Risk management: farmers could learn from insurance companies

Insurance and farming couldn’t be more different, you might think.

One is dull as dishwater and the other is a hair-raising, high-stakes continual gamble on the commodity markets.

The way they most commonly interact is through the insurance products that farmers can use to mitigate some of the risks they take on every year, whether that’s for market risk, production risk, injury risk, death risk or mortgage risk.

It’s like a pairing of opposites.

But it isn’t because deep down the fundamental role of farms and insurance companies is the same: taking on a bunch of risk to skim a margin off the top.

Sure, there are lots of differences in the types and concentrations of risk each regularly takes, but at core each is being rewarded for taking on and managing risk.

Neither has a unique product that nobody else can produce and each relies upon an expense capital base that must be maintained.

I was thinking of this recently after chatting with David Derwin of P. I. Financial, who is a proponent of using options contracts to hedge risk in a farmer’s crop portfolio.

Options are generally unpopular with farmers because they require the payment of a premium, and to many farmers, that’s just one step too far down the insurance path.

For some farmers, crop insurance makes sense, equipment and property insurance makes sense, but marketing insurance seems crazy.

Derwin doesn’t push farmers to use options for all their hedging needs, but he thinks they are a good tool for a number of marketing circumstances and make a great part of a risk management package.

This is where the insurance likeness to farming came to me. The main difference between the risks insurance companies and farmers assume is the extreme concentration of the risks farmers take on, compared to the highly diffused risks general insurance companies acquire.

However, a good crop mix, a good production mix (with more than just crops being produced), and a good marketing mix can spread out those concentrated risks.

Adding in various risk management tools spreads them out even more, and that’s where Derwin is right about putting options into the mix.

Options are not the perfect solution for every situation, but they make sense in many cases, as do futures, fixed price contracts and other tools.

By adding another mechanism into the hedging and pricing regime of a farm, the farmer reduces the critical mass that can blow up when things go wrong.

It might not be a major change to the level of overall risk on a farm, but it helps make potential problems less explosive.

Farming will never be as dull-seeming as insurance. But it would certainly help many farmers to build a little bit of dullness into their all-to-tempestuous operations.

Dull is better than dead.

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