Idea Transcript
Agribusiness Risk Management
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Like any businessperson, a farmer has to practice good management techniques, including proper risk management of all phases of the farming operation. Sound risk management techniques include exposure avoidance, loss control, contractual risk transfer, retention, and insurance. This session will present the concept of risk management as it applies to farmers and their business and offer an understanding of the various forms of insurance designed for this market.
Copyright © 2016 International Risk Management Institute, Inc.
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Agribusiness Risk Management
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The Conceptual Framework Introduction
The fact that losses or other unfortunate events could happen to you and the fact that you cannot tell for sure whether or not they will is a condition we call risk, which is a pervasive condition of human existence.” --Emmett J Vaughan
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Background On Risk Management
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The Concept of Risk •When someone states that there is “risk” in a particular situation, what do you hear in that statement? •You understand that there is uncertainty about the outcome and that the possibility exists that the outcome will be unfavorable •When risk is said to exist, there must always be at least two possible outcomes •One of the two outcomes must be unfavorable •If we know for certain that a loss will occur, there is no risk #IRMI2016
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The Concept of Risk •The term “risk” is used by people in the insurance industry to mean something very different The property is at “risk”—there could be a fire A person is at “risk” or a “risk”—a young driver may be considered a
“risky” insured to the insurance company
•To further compound the problem, the term “risk” is used by people in the insurance business to mean a peril insured against: Fire, Earthquake Flood Crop loss
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The Concept of Risk • For purposes of this class the general meaning of the word “risk” will indicate a situation where an exposure to loss exists • “Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for” • Risk is the chance of loss • Risk is the possibility of loss • Risk is uncertainty The notion of an indeterminate outcome is implicit in each of the definitions; the outcome must be in question. #IRMI2016
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Risk Management •Therefore, “risk management” can be defined as an organized approach to identify possible or probable financial harm and take steps to minimize the financial impact to acceptable levels.
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Degree of Risk •When we say that an event is possible, we mean that it has a probability between zero and one, it is neither impossible nor definite •We may or may not be able to measure the actual degree of risk (Statistician)
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Degree of Risk •“0” The outcome will not occur (event is impossible) •“1” The outcome will occur (absolute certainty)
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Definition of “Degree of Risk” •What do we mean when we say that one alternative involves “more risk” or “less risk” than another? •For those who espouse the “uncertainty” definition of “risk” the answer is the greater the uncertainty the greater the risk
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Degree of Risk •Coin Toss—Each has equal probability of one half •Probability of drawing a king from a deck of cards There are more variables But, there are statistical constants
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Degree of Risk • Those who define risk as “uncertainty” maintain that risk is greatest when there are “two” possible outcomes, each of which is equally likely to occur • Risk is at it’s highest point in the individual case when the probability is 0.5 (midpoint between 0 and 1)
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Uncertainty Theory Russian Roulette Think about a gun with 6 chambers
•There is more risk when there are two bullets than with one •There is more risk when there are three bullets than when there are two •When you add the fourth and fifth bullet, the probability of a deviation from the hoped for outcome is increased, but there is less uncertainty •When you add the sixth bullet, there is no risk #IRMI2016
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Uncertainty Theory Russian Roulette •If 0 bullets—Only one outcome (favorable) therefore no uncertainty and no risk •If 6 bullets—Only one outcome (unfavorable) therefore no uncertainty and no risk •If 3 bullets—there is the greatest uncertainty and greatest variable for two outcomes #IRMI2016
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Classifications of Risk
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Classification of Risks • Financial and Non-financial Risks • Static and Dynamic Risks • Fundamental and Particular Risk • Pure and Speculative Risk
Types of Pure Risk Personal Risks Property Risks Liability Risks Risks arising from failure of others #IRMI2016
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Methods of Handling Risk
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Methods of Handling Risk • Modern risk management theory recognizes two broad approaches to dealing with risk
CONTROL FINANCING
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Methods of Handling Risk •Risk Control (impacts frequency and severity) Avoidance Loss Control o Loss prevention (frequency) o Loss reduction (severity)
•Risk Financing Risk Retention Risk Transfer o Insurance o Non-insurance
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Risk Avoidance • Project is not started/property is not purchased • Abandon a project already begun • Not selecting a particular enterprise • EXAMPLE: If you fear loss of a crop, don’t plant it!
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Risk Avoidance • Exposure avoidance eliminates completely any existing exposure and reduces the probability of any loss “absolutely to zero” • An exposure which has been completely avoided cannot produce a loss, therefore there is no need to try to further prevent or reduce the exposure.
