This paper is the second output of the study “The Financing of Agricultural Production Shocks: A Market-Based Approach”.<sup>2</sup> The purpose of this paper is to develop a conceptual framework for financing agricultural production shocks with market-based instruments. Hence, it focuses on the risk of adverse agricultural production shocks causing drops in crop yields and on how formal market-based instruments (such as insurance/hedging, and savings/borrowings) can enable farmers to manage it.

Relying on the latest advancements in crop yield risk modeling, actuarial science, insurance and financial economics, the paper attempts to develop clear guidelines for examining the financial (business) viability of a specific crop, once the hedging costs are considered. The proposed optimal risk financing structure developed under this approach is based on an actuarial analysis of production risk characteristics and the consequent risk decomposition into distinct layers. Based on the frequency and severity characteristics of each risk layer and the farmer’s financial profile, an optimal combination of risk financing techniques consisting of insurance, savings and credit is proposed. In deriving an optimal financial structure, we consider the cost of these risk management instruments which enables us to draw some interesting conclusions about the pricing of risk hedging instruments, the concept of insurability, and ultimately the business viability of the examined crops.

One of the principal messages conveyed by this paper is that market-based solutions, without public subsidies, can enable asset-poor farmers involved in profitable business activities to maintain the viability of their agricultural business in the long run despite their constant exposure to weather-related exogenous production shocks, which sometimes can be catastrophic. This paper proposes a new typology of crop business activities based on (i) the profitability of the crop business and (ii) farmers’ ability to absorb exogenous production shocks. This typology identifies crop business activities that could benefit from market-based risk financing solutions and those that cannot be sustained without government subsidies. It thus provides a new rationale for the role of government and the private markets in the management of agricultural production risks.

The paper is structured to highlight the main ideas and initiate debate to further the discussion. Section 2 summarizes the multiple risks faced by farmers and the respective multiple risk management strategies. Section 3 presents a detailed analysis of production risk, the only risk examined in this paper, and discusses the concepts of crop business viability and profitability in light of farmers’ ability to absorb adverse weather related production shocks. It also identifies the type of farmers that would benefit most from external market-based sources of risk financing. Section 4 investigates how insurance and self-insurance, including savings and debt, could be efficiently combined to provide cost-effective risk management solutions custom-tailored to the specific needs of crop farmers. Section 5 presents a brief summary of the key findings and contributions of the paper.

# **2. Multiple Risks and Multiple Risk Management Arrangements**

There has been a growing body of work at the World Bank on the relationship between poverty and risk and efforts to manage risk. In a series of discussion papers on social protection, Siegel and Alwang (1999), Siegel (2000), Holzmann and Jorgensen (2000), and Heitzmann, Canagarajah and Siegel (2002) examine how to identify and manage risks in rural

> 2 The first output is a technical paper on combining insurance, contingent debt and insurance in an optimal corporate risk financing strategy (Gurenko and Mahul 2003).

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