CHAPTER FIVE

RISK MANAGEMENT STRATEGIES AND

INSURANCE IN AGRICULTURE

• Business firms encounter two kinds of risk-

business and financial.

 Business risk refers to the variation in net income
resulting from the type of business in which the firm is
engaged.
 Financial risk refers to the possibility of a company
being unable to meet its financial obligations.
 5.1. Sources of Risk and Uncertainty in Agriculture

Six different kinds of change or uncertainty faced by farmers.

These are:
1. Production uncertainty,
2. Price uncertainty,
3. Causality uncertainty,
4. Technological uncertainty,
5. Uncertainty caused by actions of others, and
6. Personal uncertainty,
 5.1.1. Production Uncertainty
 Production uncertainty is caused by variations in weather and by
diseases, insects and other biological pests.
 Production uncertainty in crops is concentrated particularly in those
areas where weather is unstable.
 These are high-risk areas because of their great variability of
production.
 When yields are below normal, income may be inadequate to cover
costs and, as a result, cash deficits accumulate.
 Livestock enterprises also involve production uncertainty. Death
losses from diseases and adverse weather conditions are common.
 5.1.2. Price Uncertainty
 Closely associated with weather and other natural hazards is

the risk of price fluctuations.

 Low levels of production are generally associated with higher

prices; however, this generalization may not hold for the

individual farmer.
 Price uncertainty always has been a major consideration in

farming, and farm commodity prices have fluctuated

dramatically in recent years.
Many forces cause prices to fluctuate, such as
production of other farmers, and
changes of consumer tastes.
 5.1.3. Causal Uncertainty

It arises when we are unsure about the exact causes

behind a particular event or outcome.
Property losses due to fire, flood, windstorms, theft, etc.,
are a source of risk in any business.
Causality losses can generally be covered by insurance;
however, income may still be reduced by the
interruption of normal business activity that often
follows a major loss.
 5.1.4. Technological Uncertainty

 Another type of uncertainty arises from the development and

adoption of new techniques or methods of production.
 New crop varieties, chemicals, feed combinations, models of

machines, and the like are continually being developed by research

workers and business concerns.
 While theses new developments usually are based on approved

experimental procedures, the results realized may be different on a

given farm from those expected.
 The rapidity of technological change can also continue to
uncertainty.
 5.1.5. Uncertainty Caused by Actions of Others
 The course of action followed by firms and agencies with whom
the farmer does business causes uncertainty.
 If the farmer requires part of his capital by renting, for example,
the possible future action of the landlord creates uncertainty.
 The landlord may decide to increase the rent, rent to a relative, or
sell the farm.
 If such things should occur, they might reduce the tenant’s earning
capacity .
 Similarly, if the farmer obtains capital by borrowing, uncertainty
may be caused by not knowing just what the lender will do.
 5.1.6. Personal Uncertainty
 No one knows what the future health of family members will be, i.e.,
when a serious illness may occur or when death will take family
members who are important to the farm business operation.
 Medical and hospital expenses caused by a major illness may be
substantial.
 When the farm operator is harmed, income suffers from loss of labor
and management in the business.
 Uncertainty arising from family health is of a major importance in
the farm business and should be fully recognized in considering risk-
bearing ability
5.2. Evaluating and Reducing Risk and Uncertainty
5.2.1. Analyzing Risky Situations
 The first steps in risk management are to assess one’s attitudes
toward risk and to develop a framework or set of rules for
examining risky situations.
 Most managers exhibit risk-averse behavior.
 Moreover, individuals differ in their degree of risk-aversion— some
requiring greater compensation than others to assume a given
increase in risk.
 The choice among the alternatives may be conducted using decision
trees or decision rules.
 5.2.1.1. Decision tree

 A risky situation can be defined as one in which the actual outcome

may differ from the expected outcome.
 A decision tree is one method of examining the range of outcomes
of a risky situation. It provides a clear diagrammatic representation
of decision problems that include elements of non-certainty.
 The main value of decision trees may will be that their construction
requires the manager to express all relevant alternative actions, and
events occur.
 E.g. Consider a farmer who has 1000 quintals of corn on hand.
 The marketing alternatives are:
 to sell the corn now for birr 2 per kilogram,
 to store the corn for future sale, or
 to feed the corn to 100 hogs.
 Example

A. If the corn is stored for later sale, the possible net prices
(after paying storage costs) and the associated probabilities
(which reflect the decision maker’s evaluation of the
likelihood of occurrence for each possible outcome) are
indicated in Table 5.1.
B. The prices of hogs in birr per head in the three market
conditions are also indicated.
Total direct costs for feeding 100 hogs, excluding corn, are birr
7000.
.
• .
.
 5.2.1.2.
 These rules depend upon the Selection rules attitude toward risk.
decision maker’s
 Based on the attitudes toward risk, selection criterion might be
• maximin,
• maximax or
• safety-first rule

