China: Innovations in Agricultural Insurance
Author: World Bank team of experts
For full version of the report please download file attached.
Main report (1 MB) >>>>
Annexes (1,5 MB) >>>>
China has about 328 million people involved in agricultural labor, and a vast majority of them are small and marginal farmers (operating 0.4 hectares on average). While there need not always be a direct correlation between landholding and poverty, it is likely that a significant proportion of such households are below the poverty line.
Further, the vast majority of farmers grow rainfed crops and are therefore particularly vulnerable to the vagaries of the weather. More than 20 percent of the total farmland, estimated at 165 million hectares in 2004, was affected by natural disasters on average over the period 1979–2004. The major cause of loss is drought, followed by flood. In 2004, it is estimated that China’s farmers and economy lost close to $18 billion worth of crop value due to natural disasters. In
this context, agricultural risk management products such as insurance are of critical importance, particularly for the small and marginal farmers.
The agricultural insurance market in China is extremely small. In 2005, the national agricultural insurance premium volume was $91 million, representing a mere 0.6 percent of the total Chinese non-life insurance premiums. Various management models of agricultural insurance are being piloted in China. The models range from specialized mutual insurance companies with local government subsidies, to foreign commercial insurance companies with no public subsidies. These pilots are currently under implementation in several provinces: Heilongjiang, Xinjiang, Jiangsu, Shanghai, Jilin, Xinjiang, Zhejiang, Sichuan, and Hainan.
The government of China (GoC) recognizes the importance of revitalizing the agricultural insurance industry to better meet the needs of farmers throughout China. Under the 11th Five-Year Plan (FYP) and various other government policy documents, the Chinese government has reiterated its commitment to agricultural and rural development. In early 2007, the Ministry of Finance (MoF) approved a new set of pilots in the following provinces: Jiangsu, Jilin, Xinjiang, Hunan, Sichuan, and Inner Mongolia. The ministry has allocated a budget of RMB1 billion ($125 million), equivalent to that allocated by the selected
provincial governments. The RMB 2 billion ($250 million) subsidy program aims to finance 50 percent of the agricultural insurance premiums in the selected provinces.
In that context, the challenge for policy makers is how to develop agricultural insurance that will be accessible by small farmers at an acceptable cost. Multiple-peril crop insurance (MPCI) products have been overemphasized in China. MPCI products are extremely challenging to design and administer in a cost-effective fashion, particularly in countries dominated by small farm households. World experience for MPCI has demonstrated that these programs either pay very high administrative costs or the products have extremely poor actuarial performance. Given the costly nature of developing MPCI products, most countries
chose to subsidize these products. For example, if China followed the path of the United States in product design and subsidies, the total cost could approach $10 billion.
The report explains why agricultural insurance is expensive to deliver to small farm households. This backdrop, coupled with the detailed risk assessment in four provinces, leads to a key finding that China should put more resources in developing products that are more suited to an agricultural economy that is dominated by small farm households. In particular, named-peril and index-based crop insurance products could be developed for less cost than MPCI products. The report discusses the important role of government in supporting the legal and regulatory environment, access to data for new product development, risk sharing,
and broader education of all stakeholders about the benefits of agricultural insurance. It also explains why this form of subsidy could provide improved incentives versus a direct subsidy for farmer premium.
In this regard, the government, through its MoF, requested the World Bank to conduct a comprehensive assessment of its agricultural insurance industry and provide recommendations for its future development.
Objectives and Methodology
The objectives of the study were agreed upon through extensive consultation with central and provincial government authorities, insurance companies, agricultural insurance policyholders, farmers, and other stakeholders throughout different parts of the country. The study intended to assist the government of China in the development of a forward-looking strategy for promoting access to agriculture insurance for small farmers.
An operational framework for the development of agricultural insurance was developed. It clearly identifies the key operational functions of the insurance companies with consideration of the multiple stakeholders:
Product delivery and product development are key functions. Named-peril and index-based insurance products should be key products if small farmers are to be served in a cost-effective fashion. Furthermore, bank and financial intermediaries should be involved in selling agriculture insurance to further reduce delivery costs.
Technical assistance should be national in scope in order to take advantage of the learning that takes place in many different regions of China. While the central government can be involved, it is more appropriate to try to create a service entity using, for instance, the Insurance Association of China. This entity could sell services to all firms and bring the knowledge, data, software, and other services together in a much more cost-effective fashion than insurance companies performing these services on their own.
The insurance regulatory service deserves a special function. In this case, only one primary entity is involved in facilitating that activity—CIRC.
The financing of agricultural excess losses should be based on a public-private partnership involving both central and provincial governments as well as international reinsurers.
