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Risk management and insurance

Introduction

Agriculture today, and specifically farming, is a business faced with many risks. Issues such as climate change, skills shortage and the growth in the financial markets in terms of commodity products have increased the risks these businesses face. Even though agricultural businesses have more tools available to manage and mitigate risks, this has increased the complexity of risk decision-making.

The winners of tomorrow will be the farmers and agri businesses that are able to manage the risks inherent to their farming systems at a reasonable cost. The result of effective risk management practices in agriculture will have some significant benefits for society as a whole such as:

  • ensure food security and stability of prices;
  • result in a stable and profitable commercial farmer base to ensure that agriculture is able to provide in the food requirements of the future;
  • assist in achieving long-term sustainability of the environment;
  • reduce the negative effects of natural disasters (floods, droughts etc) on humans and the environment;
  • reduce the need for taxpayer funded emergency aid packages;
  • create jobs and sustainable employment; and
  • improve the stability of farmer incomes and hence expenditure on farm inputs.

The result is economic stability in rural economies.

Primary sources of risk in farming

Although the risks provided below have been separated into varying categories, to assist in the risk identification and management thereof, these risks are not independent. Indeed some of the larger impacts on farming businesses are due to the interaction of the risks. Farmers should therefore approach risk management from a holistic viewpoint and should carefully consider the impact of even improbable risks.

Production risk

Production risk is defined as the overall uncertainty regarding production. Production risk includes contributing risks such as changes in the weather, crop performance, incidence of pests and diseases and machine efficiency. Currently the observed changes in the global climate are posing numerous and potentially significant risks to the production of crops, particularly those associated with water availability and quality as well as rising temperatures.

Price risk

Price risk results from the unpredictable and competitive nature of the prices of both farming inputs and outputs. Changing prices of products can be observed on formal markets such as the various commodity and futures exchanges, physical markets where buyers and sellers meet or by way of the transactions between individual parties.

In respect of the prices of farming inputs farmers are largely price “takers”, i.e. they have very little or no influence on the prices they pay and there are few risk management tools or instruments available to manage the risk.

For certain crops and products there exist several financial instruments and products whereby the farmer can effect price risk management. But for some the price risk associated with farming outputs can often only be managed to some extent through an effective marketing strategy. Certain producers can be price “takers” for outputs as well, e.g. milk producers.

Political risk

Changes in government or to government policies relating to matters such as land reform, employment targets, subsidies, animal welfare, food and safety are often uncertain and may have a large impact on farmers.

Funding and funding liquidity risk

A successful farming business has implemented a well thought through funding plan. Farming businesses can be exposed to cyclical cash flow patterns. Therefore, managing the funding risk of the farming business is crucial. The recent crisis has taught us that any business needs to plan its operational cash-flow and investments properly and put in place a funding plan that provides some comfort on the availability of the funds at the crucial times. Where substantial funding is required this should be secured well-ahead of time, so that the lack of available funding does not negatively impact the business.

Currency risk

The appreciation or depreciation of the South African Rand affects both import and export demand and domestic prices for competitively traded inputs and outputs. Currency risk can also have a significant impact on price risk, particularly where prices of inputs or outputs are referenced against a foreign currency, e.g. the price of maize in US$.

Legal risk

A large number of farming activities have legal implications. Legal risk is inherent in contractual agreements and is always present in the form of environmental liabilities, food safety liabilities, etc.

Personal risk

Personal risks are those risks relating to the people who are involved with the actual management of the farm. They include farm safety, divorce, illness and death.

Source: Albré Badenhorst, Financial Risk Services at PwC South Africa

Factors farmers should consider before attempting to manage risk

The degree to which various types of risk are managed will depend on many factors. Farmers will need to consider the following in determining the appropriate course(s) of action necessary with regard to dealing with risk:

  • own personal appetite for risk;
  • the likelihood and impact of any potential risks within the particular business;
  • the strategies or processes available to manage or mitigate the risk;
  • the cost of mitigating or managing the risks; and
  • the consequences of not managing the risk.

What options could be considered to manage and/ mitigate the Risk? Risk Management Strategies can be classified along the following lines:

Avoidance or acceptance strategies

  1. avoiding/terminating activity giving rise to exposure or intolerable risk
  2. accepting risk where exposure is within the risk appetite

Diversification strategies

  1. treating, reducing or mitigation through improvements to the control environment and the management processes
  2. exploiting risk where exposure is a potential missed or unrealised opportunity

Risk sharing strategies

  1. sharing of risk between parties and stakeholders
  2. transferring risk to a third party (outsourcing /insuring)
  3. integrating a series of risk responses through combination of responses
Source: Albré Badenhorst, Financial Risk Services at PwC South Africa

Risk sharing strategies

4.1 Avoidance or acceptance strategies

Avoidance and acceptance strategies should be based on the impact and likelihood of the risk. Below are some examples:

  • Planting a crop in an area not suited to its production is avoided because the likelihood of an inferior crop is very high.
  • Planting below the 1 in a 100 year floodline may be an acceptable risk owing to the likelihood of a flood being low.

