Anyone who has worked in Australian agriculture for more than a couple of days will have heard one of the above, albeit most likely with stronger adjectives.
If there is one guarantee for farmers in Australia it’s that we are at the mercy of the gods when it comes to weather. In such a big country, there will always be an area where something will be going wrong with the weather.
Many of you will have heard about multiperil crop insurance, but what about weather insurance & derivatives. Are these a suitable risk management option for protecting against the weather?
Multi-peril crop insurance(MPCI) products are quite clear with their intentions, they are purchased by producers to protect against a multitude of potential impacts to the crop. These products are generally revenue protection products, and are designed to safeguard against unexpected events. Whereas the MPCI products are catch all, the index products are targeted towards a specific risk factor.
In this article we will use the term ‘weather index’ to describe both derivatives and insurance products. There are some small differences* between the two product types, but they largely provide the same service for farmers. I won’t be discussing the individual offerings from providers, as there will be some small intricacies that will be different from product to product, however it is intended to give an overview of the general weather index offering.
These products will work well with growers who understand their business intimately, and want to protect against a specific risk. The risk being covered must be quantifiable, for example rainfall levels or a temperature range.
When a farmer has identified a specific weather risk the provider will create an appropriate index. The product is tailored for each situation, and should always be based on an independent and robust weather recording service. An agreed payout trigger is then agreed. If the trigger is achieved, then the producer will receive an agreed payout.
The index provider will charge a premium for this service, and this will be based on the likelihood of the policy being triggered. As would be expected, if you have a high chance of a detrimental weather event occurring, then your premium will be more expensive.
An example – 'Jack Frost'
Let’s look at an example. It’s the middle of September and my crop is looking in pretty good shape, the major risk to the crop is frost. I don’t want to get this close to harvest, just to see the crop lost as a result of a frost event.
I have discussed the trigger with my agronomist and my index provider, and have decided based on price and risk to have a payout trigger if the minimum temperature drops below -5°c over the next 30 days. In figure 1, we can see that during this period of time the minimum temperature reaches -4.9°c and will not receive a payout, however in figure 2 as the temperature dropped below -5°c a payout is trigged.
It is important to remember that the trigger is key to whether you receive payment or not, and it can be frustrating to narrowly miss out on a trigger. This is why it is extremely important to think long and hard about your trigger.
Important points to note when considering weather indexes:
When creating the product, there may be an element of flexibility with the provider to create the pricing mechanism, for instance being covered if it falls below 5°c should be cheaper than being covered below 0°c. The pricing should be reflective of the risk of the payout being triggered.
These products only cover a prescribed risk, therefore if you are covering frost, you get no cover for hail. This should make for cheaper premiums, and more flexible cover.
Cliff faced payouts
There are no if’s or buts, if you hit the target you get paid. If you are close to the trigger but not over then no payment will be made. This makes trigger selection of paramount importance, to ensure cover will protect your crop.
The index products typically use a nearby weather station to determine the risk profile for your farm, and the trigger for your payout. As we all know these weather stations can be a considerable distance away, and therefore you may have an event destroying your crop yet not receive a payout.
There are some providers who will provide an index based on BOM grid data, when using this data, it is important to have your own on-farm datasets to compare the accuracy between the BOM grid data and what has occurred on farm.
Index based weather products are based on data and are relatively easy to set up. They can be set up in season, and cover a limited amount of time.
Involve your agronomist
To get the best result from these products, it might be advisable to discuss the creation of triggers with an agronomist to get the best fit for the location and crop conditions.
*Weather derivatives can only be provided by an advisor with an Australian Financial Services licence which allows for derivatives, with the same compliance requirements as providing grain futures advice. Weather insurance products, although the same are exempt provided the buyers have an exposure to the underlying risk covered i.e. they cannot be used for speculative purposes. Weather insurance will attract stamp duty (dependent on state), whereas weather derivatives are exempt.
To read our previous article on MPCI follow the link below: