Harvest insurance based on index could usher in new era

26 March 2024

South Africa’s Prudential Authority has for the first time approved index-based crop insurance for farmers.

Index-based insurance, also known as parametric insurance, involves a policyholder receiving a payout if the relevant index, which could be based on factors like soil moisture or rainfall, moves above or below a predetermined threshold. This is according to Daniel Stevens, executive head of crop insurance at Santam, the insurer granted approval to offer these policies.

“This type of insurance is ideal for small farmers and is particularly beneficial for farmers in remote areas where access is limited,” he says.

“Both commercial and emerging farmers can benefit from it. Because it is not based on individual compensation but calculates loss based on deviation from an index, it is often more suitable where large numbers of small farmers farm in the same area.”

The success of such coverage depends on there being enough farmers in a specific coverage area who take out the insurance and continue to do so.

How it works

Stevens says the index used for index-based insurance is designed to reflect losses resulting from a specific weather-related event, such as excessive or insufficient rainfall.

“The benefits of such insurance are that the cost and administration associated with it are lower because the insurer does not send an assessor for insurance claims, and the insured loss can be calculated and paid out much faster. A claim arises when the index moves above or below the threshold.”

While cost savings can be achieved in this way, it is important to bear in mind that the risks of droughts and floods in Southern Africa are significant.

One of the disadvantages of this type of insurance is that satellite measurements provide readings over large areas (10 km x 10 km), leading to a so-called basis risk.

“This refers to the risk of a payout not being equivalent to the actual losses of any specific point within the established reference area,” says Stevens.

“Although it is difficult to avoid, there has been significant improvement in the resolution of satellite measurements, and several insurance specialists internationally are working to reduce the basis risk of index insurance.”

Index-based coverage can be offered on any crop affected by insurable risks but Santam cannot say when it will start offering these policies. Having received approval, it now has to refine its product offering and marketing strategy.

Subsidy would be welcome

Stevens says in most other countries where index-based insurance is used, the government provides a premium subsidy to make it more affordable, especially for small farmers.

“In South Africa, agriculture would certainly favour subsidised insurance. It can be used for coverage against droughts and excess rainfall or floods because these are the types of risks for which farmers cannot easily obtain coverage.

“The subsidised model is currently being used internationally for coverage against droughts and floods. If it becomes a reality in South Africa, it should be available to all farmers, large and small.”

State involved in pilot project

The South African Insurance Association, the Financial Sector Conduct Authority, the Department of Agriculture, Land Reform and Rural Development and the Prudential Authority earlier asked Santam to undertake an index insurance pilot project to test the principle and applicability.

According to Stevens, 12 farmers in the eastern Free State were insured in the 2021-22 season. “We used information from the European Space Agency to track soil moisture levels. Because soil moisture was not below the index threshold in 2022, there were no insurance claims that season.”

During this time, Santam met monthly with the government, and other feedback sessions were held with the relevant group manager and the insured farmers.

How farmers currently hedge risks

Stevens says commercial farmers in South Africa mostly use individual compensation products, such as a hail policy, to insure their crops. A hail policy usually also includes coverage against fire, frost and damage while the harvested product is being transported.

“We estimate that only about 30% of commercial farmers in South Africa take out crop insurance. Most of it is taken out by grain farmers, namely for maize, soybeans, sunflower and wheat. An estimated 80% of South Africa’s wheat in the summer rainfall areas is insured.

“A farmer decides on the value at which he wants to insure his crop per hectare. When there is damage, an assessor determines the extent and value. Based on this, the insurer pays the claim as a percentage of the amount insured.”

When there are visible signs of damage to a crop caused by an insured risk, farmers cannot take out crop insurance, says Stevens.

Continuous insurance

Gerhard Diedericks, formerly of Santam Agriculture and who started the consultancy firm Financial Risk Evaluation after his retirement, says it is important for farmers to take out crop insurance continuously and not just in certain years.

When farmers choose not to insure their crops in certain seasons, it affects insurers’ and reinsurers’ decisions about the availability of crop insurance.

Therefore, when there is an El Niño weather phenomenon, it can be more difficult for farmers who have not continuously taken out insurance in recent years to get cover.

According to Diedericks, it is difficult to generalise about who takes out crop insurance, but it is often producers with farms of average size who do not have such a strong balance sheet, and who take it out as collateral for financing their input costs.

“I see a tendency for producers with a larger balance sheet to be more inclined to bear certain risks themselves and to insure their high-risk crops based on statistics. Many producers also hedge themselves by planting other crops in geographic areas with different types of risks,” says Diedericks.

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