It is important to conduct a thorough analysis of the risk that is being accepted to completely understand the impact of such a risk should it occur, including negative financial consequences which may jeopardise the survival of the farming operation and its impact on cash flow and fund availability.

 4.2 Diversification strategies

CROP DIVERSIFICATION

By broadening the variety of crops under consideration and selecting crops which behave differently in various financial and environmental conditions, farmers can successfully reduce overall risk. In addition mixed farming operations can also be practiced, e.g. combining crops with livestock, tourism, etc.

FLEXIBILITY

Flexibility is of vital importance when confronted by an ever-changing environment. Farmers should remain as flexible as possible and can do so by growing crops with short production cycles and storing a portion of a harvest so that sales can be made throughout the year at favourable prices. The latter of these options allows farmers to take advantage of price increases but also exposes them to price decreases, but financial instruments are available to hedge farmers against these risks, if appropriate.

4.3 Risk sharing strategies

Contracting

PRODUCTION CONTRACTS

A production contract entails a contractor supplying the necessary farming inputs, including finance, to a farmer, and the farmer delivering a specified quantity and quality of product to the contractor. The farmer is then compensated accordingly for goods and services provided. This form of contract is of obvious benefit to both parties. Contractors are entitled to a predetermined quantity and standard of commodity at some future date, while growers are guaranteed the required inputs and a fixed income stream (production contracts are often also referred to as “off-take” agreements).

MARKETING/ DERIVATIVE CONTRACTS.

Several variations of such contracts exist, including:

  1. Forward Contracts are the most commonly used derivative product available, primarily because it is the most basic and easily understood. A forward contract gives the holder the right and full obligation to conduct a transaction involving an underlying commodity at a future date at a predetermined future price. In other words, an eventual buyer (known as the person assuming the long position) pays the contract price and receives the underlying commodity (grain, wheat etc), and the eventual seller (known as the person assuming the short position) delivers the underlying commodity at the set price. Essentially, a forward contract is a personalised trade agreement between two private parties to be executed at some future date at a predetermined price. A major disadvantage of a forward contract is that these types of contracts are often highly illiquid. This characteristic of a forward contract stems from the fact that it is usually very difficult to exit the contract prior to maturity.
  2. Futures Contracts function in much the same way as a forward contract with one exception. Futures contracts are traded through a centralised market known as a futures exchange [e.g. the South African Futures Exchange (“Safex”)] and as a result are standardised in the terms of the agreement. In other words, the particulars of the contract (expiration date, amount of the underlying asset, price etc) are not personalised as in the case of the forward contract. The standardised nature of these contracts allow for far more liquidity than is the case with forward contracts. Currently the only soft commodities traded on Safex are white and yellow maize, wheat, sunflower seeds and soya beans. There are however derivative contracts on other financial instruments, e.g. on the Industrial share index of the Johannesburg Securities Exchange (“JSE”), on interest and exchange rates, etc. By use of these instruments the risks associated with interest and exchange rates can be effectively managed. Futures contracts also require that both parties to the contract post collateral, commonly referred to as margin. Each contract has a specified amount of “initial” margin placed upon trading the derivative as well as “variation” margin reflecting the accrued profit or loss due to movements in the price of the derivative. These collateral amounts are necessary to protect individual parties in the event of default.
  3. Option Contracts give the holder the right, but not the obligation, to purchase or sell an underlying commodity at a predetermined future price and date. Options can be traded on an exchange such as futures contracts discussed above or in informal markets, commonly referred to as Over-The-Couter (“OTC”) markets. The key distinction here is that the buyer or seller of the commodity in the future has the right to conduct the transaction, but is not obligated to do so. Two types of option contracts exist: (i) Call option which entitles the holder to the right to buy an underlying security; (ii) Put option which entitles the holder to the right to sell an underlying security.
The use of an option contract is best shown by way of example:

A grain farmer may elect to use an option contract in order to eliminate the risk of a low grain price in the market in the future. The farmer purchases a put option by paying a certain premium for the contract. The option entitles the farmer to sell a fixed amount of grain at a predetermined price in the future – the contract does not, however, obligate him to do so. When the option expires, the farmer will consider his choice to sell the grain relative to the market price for grain at that time.

  • If the price of grain in the market is lower than the price agreed upon in the terms of the option contract, then the farmer will exercise his rights with regard to the contract. The farmer will elect to sell the grain at the higher price agreed upon in the contract since the market price is lower.
  • If the price of grain in the market is higher than the price agreed upon in the terms of the option contract, then the farmer will waive his rights with regard to the contract. The farmer in this instance will choose to sell his commodity at a higher price in the market since the strike price agreed upon in the contract is lower.

It should be noted that in the second scenario, where the farmer forfeits his right to exercise the contract, he/she loses the initial premium paid, and as such the option premium can be considered similar to an insurance premium as it provided the farmer with protection in case of the price reducing.

