Livestock Index Products in China and Overseas
By Yu Deng and Xiaofei Liu, Swiss Re Agriculture Reinsurance
Livestock insurance plays a critical role in the agricultural insurance system in China. Ministry of Agriculture and China Insurance Regulatory Commission jointly held a livestock insurance conference on 28 August 2014. Their main focus was on a new strategy to expand the insurance footprint to support livestock using various approaches such as product innovation. In the United States and Canada, two well-developed markets that we can learn from, a number of products are available for livestock index insurance. Therefore, this article compares hog price index products in China with those in the United States and Canada. The aim is to initiate a discussion on product design and to provide some suggestions for product innovation.
Livestock Price Index Products in North America
In North America, the primary livestock price index products are Livestock Risk Protection (US), Livestock Gross Margin (US) and the Western Livestock Price Insurance Program (Canada).
1. Livestock Risk Protection
Livestock Risk Protection penetrates into 37 states in the US which provides protection for beef cattle and hog prices. A policyholder is required to be a certified professional farmer in order to receive daily policy information from the US Department of Agriculture website. The information includes floor price, variable coverage level (70%–95%), policy periods, ending dates and rates. Certified farmers can also buy an insurance policy online. A portion (13%) of the premium is subsidised by the government. If the composite price index published by the Chicago Mercantile Exchange is lower than the floor price that the farmers selected, the difference will be compensated by the insurer. To match the production cycle, on any working day a farmer can purchase an insurance policy with a three- to six-month expiration date. Farmers benefit from the flexibility and timeliness of the daily policy updates and instantly-published rates.
2. Livestock Gross Margin
Livestock Gross Margin insurance protects policyholders against the dynamic correlations among the prices of breeding hogs, growing corn and soybeans. In the US, Livestock Gross Margin insurance is available in 48 states. Based on the expected monthly finished hog marketing plans for the following six months, farmers can purchase a policy on the last Friday of the current month. The policy includes deductibles, monthly number of finished animals targeted for marketing and the contract monthly price of hog futures, as well as the corn and soybean futures prices three month prior to the contract month. The total sum insured is the gross margin, which is the difference between the value of the dressed meat production and the feed cost. In order to determine the feed cost the corn: soymeal and corn ratio formula is retrieved from the US Department of Agriculture. Moreover, the formula can be adjusted according to different hog production segments such as farrow-to-finish, grower and finisher. Some difference between the actual and expected slaughter weight for each month is acceptable, but the actual total slaughter should not be larger than the expected total slaughter. However, if the actual total slaughter is smaller than 25% of the expected total slaughter, the claims will be reduced proportionally. This pricing method is based on option pricing theory which associates the market demand and supply with the price outlook and volatility expectation. It is also a forward-looking method.
3. Western Livestock Price Insurance Program
In Canada, the major Livestock Price Insurance products include beef cattle and hog price insurance. The premium, floor price and settlement price are published online by province-level agricultural insurance companies on Tuesdays, Wednesdays and Thursdays. Each province can adjust its own settlement price to minimise basis risk. Farmers can purchase an insurance policy either online or from sales outlets of province-level agricultural insurance company. The policy period can vary from two to ten months. This means that the policyholder needs to determine a target price for the following two to ten months based on his/her own marketing plan. Once the policyholder pays the premium based on the instant premium rate online, the policy will be effective. On any working day within four weeks before the policy expires, the policyholder will be able to compare the daily settlement price and the target price. If the settlement price falls below the target price, the policyholder can then file claims. If the policyholder has not yet filed any claims, the insurance company will pay the claims based on the average of the settlement prices during the last month in which the policy expires. In addition, the Livestock Price Insurance Program complements the products available from agricultural financial services companies, such as agricultural loans, insurance premium discounts and priority access to other subsidies.