The study focused its analysis of the industry on the following four target provinces: Hainan, Heilongjiang, Shanghai, and Xinjiang. These target provinces were selected based on their spatial coverage of China, the differing agro-ecological conditions, the divergent agricultural risk profiles, and varying experiences with both government- and non-government-supported agricultural insurance.
The study was divided into three successive phases: Phase 1 focused on agricultural-, weather-, and insurance-data collection at both the national and provincial levels. This data collection was coordinated mainly by the provincial finance bureaus and CIRC offices, in close collaboration with the relevant line bureaus and insurance companies. Phase 2 focused on the detailed technical analysis of the data collected by a multidisciplinary team of economists, insurance and financial sector specialists, legal and regulatory specialists, and researchers. Phase 3 presented the draft report and findings for discussion with all relevant stakeholders,
namely central government agencies, provincial line bureaus, insurance companies, and representatives of the reinsurance industry, among others, to gain feedback before finalizing the report.
Key Challenges Facing the Agricultural Insurance Industry in China
National agricultural insurance uptake is low. In 2005, the agricultural insurance premium volume approximated RMB729 million ($91.1 million)—less than 0.6 percent of national non-life insurance. On the supply side, agricultural insurance is only available in a few provinces. On the demand side, the majority of Chinese farmers lack awareness and education related to insurance in general and crop and livestock insurance in particular.
Pilot crop insurance initiatives, as currently designed, are not geared toward small farmers. The current crop insurance products, as well as the new pilot insurance products, are designed mainly for farmers insured in former military reclamation areas, and where individual-grower crop MPCI programs are feasible. This is because of the unique features of the reclamation areas, large farm structure, and the organization of agriculture. These MPCI products are not well suited to wide-scale replication with small farmers outside the reclamation areas.
China’s crop risk profile shows great differences in risk across crops and geographic areas. Risk exposure for small and geographically concentrated crop-insurance companies can be high because of the high level of covariate risk such as droughts, floods, and typhoons. However, pooling agricultural risks across the country can significantly reduce the peak risk exposures.
Insurers have limited financial capacity to deal with catastrophic losses. Domestic insurers are exposed to catastrophe risks and have limited opportunity to diversify their portfolios.
Agricultural insurance products offered by the insurance industry are limited. Crop insurance products currently available are mainly MPCI products, which present numerous challenges for the insurance industry to develop successfully and are not fully appropriate to meet the insurance needs of the agriculture sector.
Agricultural risk assessment capacity is inadequate. The risk assessment conducted under this study shows that domestic insurers tend to underestimate the underlying crop yield risks and therefore may under price their products.
Domestic insurers have limited access to technical services and international agricultural insurance expertise. Provincial insurers have limited access to technical insurance services in specialized in areas such as product design, ratemaking, underwriting, and loss adjustment.
Government support is not geared to providing insurers with incentives to improve their operations and expand their services to small farmers. Public support to agriculture insurance is mainly through direct premium subsidies. This does not create incentives for agricultural insurers to provide better services to existing insured farmers or to offer new products tailored to small farmers.
The legal and regulatory framework for agricultural insurance is ambiguous. The present insurance law includes no specific provisions for agricultural insurance, therefore insurers operate without a clear legal framework.
Lessons from International Experience in Agricultural Insurance
Agricultural insurance is challenging under any circumstances. It is even more challenging when farm units are small, markets are not well-developed, regulations are unclear, and data and information are limited. International experience has been mixed for many types of agricultural insurance. Governments have become increasingly involved in agricultural insurance, in some cases as a direct insurance provider, in others via public-private partnerships.
Central to the development of a sound and sustainable agricultural insurance program, is the application of sound actuarial principles to determine the cost of agricultural insurance (that is, insurance premium). It is therefore important that any agricultural insurance program takes into account the pure cost of risk (expected annual loss), the operating costs (that is, delivery costs, loss adjustment costs, and so on) and the reserve load (that is, cost of holding reserves or cost of reinsurance).
The cost of insurance can greatly vary across different product designs. The benefits and limitations of three types of insurance products can be considered:
• Named-peril insurance: Named-peril insurance products (for example, hail) have been the first crop insurance products offered in many countries. The cost of offering named-peril insurance is significantly less than the cost of offering multiple-peril insurance, because (1) it is easier to conduct risk assessment for a single named peril than for multiple perils; (2) risk classification is easier, so thepotential for adverse selection is greatly reduced; and (3) the loss-adjustment costs are usually lower.
• Multiple-Peril Crop Insurance (MPCI): MPCI is an attractive product in cases where the damage to crops is complex (for example, many perils interacting, such as rainfall and disease). Furthermore, it provides a guarantee to the farmer of an indemnity if the actual realized yield is less than an agreed percentage of the average yield established for the farm. Despite the advantages of MPCI to the farmer, individual-farmer MPCI has proved to be highly problematical for insurers, because it is very expensive to administer and farmers (and especially smallholders) are usually unwilling to pay premiums that are sufficient to cover the insurer’s cost of providing MPCI. Thus, all MPCI programs (except in South Africa) have large premium and/or administrative subsidies paid for by government.