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Risk Avoidance Risk avoidance should be used in those instances in which the exposure has catastrophic potential and the risk cannot be reduced or transferred
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Loss Control—Reduction •Loss Reduction focuses on reducing the severity or amount of a loss Reducing the speed limit on the highway Reducing the number of cattle transported in any one vehicle or
stock car Stacking hay in multiple small stacks instead of one large stack
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Loss Control—Prevention •Loss prevention is any action which reduces the probability or frequency of a particular loss •Loss prevention does NOT completely eliminate the “possibility” of loss as did avoidance •In general, loss prevention is an action taken to physically safeguard in order to break the chain of circumstances •Keeping fences in good repair to keep livestock off the highway. •Loss control/safety programs #IRMI2016
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Segregation/Separation as a Loss Control Measure •The term “segregation of exposure units” combines two distinct but closely related risk management techniques: Separation of exposure units Duplication of exposure units
•Both concepts attempt to reduce an organization’s dependence on a single asset, activity, or person thus tending to make individual losses smaller and more predictable
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Loss Reduction/Prevention Forecasting Loss •Developing data on past loss •Finding patterns in past losses •Probability theory
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Risk Financing •An organization’s decision whether to retain or to transfer a given exposure depends on The characteristics of the potential losses The vulnerability and characteristics of the organization
•Typically an organization can cost-effectively retain exposures that Are limited in size for any individual loss—within the organization's
ability to retain Unlikely to cause a large number of losses Sufficiently frequent to be budgetable #IRMI2016
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Risk Retention •There are two basic reasons an organization may retain risk Retention is forced—there is no transfer option Some forms of retention are more cost effective than transferring
the risk
•Passive o Failure to identify o Failure to follow through
•Active o Conscious intent to retain
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Transfer •A contractual arrangement whereby someone else takes on some of the chance of a negative occurrence in exchange for consideration •Non-insurance Hold harmless Physical transfer
•Insurance
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Risk Financing and Insurance • The uncertainties facing an insured in using insurance as the risk financing/transfer mechanism are: Insurance company insolvency Insurer and Insured disagreeing as to whether loss is covered or in what amount The size of the potential loss being outside the insurance transfer mechanism in
whole The type of loss being uninsurable
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The Risk Management Process
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The Risk Management Process 1. Determination of objectives 2. Identification of risks 3. Evaluation of risks 4. Consideration of alternatives and selection of the technique for dealing with each risk 5. Implementing the decision 6. Evaluation and review #IRMI2016
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Determination of Objectives •Deciding precisely what it is that the organization expects its risk management program to do •The primary objective of the risk management effort is to preserve the operating effectiveness of the organization
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Determination of Objectives • Post Loss Objectives
• Pre Loss Objectives Economy
Survival
Reduction in anxiety
Continuity of
Meeting externally
operations Earnings stability Continued growth Social responsibility
imposed obligation Social responsibility
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Identification of Risks Before anything can be done about risks, someone must be aware of them.
In one sense, risk identification is the most difficult step in the risk management process
It is difficult because it is a continual process and because it is virtually impossible to know when it has been done completely
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Identification of Risks Identification requires a general knowledge of the goals and functions of the organization, what it does and where it does it • Orientation • Risk Analysis Questionnaires • Exposure Checklists • Insurance Policy Checklists • Flow Process Charts • Analysis of Financial Statements • Other Internal Records • Inspections • Interviews • Loss runs #IRMI2016
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Evaluation of Risks •Once the risks have been identified, the risk manager must evaluate them •This means measuring the potential size of the loss and the probability of its occurrence •Ranking should be based on the financial impact of a loss
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Evaluation of Risks • Critical Risks Include all exposures in which the possible losses are of a magnitude that
would result in bankruptcy
• Important Risks Include those exposures in which the possible losses would not lead to
bankruptcy, but would require the firm to borrow in order to continue operation
• Unimportant Risks Include those exposures in which the possible losses could be met out of the
existing assets or current income of the firm without imposing undue financial strain #IRMI2016
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Consideration of Alternatives and Selection of the Risk Treatment Device
•Once the risks have been identified and evaluated, the next step is consideration of the approaches that may be used to deal with risks and then selection of the technique that should be used •This can be broken down into two broad categories Risk Control o Focuses on minimizing the risk of loss to the entity
Risk Financing o Concentrates on arranging the availability of funds to meet losses arising from the
risks that remain after the application of risk control techniques #IRMI2016
