The viability of weather index insurance in managing drought risk by Australian wheat farmers

In this study, the viability of weather index insurance in managing drought risk for Australian wheat farmers is considered. The relationship between wheat yield and rainfall index is examined as a prerequisite for the analysis of hedging efficiency of the insurance contracts. Also, the prospects of diversifying a pool of insurance contracts was analysed and opinions were sought from stakeholders on policy issues. The relationship between wheat yield and Cumulative Standardized Precipitation Index was estimated for 23 shires (counties) in Queensland and 40 in Western Australia over the period 1971 to 2010. The relationship was found to differ across locations but overall, it was sufficiently high to permit the use of the index as a proxy for calculating insurance payouts. It was also found that the hedging efficiency of the insurance varies by locations and was higher in locations with higher rainfall variability. The major contribution of this study is that when prices were allowed to vary over the period considered, hedging efficiency reduces relative to the constant price assumption. This result suggests that previous studies did not capture the cost of price stabilization or it could be said that the natural hedge between yield and price reduces the willingness of farmers to pay for weather insurance. Although, the efficiency was not sufficiently high to permit the use of the model in this study in that improvements will be required to make it marketable, some important policy recommendations are evident from the results. Also, the loss ratio analysis indicated that risk pooling would reduce the burden to the insurer over the long term. However, it was noted that insurers will be able to diversify moderate drought risks than intense droughts while farmers may be willing to hedge intense drought risks. Policy recommendations made in this study therefore aim at bridging this chasm. Also, there was no significant correlation between hedging efficiency and the measures of the relationship even when the yield-index relationship was disaggregated at the corresponding quantiles to the efficiency levels. Furthermore, the results from farmers’ interview show that; ‘it is against the DNA of farmers to pay taxes and they spend one dollar to save 30 cents’. This attitude of suboptimal choices reduces the tax delivered to the government coffers and farmers who were probably capable of being profitable avoid declaring profits because they were avoiding taxes. It was clear from the interviews that farmers detest welfare approach to risk management but would prefer the market options because it facilitates self-reliance and mutual obligation which the government of Australia aims to promote. However, demands for such market options like weather index insurance have been known to be low and the hail and fire insurance that has been in the market for a long time is not meeting the needs of the farmers. The poor uptake of weather insurance was traced to systemic risk, basis risk, lack of incentives and low awareness of the option among farmers. Although, there have been attempts to offer the product, the problem of moral hazard it is purported to resolve is the bane of its uptake because farmers are morally hazardous investors who use insurance as a financial option when production outlook is bleak. It was recommended that the government should give tax incentives on insurance premium in addition to the recent welfare provision for farmers to encourage them to make optimal decisions to become profitable. Doing otherwise could unnecessarily inflate the value of assets used to earn the welfare supports. It was noted that state stamp duties on insurance should be abolished otherwise; insured farmers will be paying the cost of assisting their uninsured counterparts. Should this policy be implemented, it is expected that the rural debt trend recently put at $66 billion will be alleviated as the cost of capital to the rural sector decreases. Finally, the history and future of agro-risk management was documented, the legal and regulatory requirements for the smooth running of this policy recommendation and the necessary theories are also explored and related to the analyses.