Crop insurance

Insurance is a highly common risk management strategy. An insured person pays a premium to an insurance company at regular intervals and in return receives payment from the insurer if an insured loss occurs.

Leasing

Leasing inputs such as land and machinery provides producers with sufficient flexibility to respond to changing markets. It also decreases the capital required to expand operations, so reducing financial risk.

Equity finance

Equity financing is an effective way of spreading risk. Equity investors in the agricultural operation receive a pro rata share of the returns of an investment, but also suffer proportionately in any losses.

Savings

The use of a savings account is a constructive method of reducing income variability. By transferring income into an account during successful periods and withdrawing from it in difficult periods is a reliable means offsetting unexpected declines in farm income.

Liquidity

Liquid assets are those assets that can be easily converted into cash. Ownership of such assets may be very useful in the event of emergencies. These assets provide a safety net for production disasters and poor market conditions. It is important to note that an appropriate balance is required between fixed assets and liquid assets, since fixed assets have the ability to generate higher profits.

Source: Albré Badenhorst, Financial Risk Services at PwC South Africa

National strategy and government contact

The Disaster Management Act of 2002 applies. Where the particular nature of drought conditions, veld fires etc cannot be declared disasters under this act, relief can be provided in the form of a “specific measure”. Also read about the National Disaster Management Framework of 2005 at www.ndmc.gov.za.

Government has worked with role players to explore a state-aided agricultural insurance scheme but at this stage farmers and the private sector carry production risk on their own.

Department of Agriculture, Land Reform and Rural Development (DALRRD) www.dalrrd.gov.za

Directorate: Agricultural Risk and Disaster Management

This directorate:

  • manages, develops and implements government policy, legislation and prescripts in respect of risk and disaster management in the agricultural sector;
  • prepares a strategic plan for agricultural risk and disaster management;
  • assists and supports provincial and local governments to manage agricultural risks and disasters.

Department of Cooperative Governance and Traditional Affairs (CoGTA) www.ndmc.gov.za

South African National Disaster Management Centre

Find the links to the SA National Fire Danger Index, Advanced Fire Information System (AFIS), Flash Flood Guidance System (FFGS) and the Integrated National Early Warning System (INEWS) on the website.

South African Weather Service www.weathersa.co.za

Subscribe to the various weather notifications and sms services.

The Provincial Departments of Agriculture have units to deal with risk and disaster management. In KwaZulu-Natal, find the relevant web pages under “Resource Centre” at www.kzndard.gov.za. Find details of Provincial Departments of Agriculture on the “Agriculture in the provinces” page.

Role players

Note: Click to expand the headings below.  To get a free listing on our website like the ones below, visit here for more information or place your order here. Disclaimer: The role player listings are not vetted by this website.

 
ABSA Insurance Company Ltd – www.absa.co.za>
T&E FinOps – www.tefinops.co.za
Old Mutual Insure – www.ominsure.co.za
African Risk Capacity – www.arc.int
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North-West University Economics Sciences – https://commerce.nwu.ac.za/economic-sciences B Com Agricultural Economics and Risk Management
University of the Free State (UFS) Department of Agricultural Economics – www.ufs.ac.za
University of the Free State (UFS) Disaster Management, Training and Education Centre for Africa (Dimtec) – www.ufs.ac.za/dimtec
Insurance Sector Education and Training Authority (Inseta) – https://inseta.org.za Inseta is the Sector Education and Training Authority (SETA) for the insurance, risk management, reinsurance, pension funding etc industry.

Further reference:

Find details of the following on the “Providers of financial services” page:

  • Financial Intermediaries Association of Southern Africa
  • South African Insurance Association (SAIA)
  • South African Underwriting Managers Association
  • The Ombudsman for Short-Term Insurance
  • The Ombudsman for long-term insurance
  • Actuarial Society of South Africa
  • Association for Savings & Investment SA
  • Financial Planning Institute of Southern Africa (FPI)
  • Financial Services Board
  • Institute of Retirement Funds of South Africa (IRF)

Companies involved

  • Your regional co-op or agribusiness (see “Agribusinesses” page)

Credit insurance

  • Credit insurance means that if your customer goes into liquidation or if payment is prevented by some other event, the credit insurer will foot the bill.

Training and research

Other role players

  • The Regional Emergency Office for Southern Africa (REOSA) of the United Nations Food and Agriculture Organization (FAO) provides co-ordination, technical and operational support in food security and agriculture Disaster Risk Reduction and Management (DRR/M) to governments, regional partners and to FAO Country Offices within the southern Africa region. Visit www.fao.org.
  • Friends of Agriculture https://friendsofagri.com

Some articles

Our thanks to Albré Badenhorst, Financial Risk Services at PwC South Africa, for rewriting much of the content of this chapter. Contact him at albre.badenhorst [at] za.pwc.com

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