Livestock Price Index Products in China
The pilot product mainly focuses on hog price index insurance. It features the "pork grain ratio" that is used to establish underwriting and claims settlement guidelines, which significantly simplifies the claim process. The pork grain ratio as a production parameter is mainly used in China – the larger the ratio, the higher the profit margin. Usually when the pork grain ratio is 6:1, pig farming is at the break-even point so it is often used as the claim pay-out trigger for hog price index insurance. The policy period varies from several months to one year. Insurers refer to the pork grain ratio published by the Chinese government. Whenever the average pork grain ratio is lower than the trigger point, claims are made.
From the design point of view, China’s hog price index is similar to gross margin insurance in the US, but there are some significant differences between the product design and operation. Key differences include the method of determining the sum insured, the indemnification process, the sales process and the continuity of policy sales volume.
Generally speaking, the design of the hog price index in China is more appropriate for the Chinese market because it is easy for farmers to understand. However, the hog price index has some shortcomings such as the mismatch between policy period and production cycle. At the same time, the pork grain ratio can have a significant influence on the decision to purchase insurance policies and even distribution of policy sales. The existing pricing methodology can be described as static rather than forward-looking. In contrast, the US gross margin insurance is designed so that coverage matches the production cycle and responds concurrently to market dynamics to encourage even distribution of sales. Instant pricing is forward looking and corresponding to latest market conditions. However, the operation is complicated and the policy is not easily understood or accepted by farmers. In US, underwriters still rely on the price information from large futures market where liquidity is quite high.
Suggestions for Innovating the Livestock Price Index Product
In global markets, livestock gross margin insurance has its advantages when compared to using traditional hedging method with standardised futures contracts. With gross margin insurance, there is no restriction on lot size which is required by futures contract. Rather than managing risks by hedging three correlated commodity futures contracts, owners of small- and medium-sized farms can purchase gross margin insurance and simplify the process of locking the margin. At the same time, the price expectation embedded in the futures price can still be used in gross margin insurance as one of the pricing elements. The calculation of gross margin, for example, is based on hog futures prices so that unforeseeable drop in profit can be insured and market uncertainty reduced.
We think that the use of publicly available market prices can improve insurance product design and make insurance purchase increasingly convenient and relevant to production activities. Agricultural products, especially livestock products, are significantly dynamic and cyclical in nature. Therefore, by purchasing insurance policy based on real time market information, insureds can lock in their profits when the market price or margin is favourable and lessen losses when the market is unfavourable based on their own production cycle.
In addition, providing policies with a variety of periods, sum insured and coverage levels can improve the flexibility of insurance products. It will be easier for farmers to purchase a policy that is suitable to their production and financial position. Theoretically, the pricing of price insurance or margin insurance is similar to the pricing of a put or spread option – the longer the coverage period, the lower the reserve price and the higher the premium rate. In each province, insurers make adjustments based on the sum insured and claim parameters to reflect the real situation in order to reduce basis risk. Practically, to prevent moral hazard and to control the total exposure, some limitations can be placed on the total number of insured animals for a single farmer. In the US, each policy has a maximum insured numbers of 10,000 heads and a maximum insured numbers of 32,000 heads per annum. What’s more, if a person buys an insurance policy, any other futures or options will not be allowed for hedging. The US Department of Agriculture also has the right to suspend all sales of policies in the event of major epidemics, such as foot-and-mouth disease.
Nowadays, the risk of market prices and the risk of natural perils are equally important to farmers. The current agricultural insurance products mainly protect farmers from natural perils, but still leave farmers exposed to market price risk. Product innovation is therefore essential to ensure the growth of the insurance market in China that meets the needs of farmers. We also notice that price risk is a systemic risk that can lead to enormous losses; and, in extreme cases, those losses may exceed the tolerance of the insurance company or industry. Therefore, the sustainable development of price index solutions has a long way to go. Overall, we hope that insurers in China will continuously work on innovation and improvement for price index products to protect the interests of livestock farmers so that the industry can grow sustainably.
Published 8 April 2015