Photo graph shall be taken for high value animals f
rom three dimensions.
Healthy and free from any injury.
Absence of pre-existing diseases
Zero-grazing in urban and may be field grazing in
rural

300. Con’t
• Example:- Let’s say Kebede insured 20 Goats,10 Sheep
and 20 Cattle in Andasa dairy farm
• 1cattle = Br.15,000
• 1Goat = Br.800 and
• 1sheep= Br. 700; TIHV =
[800*20+700*10+15,000*20] =
[16,000+7,000+300,000.00] = 323,000.00;
• Premium = ETB 7.54%* 323,000.00 = ETB 24,354.2

301. Period of insurance and renewals
Renewals, therefore, apply to insurance issued in r
espect of;
fattening steers which can be insured for further pe
riods of 3,6 or 12 Months until the animal
attains age 9 years; and
Draft horses which can be insured for further perio
ds of 1 or 2 years until the animal attains
age 12 years.

302. Con’t

303. Con’t

304. Con’t

305. B. Weather Index Insurance (WII)
 Having undertaken a risk assessment, identified a
particular risk (weather), chosen management strategy
 (transfer), considered the relevant risk-layering
arrangements, and decided that perhaps a traditional
 agricultural insurance product may not be the most
suitable solution,
 we find ourselves at the juncture of needing to discuss in
more detail what exactly WII is and, equally important,
what it is not.
 Index insurance is a simplified form of insurance in
which indemnity payments are made based on values
obtained from an index that serves as a proxy for losses
rather than upon the assessed losses of each individual
policy holder.

306. Con’t
 The sum insured is normally based on production cost on
an agreed value basis (fixed in the policy in advance), and
payouts are made based on a pre-established scale set out
in the insurance policy.
 The origins of WII come from the international weather
derivative market, where major corporations hedge
weather risks.
 The interest in WII applications for agriculture grew from
a belief that traditional insurance products (especially
MPCI) were not viable for developing countries,
 where limited commercialization and small average farm
sizes are a major hindrance to the sustainable development
of commercial agricultural insurance products.

307. Con’t
 In order for the underlying index to be a sound proxy for
loss, it has to be based upon an objective measure
 (for example, rainfall, wind speed, temperature) that
exhibits a strong correlation with the variable of interest
(in this case, crop yield).
 Additionally, the weather variable that can form an index
must satisfy the following properties:
 Observable and easily measured, Objective, Transparent, I
ndependently verifiable, Reported in a timely manner, Co
nsistent over time, and Experienced over a wide area,
Given the above requirements,
 weather indexation is most applicable to highly
correlated risks, such as drought and temperature.

308. Con’t
 Localized (independently occurring) risks, such as
hail or fire, do not lend themselves to index insurance.
Indemnity payouts are made in
accordance with a schedule laid out in the policy itself.
 Index Based Livestock Insurance: is used to protect
against shared rather than individual risk
such as the risks associated with weather fluctuations, dise
ase out breaks or price loss.
– The geographical area that the contract covers.
– The “premium” or the price paid for insurance coverag
e.
– The “strike point,” meaning the index level at which th
e insurance is activated & payouts

309. Con’t
 Begin
– The value that will be paid for each livestock unit that is lat
er estimated to have been lost.
– The length of time for which paid coverage lasts.
 Unlike traditional insurance which assesses loses on a case
by case basis and makes
payouts based on individual client’s loss realizations, IBI
offers policy holders a
payout based on the external indicator which triggers a
payment to all insured
clients within a geographically defined space.

310. Con’t
 Example: Alemu kebede family insures an index insuranc
e for their cattle as follows;
 1TLU= Br. 10,000.00 and Alemu kebede has 10TLU, th
en the
 Sum insured=10*10,000 =Br.100,000. Premium=100,0
00*3.5% (assumed) = Br. 3,500.00
 Strike point =15% (assumed), First period predicted mo
rtality rate = 12%
 Second period predicted mortality rate =20%, First
period=null
 Second period=20-15%=5% therefore
Alemu kebede family will receive 5%*100,000.00=5000
birr each.