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Implementation of the Decision • The decision is made to retain the risk May be accomplished with or without a reserve or fund If the plan is to include the accumulation of a fund, proper administrative
procedure must be set up
• The decision is made to try to prevent a particular risk The proper loss prevention program must be designed and implemented
• The decision is made to transfer the risk to another or to an insurance company Contracts must be designed and implemented Insurance must be negotiated and placed #IRMI2016
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Evaluation and Review •Should be a continuing function •This is often the failure of the program because it is not maintained and measured
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Rules of Risk Management
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Rules of Risk Management • RULE #1
Don’t risk more than you can afford to lose—The first and most
important The first rule provides guidance regarding risks that should always be transferred (those
bringing catastrophic losses whose potential severity cannot be reduced—probability may not matter) • RULE #2
Consider the odds The second rule governs those situations that should be transferred—those in which the
probability of loss is very high • RULE #3
Don’t risk a lot for a little The third rule dictates that there should be a reasonable relationship between the cost of
transferring a risk and the value that accrues to the transferor #IRMI2016
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High Frequency Probability
Low Frequency Probability
High Severity
Avoid
Insurance
Low Severity
Reduce
Retain
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Insurance as a Last Resort • Insurance always costs more than the expected value of the loss • People who purchase coverage against small loss exposures are trying to beat the insurance company at its own game • Insurance should be used as a last resort
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Priority Ranking For Buying Insurance •Essential Insurance Coverages include those designed to protect against loss exposures
that could result in bankruptcy or required by law
•Important Insurance Coverages include those which protect against loss exposures that
would force the insured to borrow or resort to credit
•Optional Insurance Protects losses that could be met out of existing assets of current
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Common Errors in Buying Insurance •Buying too little Need Flood/Earthquake, don’t buy because of cost. Risk is
high. Because they think it is remote, don’t transfer to insurance and don’t risk manage. They are not doing a prediction of risk.
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Common Errors in Buying Insurance •Buying too much Could handle themselves. Instead of designing an insurance
grogram around predicable or unpredictable risk they are buying based on cost of insurance rather then cost of risk.
•Buying too much and too little at the same time
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Risk Management and The Agricultural Industry
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The Agricultural/Farm Risk •Agriculture is particularly complex and requires a strong understanding of the risks involved and the means to mitigate those risks •Because agricultural and farm risks are so diversified, they present a variety of special risk control issues •No matter what a farmer grows, they need to sell it at a profit if they are going to stay in business. Much of Enterprise Risk Management deals with effective agricultural business planning to help farmers manage the amount of risk in their enterprises. #IRMI2016
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Risk Management and Speculative Risk •Typically Risk Management has had its roots in “pure” risk. •Enterprise Risk Management incorporates concepts relating to both pure and speculative risk, particularly in the field of finance
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Agricultural/Farm Production Risks Relating To Animals
•Animal Breeding •Animal Health •Animal Growth •Disease Management •Pest Management •Manure & Nutrient Management •Aquaculture
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Production Risks Relating To Farming/Agriculture • Agriculture and Food Bio Security—Agro Terrorism • Grain Dust Explosions • Pollution • Air Quality • Global Change • Soil Conditions • Water • Weather Conditions • Chemicals #IRMI2016
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Price or Market Risk •Refers to uncertainty about the prices producers will receive for commodities or the prices they must pay for inputs. The nature of price risk varies significantly from commodity to commodity
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Financial Risk •Relates to your ability to pay the farm’s cash obligations in a timely manner (liquidity) and protect or grow your equity (solvency). Obviously, this is closely tied to production and marketing risks. Financial risk also includes the risk of inflation and changes in interest rates.
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Financial Risk •Financial risk tolerance deals with Supply & Demand Control of fixed and variable costs Cash Flow Maintenance of asset base (increase)
•Money management is key and understanding the futures market
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Institutional Risk •Results from uncertainties surrounding government actions Tax laws Regulations for chemical use, rules for animal waste disposal The level of price or income support payments
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Legal Risk •Legal risk refers to the possibility of being sued, fined or otherwise penalized for violating a law or regulatory standard •Legal risk also includes your liability for environmental problems that might result from your farming practices.
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Human Resource Risk •People Risk (also called “human resources risk”) includes the four D’s—death, divorce, disability and disagreement
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Notes This file is set up for duplexed printing. Therefore, there are pages that are intentionally left blank. If you print this file, we suggest that you set your printer to duplex.
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