• Index-based insurance: Because index insurance indemnities are based on the realized value of a predetermined index rather than farm-level losses, the operating costs of providing index insurance are less than the operating costs of indemnity-based insurance. It offers (1) limited moral hazard, because the farmer cannot influence the likelihood or magnitude of an indemnity; (2) no farm-level loss adjustment; and (3) a simpler enrollment process, since there is no need to establish and verify average farm-level yield.
Even when these best practices are followed, the cost of delivering and loss adjusting MPCI policies will likely be excessive for smallholders. There are several ways for the government to provide subsidies that reduce the costs of providing various types of crop insurance—for example, through the development of risk market infrastructure.
Legal and Regulatory Framework: Among the most important functions for government in facilitating agricultural insurance markets is the establishment of an enabling legal and regulatory framework. Agricultural insurance is a special class of insurance business that has characteristics that are somewhat different from other classes of general insurance, such as automobile or property and casualty insurance. It is important for the insurance law and the regulatory system to account for these differences. For example, index insurance creates some unique legal and regulatory challenges, since indemnities are not based on the actual loss incurred. Thus, even when strong legal and regulatory systems are in place, it is likely that modifications will be required.
Enhancing Data and Information Systems: To develop any crop insurance product, insurers require reliable, impartial data on agricultural production. Because much of the data required for crop insurance has public-good characteristics, it is unlikely to be collected, cleaned, and archived by private sector companies. Therefore, the government should provide this kind of data. Crop insurance companies in China currently make extensive use of the National Bureau of Statistics (NBS) data on hectares planted and production of various crops, as well as the data on hectares covered by, and affected by, various natural disasters. Further government investments in collecting, cleaning, and archiving relevant data—as well as ensuring that this type of data is easily available to insurance companies—could further stimulate the development of the agricultural insurance market in China.
Public Awareness and Capacity Building. Government should be actively engaged in public awareness and capacity building during the early stages of crop insurance market development. Very often crop insurance, or even general insurance, is not very well understood by rural farmers, and therefore these kinds of efforts are critical to ensure that farmers understand the advantages and disadvantages of different crop insurance products.
Catastrophe Reinsurance and Risk Sharing. Crop insurance is highly subject to spatially covariate risks, such as drought or extreme temperatures. This implies that, in any given year, indemnities can be very high relative to premiums collected. Insurers must have access to large amounts of ready capital to pay these indemnities. Reinsurance is the most common means that insurers use to gain access to additional financial capacity. However, reinsurance can be expensive. Governments often provide subsidized reinsurance for MPCI policies. In the United States, the federal government provides a highly subsidized reinsurance contract for insurance companies that sell MPCI policies. In Spain, the consortium of insurance companies is mainly reinsured by the public reinsurance company Consorcio de Compensacion de Seguro.
To date, the experience on weather-index insurance is limited. However, it is likely less costly to obtain private sector reinsurance on index insurance products than on MPCI. Some weather variables are less spatially covariate than MPCI losses. More important, however, is that, compared to MPCI, index insurance products are simple, transparent, and less susceptible to adverse selection and moral hazard problems. This reduces the reinsurers cost of due diligence so they can provide reinsurance on index insurance at more favorable terms than reinsurance on MPCI.
Public Subsidies. In almost all MPCI insurance programs (including those in China), the government subsidizes the premium cost to farmers. By way of contrast, government premium subsidies have rarely been applied to named-peril insurance products such as hail insurance. This is because the costs of providing named-peril insurance are low enough that farmers can afford to pay the premium. Premium subsidies may make MPCI more affordable for farmers, but they do not address the underlying high costs of providing MPCI (that is, adverse selection, moral hazard, and high loss adjustment, delivery, administration, and reinsurance costs). Furthermore, for a fully scaled-up MPCI insurance program, public sector premium subsidies can be prohibitively costly. In 2006, the U.S. government paid $2.7 billion in crop insurance premium subsidies despite numerous studies documenting widespread adverse selection and moral hazard problems with the MPCI program in the United States. If China adopted a similar program, the annual cost of the subsidy program to the government could be as high as $10 billion.
Premium subsidies can also create perverse behavioral incentives. Premium subsidies are typically calculated as a percentage of the commercial premium (for example, a subsidy might be equal to 50 percent of the commercial premium). Farmers producing the most risky crops or producing in the highest risk areas, who should be charged the highest premiums, get more subsidies (in value terms). Government premium subsidies can also encourage farmers to produce a high-valued but risky crop in a region that is not well-suited to produce that crop, thus assuring greater losses in the future.