311. Advantages and disadvantages of index insurance
 Advantages of index insurance: Although the
development and application of WII is still in
itsearly stages, there are a number of theoretical
advantages of the product.
 The degree to which
these theoretical advantages may be realized through
implementation and further development of
the product remains to be seen
 Reduced risk of adverse selection: Adverse selection can
occur in agricultural insurance because farmers are more
likely to buy insurance if they are a higher risk.

312. Con’t
 Underlying this is an asymmetry of information, which places
the insurer at risk (one that they need to manage through
detailed, individual risk appraisal prior to premium pricing).
 An advantage of index insurance is that farmers subscribe
based on the terms, conditions, and payout scale for all farmers
in their defined area, virtually eliminating the adverse selection
problem for insurers.
 Reduced moral hazard: In traditional insurance farmers may
be able to influence the claim (by exacerbating physical losses)
through their behavior, a phenomenon referred to as moral
hazard.
 With index insurance, farmers have no ability or incentive to
influence the claim, since payout is
based on an independent and exogenous weather parameter,
independent of farmers’ behavior.

313. Con’t
 Field loss assessment is eliminated: Loss assessment is a
challenge for any traditional crop insurance program,
because of the need to mobilize large numbers of skilled or
semiskilled assessors who possess some agronomic
knowledge. The ability of index insurance to make payouts
without field assessment clearly reduces administrative
costs by eliminating the need for assessors.
 Reduced information requirements and bureaucracy:
Traditional insurance products require
considerable work to collect data to establish yields and to
classify farmers according to their
individual risk exposures. Because of the use of the index, it
is not necessary to collect such detailed data, nor to
differentiate between individual farmers. This can be
particularly useful in
countries in which there is limited access to detailed data.

314. Con’t
 Facilitation of reinsurance: Experience suggests that
international reinsurers are likely to
reduce the portion of the premium charged for uncertainty
(“loading”) when the insurance is
based on independently measured weather events.
 Transparency: The assessment process in traditional products
often leads to disputes between
farmers and assessors due to the partly subjective nature of the
loss adjustment process. Weather
index contracts are based on the measurement of weather at
defined weather stations and are
therefore extremely objective and theoretically less likely to lead
to disputes (although basis risk
becomes the real driver for dispute).
 Facilitating access to financial services: By removing the most
catastrophic, spatially correlated risk from vulnerable
communities, successful index insurance markets have the
potential to facilitate other financial instruments that are
important for poverty alleviation and economic development.

315. Challenges in index insurance
 Despite, the apparent advantages of the weather index product,
practical implementation through
pilots and feasibility studies has shown that there are a number
of challenges or disadvantages
inherent with index products.
 Basis risk: Basis risk is the most problematic feature of index
insurance. It is the difference
between the payout as measured by the index and the actual loss
incurred by the farmer. Because
no field loss assessment is made under index insurance, the
payout is based entirely on the index measurement and may be
either higher or lower than the actual loss.
 The level of basis risk is influenced by several issues. First, basis
risk is lower when the insured risk is correlated—that is,
affecting a large geographical area relatively to the same extent
and simultaneously.
 Poorly
correlated risks are hail and localized frost.

316. Con’t
• Better correlated risks are drought, temperature, and
winds. Second, basis risk is higher where there are local
microclimates, different management
practices, and different crop varieties—that is, the weather risk
may be correlated, but its impact
is highly variable.
Data availability: Despite simpler data requirements, accurate
and complete data sets are still
required for index insurance. This applies to the historical record
of the chosen weather
parameter(s) for underwriting and pricing purposes and for the
recording of the parameter(s) for
payout calculations during the period of insurance, as well as
historical yield data to assess risk,
design, and price the product, if the weather index is to serve as
an accurate proxy for loss. For
weather index insurance, a long and high-quality time series of
meteorological data are required
(approximately 30 years of daily data).