Maximin rule: Some conservative decision makers appear to use a maximin

rule (maximum of the minimum), which results in selection of the
alternative with best of the worst outcomes.
In this example, the maximin rule would result in the choice of selling the
1000 quintals of corn now for birr 2 per kilogram because the worst (and
the best) outcomes for this alternative is birr 2000.
 Maximax rule: A risk seeker might use the maximax rule
(maximum of the maximum), which leads to the alternative with
highest possible income.
 In our example, the maximax rule would result in deciding to
market the corn by feeding it to 100 hogs, even though this
alternative could result in a return of as little as birr 1700.
 Safety-first rule: The safety-first rule represents a
compromise(cooperation) between the maximin and maximax rules.
• With a safety-first approach the alternative with highest expected
return is selected, subject to an acceptably low chance that the
income will fall below some minimum level.
• The hog-feeding alternative would be ruled out because it
involves a 20% chance that the income will be less than birr
1700.
• Storing the corn would be the best alternative; it offers a
higher expected return than does selling the corn now, but the
probability that income will fall to the birr 180 disaster level is
only 10%.
 5.2.2. Strategies to Reduce Risk and Uncertainty

 Risk and uncertainty cannot be totally eliminated.

 However, risks can be reduced, and there are several strategies
for improving one’s ability to withstand adverse business
conditions.
 Some of the risk management tools used in agriculture help
reduce the amount of risk the manager faces, while others help
soften the impact of an undesirable result.
 Cont..
There are many strategies that can be used to reduce risk and
uncertainty. These include the following:
a. Financial strategies,
b. Marketing strategies, and
c. Production strategies.
5.2.2.1. Financial Strategies
These strategies include:
 cash reserves,

 non-cash reserves,

 reserve borrowing capacity, and

 5.2.2.2. Marketing Strategies
• Many producers as well as processors and wholesalers of agricultural
commodities use strategies such as hedging, options, forward
contracting, and spreading of sales or purchases to protect themselves
against price changes.
 Hedging: is a technique used to reduce the risk of a financial asset.
 It is risk management strategy which reduces adverse price
fluctuations in a asset.
 Hedging on the futures market allows buyers and sellers to establish
now the prices of products they intend to buy or sell on some future
date.
 Commodity options: it allows the owner the right to buy or
sell the underlying goods at a strike price on a future date.
Commodity options offer sellers and buyers of many farm
commodities an opportunity to ensure against adverse price
movements without eliminating the possible gains from
favorable price movements.
 Forward contracting: Forward contracting is another method
locking in prices.
• For many farmers forward contracting has some important
advantages over hedging or options.
 Spreading sales: spreading sales is a marketing technique that can be used
 5.2.2.3. Production Strategies

 Diversification: is one of the more common methods employed to

alleviate risk and uncertainty.
 Having more than one enterprise in the farm business, the chance
of a large loss from a given hazard is reduced.
 Flexibility: As time passes and added information is obtained, a
flexible business can be adjusted to meet new circumstances.
Flexibility in organization of a farm business can be of three
types:
time flexibility,
cost flexibility, and
 Time flexibility refers to the time involved in producing a
product.
 Cost flexibility is attained by keeping fixed costs low in
relation to total costs.
 Product flexibility refers to the possibility of adjusting the
product produced to meet changing conditions.
 5.3. Insurance in Agriculture
 Insurance serves one basic purpose – to provide protection
against economic losses arising from adverse events.
 Automobile insurance protects the policyholder against
losing the asset itself because of accident, theft, fire, or other
calamity.
 The basic purpose of life insurance is to protect surviving
dependents against the loss of income and added expenses
that occur when a family member dies.
 5.3.1. Pooling of Risks
 Insurance is the combining or pooling of enough small
unpredictable risks so that annual losses for the combined group
become statistically predictable.
 The basis of all insurance is the “law of large numbers.
 What is a burden some risk for the individual becomes in the pool
an easily carried, relatively constant, annual loss expense for the
insurance agency.
 The premium paid by the individual can be charged as an expense
to take care of the particular risk involved.
5.3.2. Insurable and Non-insurable Risks
 Some risks are more easily insured than others. Why it is so?
These factors are:
 Predictability: An event is insurable if the probability of its
occurrence can be predicted and the cost of the event to the
insured party can be determined.
 Size of loss: Generally, the loss must be important enough to
cause economic hardship to the insured.
 For this reason very large losses are not generally insurable.
 Moral hazard: The risk must generally be accidental in nature, and
the loss to occur to collect the insurance fraudulently.
 Isolated risk: Natural hazards vary in their insurability. Where the
occurrence of the risk is isolated, as with the usual farm fire, a local
insurance company covering a county can handle most of the risks.
• But where the occurrence might be widespread, a state or nationwide
unit is better able to handle the risk.
• Crop failures due to drought that may cover wide areas are difficult to
predict.
• As a consequence neither local nor state units are big enough to do the
insuring. Only a nationwide agency can cope with this type of risk.
 Predictable frequency and volume of cases: Personal hazards
such as illness, accidents, and death lend themselves to insurance
because they occur with predictable frequency when large
numbers are included.
 Widespread and unpredictable risk: Price fluctuations do not lend

themselves to insurance as well as natural hazards because they are

not as predictable and are likely to affect wide areas or even the

whole nation at the same time.

 Prices do not fluctuate about a predictable average because they are

the result of unpredictable factors such as weather conditions and

other natural hazards.