If governments wish to provide crop insurance subsidies, it is likely far better to focus those subsidies on developing risk marketinfrastructure, such as the items mentioned earlier (that is, product development, catastrophic risk financing, an appropriate legal and regulatory framework, high-quality data, public awareness, capacity building, and so on).
One size does not fit all. No single product solution will meet China’s needs, due to the very wide range of climatic and farming conditions. A variety of appropriate crop insurance products is required in each province. As a result, a mix of existing crop insurance products and index products is recommended, to allow for the expansion of crop insurance. A structure whereby products are developed within each province will increase the likelihood that tailored agricultural insurance products will be developed to match the great diversity of agriculture in China.
New crop insurance products should be specifically developed for small farmers. These products should offer effective and affordable insurance to small farmers and should focus first on the financing of catastrophic losses.
Insurers should perform a formal portfolio risk assessment. Insurers should conduct a formal assessment of the catastrophic risk exposure of their portfolio of insurance business. This would allow them to identify peak exposures in their portfolio, rebalance their portfolio, and structure cost-effective risk financing strategies (including risk retention, pooling, and reinsurance purchasing), leading to an increased capacity to sustain catastrophic losses.
Agricultural insurance rate making techniques should be revisited in the light of international best practice. Insurers must consider using actuarially sound rating techniques consistent with international best practice and with Chinese conditions.
Risk Financing Strategy
The government should contribute in the financing of losses that cannot be transferred to the private market at acceptable costs. The government should focus on catastrophic losses, acting as reinsurers of last resort, when the financial resources of the domestic insurance industry are scarce and access to international reinsurance markets is limited.
Fostering commercial agricultural reinsurance capacity. The provincial and central governments should further promote access to agriculture insurance to local reinsurers (for example, China Re) and international reinsurers in order to increase commercial agricultural reinsurance capacity.
The role of the central government and provincial governments in the financing of catastrophic risks in agriculture should be clarified. If the central government wishes to offer a subsidy to local insurance companies, the central government could offer free stop-loss reinsurance at an agreed proportional level above certain extreme levels, to the provincial government or the provincial insurance companies. The central government could also sell stop-loss reinsurance for the remaining portion. The provincial government could buy this stop-loss reinsurance for its local insurers.
Institutional Capacity Building and Technical Assistance
A technical support unit should be established as a central agricultural insurance service provider. This unit should have support from the central government and linkages to the provincial governments, insurers, and reinsurers. This center of expertise would providemarket services for a fee to support rapid development and scaling up of agricultural insurance.
Legal and Regulatory Framework
An appropriate legal and regulatory framework should be developed to support agricultural insurance. Although there are some differences between agricultural insurance and other forms of general insurance, the principles governing the regulation and supervision of general insurance, and insurance contracts, are largely applicable to agricultural insurance. Given the considerable overlap, it is recommended that the Insurance Law be applicable to agricultural insurance, but allow different provisions to be made for agricultural insurance, where appropriate, through regulations made under the Insurance Law.
Government Support and Public Subsidies
The objectives of public intervention should be clarified. If the policy objective is to increase the incomes of rural households or to create a safety-net program that assures some minimum level of income for farm households, agricultural insurance is not a cost-effective instrument. These types of social policies involve direct transfers of wealth from the government to rural households. Agriculture insurance can be an effective risk-management tool but is not an effective tool for transferring wealth to economically disadvantaged rural households.
The Government should facilitate the pooling of agricultural risks. Provincial agricultural coinsurance pools, like those established in Hainan and Zhejiang, should be supported by the provincial governments to help local companies reduce their risk exposure.
Ongoing pilot initiatives on agricultural insurance should be better coordinated. The central government, through the MoF, and the provincial governments, through their finance bureaus, are piloting a series of agricultural insurance initiatives. These pilots should be better coordinated and be implemented as part of a national policy framework for the development of agriculture insurance.
A public subsidy program should be developed to create incentives for agricultural insurers to expand their services to small farmers. Public support should focus on the development of risk market infrastructure and public goods that will give agricultural insurers incentives to offer affordable and effective insurance to farmers, particularly small farmers.
Targeted premium subsidies could support marginal farmers as a social tool. Premium subsidies could be targeted to marginal farmers under a social program. However, they should be combined with the promotion of risk-mitigation activities (for example, drought resistance seed, and so on).
Government reinsurance should complement private reinsurance. Public subsidies for reinsurance should be made available for risk layers that cannot be transferred to the reinsurance market at acceptable costs or for which reinsurance capacity is unavailable. This is usually the case for top (catastrophic) layers, where the government could act as a reinsurer of last resort.