317. Con’t
 Integrity of weather stations: Weather stations used for
index insurance must be sufficiently
secure to prevent tampering. Additionally, they should
have automatic, as opposed to manual,
recording of data. Preferably, data will also be collected
from the weather stations using
automatic reporting systems such as Global System for
Mobile Communications (GSM) devices.
Not only do these provisions increase the quality of the
data, but they also reduce the potential
for human error or data manipulation. The degree of
integrity has a direct impact on the cost of
the uncertainty loading that goes into the insurance premi
um.

318. Con’t
Need for farmer/insurer/regulator capacity building
and education: Index insurance is a new
concept for farmers, and therefore any rollout of the
product requires intense education programs
to help them to understand the principle of the
payout system and also the fact that it covers only
one risk variable. To date, experience with this
education requirement has provided mixed
results. For insurers, this is a new type of insurance
product, so they require substantial technical
assistance in designing contracts and indexes and
extensive capacity building to enable them to
undertake product development on a sustainable
basis. Experience in this area has shown that
transferring sufficient capacity is extremely
challenging.

319. Con’t
• Likewise, index insurance will be a
novel concept for many insurance and other regulatory authorities
that have jurisdiction over
index insurance. Involving these regulatory authorities from the
outset helps ensure their support,
legal guidance, and favorable legal classification, all of which are
critical to the product success.
• Currently limited product options for different weather risk: The
majority of WII products have been designed for rainfall risk, which
is not necessarily the most serious or prominent weather risk in
many areas. Experience insuring other weather risks with new
indexes is needed. In many regions farm losses often result from a
complex interaction of perils—for example, increased temperature
that leads to pest problems.

320. Con’t
• A “simple” WII product is not suitable for this and thus would need to consist of
more than one index rolled into a single product or would require the farmer to
take out a different type of insurance product for the other risks.
Research, local adaptation and scalability: The process of designing an index
involves the
analysis of weather data and interpretation of it in relation to the specifics of the
crop to be
insured. Correlations need to be carried out between the weather data and
historical yield data in
order to find good index parameters. Once the product is designed, trigger levels
have to be
adapted to each weather station. Where new automatic weather stations are
needed, they need to
be calibrated based on interpolation between stations. Further, ongoing annual
reviews of the
trigger levels are advisable, especially in the first years of a program. All of this
technical work
limits the speed at which the scaling up of a pilot program to a regional or
national program can
be carried out. It should be remembered that any given index needs to be
reviewed and

321. Con’t
• WII does not have universal application: WII can
be an effective instrument, but not for all
crop types, cropping systems, or hazards. Where
crop type or climate show complex and multiple
factors affecting crop damage or loss, as may
occur in humid climates or where pest and
disease
are dominant causes of loss, indexation with WII
may be problematic. In such circumstances, an
area yield index product may be more applicable

322. 5.3. Strategies for Development of Agricultural Insurance in Ethiopia
• The main challenge of agricultural insurance in developing countries
like Ethiopia is how to create sustainable agricultural micro insu
rance markets. To meet this challenge, the following three elem
ents are needed: (1) designing high quality products that are comm
ercially viable with minimum possible
government support, (2) existence of a large and sustained
demand, and (3) presence of a competitive supply mainly from the
private sector. Given limited resources
in developing countries like Ethiopia and many other sectors requiri
ng attention, promoting strong private-sector participation in
agricultural micro insurance markets complemented with well-
targeted government support is the most realistic
option. The evidence with traditional all-
risk indemnity insurance programs in developed countries is that th
ey require massive government support because of high costs due
to information asymmetries (moral hazard and adverse

323. Con’t
• selection), let alone the political economy behind disguised transfers from
tax payers to farmers as premium subsidies. The small-
scale nature of farming in developing countries would add costs
to such traditional insurance schemes, making them nonviable unless new
technologies
or approaches make them feasible at affordable rates to either small scale
producers or governments willing to provide support within their limited b
udgets. In a broader context agricultural micro insurance
markets should provide incentives to adopt best agricultural practices
rather than substitute for them, complement other efficient risk
management strategies such as risk-reduction
investments including newly available seed varieties that have tolerance t
o abiotic shocks, such as flood, drought, and extreme
temperatures, and when possible become an ex-ante system for
government disaster risk management.