Multi-peril Crop Insurance – When Should Australian Farmers Opt for it?
MPCI or Multi-peril Crop Insurance is typically considered an excellent way for farmers to protect their farm businesses from the period of “disasters” that can have a severe impact on farm viability and are usually held liable to cause failures of farm business. In fact, farm businesses fail because of absence of profitability over a duration which eats away their equity and their capability to withstand the ‘disaster’ period.
Any insurance comes for a price and the price will decrease profitability. MPCI may never be the “magical solution” to prevent failures of farm businesses. It may delay the unavoidable expiry of a non-profitable business if it undergoes a poor year when it’s loaded with debts, but through a decrease in profit, it may also decrease the time taken for a non-profiting business to achieve unsustainable debt levels.
The most ideal way for a business to defend itself during a “disaster” period is to gain profit and maintain a solid balance sheet. A solid balance sheet refers to adequate funds or the ability to borrow adequate cash to cover a loss and still sufficient funds remaining to buy inputs and cover operating costs to get the next harvest successfully and repay the debt and replenish these funds.
Insurance companies always calculate the premium around the likely size and frequency of the claims. They calculate premiums to gain a profit through gaining higher income than payouts. Businesses can benefit if there are not many events having a huge impact. This is why most grain producers buy fire and hail insurance. Its premiums are about 1% of revenue and loss in a disaster can be up to 100% of the crop.
If good protection is to be achieved from multi-peril crop insurance, you should be prepared to give up some profit while transferring risk. Premiums will be very costly in case of big and frequent payouts. If payouts will be small and infrequent, the outcome of your business won’t be changed enough to make it worth having. For most insurance products, higher payments for a greater level of protection offer a better outcome for the business.
Insurance providers often face the issue of adverse selection. This is when the customer buying an insurance product tries to swing the balance of premiums against payouts in their favour by choosing specific situations or paddocks which are a greater risk than the general risk on which the insurance providers have calculated premiums.
If you plan to work out this system and get benefited from adverse selection, you may gain a few wins in a short term, but not for longer because the insurance companies will change the rules to prevent this type of activity. A huge benefit of buying MPCI is that it provides confidence to a business to chase a long term profit outcomes that have a greater short-term risk. Examples of this have taken place, especially in the Eastern States, where levels of borderline soil moisture would have prevented some farmers from sowing early and taking the opportunity to follow up rain. It was MPCI with which they prepared to take the risk by knowing that some of the risk can be loaded onto the insurance provider for a price. A solid balance sheet can offer similar confidence since the risk can be covered internally.
A farming business having no capability to borrow more cash to continue farming, to make a long term difference, the multi-peril crop insurance would have to cover a considerable part of the cash running costs of that business. The needed cover would have to be minimum 60 to 75% of the long-term average revenue.
MPCI products come under 3 broad categories:
- Agreed minimum yield
- Parametric/Weather index
- Income protection (maintains revenue proportion, includes cost of production recovery)
1. Agreed Minimum Yield Products
Now many products are available as insurance providers have realised the benefit of keeping insurance easier to administer because of which costs of delivery can be kept down and insurance companies can gain a profit without making premiums too expensive.
2. Parametric/Weather Index Products
If your equity position is 75% or less, the ratio of your bank loan to value would be almost 50% (or higher) of land value. In such a case, the risk of undergoing a financial pressure is greater if there is a very poor year. You may tend more to get insurance protection to mitigate the problem and protect the business from landing into an unmanageable position.
If you lease a great area of the land on which you farm, even at average to excellent equity levels, you have more chances to have a scarcity of bank security. Similar to the lower equity situation, your position may be weaker to wear a disaster due to the debt gearing. Such a position might evoke you to take some risk cover from this kind of product.
You may even have to share the risk where you are entirely committed to a big dry seeding program.
Insurance is to be used to prevent the dual problem of a poor year and extra machinery repayments, understanding the better machinery will cover the insurance cost through higher productivity over the next decade.
3. Income Protection Products
The income protection options are usually considered to be the ultimate crop insurance products since they excellently protect against the risk of production and price since it is based on the inconsistency of revenue.
It doesn’t actually matter why the revenue has gone down in case of an insurable situation. In farming, such possibilities are countless (diseases, hot Septembers, world commodity prices, frost, pest, wet harvests and rainfall to name just a few).
Premium is calculated on the basis of information about your business and it is:
- Area of crop
- Average figure of cropping income
These two should be covered by the income protection product to prevent adverse selection problems.
There are a range of products that may be useful to a farming business. The best long-term crop insurance is to own a profitable farm business and maintain powerful levels of equity. This will offer flexibility in your business to tackle the adverse seasons and lower prices.