Why is Parametric Insurance Emerging as an Attractive Investment Opportunity?
By: Kush Gupta
DISCLAIMER — This is not legal advice; we at Newlin Ventures wrote this article for informational purposes only; you should not rely on any of the information contained here as true, legal, recommendation, endorsement, financial, or any other type of advice.
Why is agri-tech insurance exciting?
Farmers face many risks in their day-to-day life- from worrying about their crop yield to marketing, pricing, and selling their produce. Recent catastrophic events including the COVID-19 pandemic and the Ukraine-Russia war led to unpredictability in the global food supply chain, which made farmers realize the importance of being financially literate in hedging techniques like forward contracts and options. Additionally, weather risk remains the major reason behind farmers opting for crop insurance, which is reasonable as it is also the leading cause of crop loss in the U.S.A.
The need for agriculture insurance is rising due to inflation, which increases the prices of raw material inputs, including fertilizers and iron ore equipment. However, at the same time, the cost of Insurance policies is also increasing. This is in part due to climate change and the risk it bears of causing significant environmental destruction, something that is garnering attention from NGOs and governments from all over the world.
Problems with the traditional agriculture insurance sector:
1. Farmers’ lack of knowledge of insurance policies:
The American agriculture insurance market is majorly driven by private companies, with limited government-subsidized insurance policies. With so many policies to choose from, American farmers usually end up with a bad choice especially as many don’t hire actuaries who assess risk holistically. They rather select insurance plans based solely on the assessment of premium payment. Additionally, farmers are still unaware of technology advancements (how to use mobile applications to their benefit) in the insurance industry.
2. Insurance industry’s rigid structure:
The agriculture insurance industry is still people and paper-driven. With a dearth of innovation, insurance policy re-configuration and re-assessment remain difficult and costly. Time and effort associated with policy distribution and farmer surveys are the other factors leading to the slow pace of change in the industry, which puts pressure on farmers’ margins by adding any extra cost of the policy.
3. Spatial, temporal, and design-based risks of indemnity-based insurance:
Indemnity-based insurance policies are based on past events as well as real-time data, which is generated on and around the farm. Satellite and weather forecasting data are both used to report and verify events and losses on a day-to-day basis. Weather-based insurance deals with farmers not being able to grow as much as anticipated. This is due to challenges posed to insurance companies including hiring agents to be on the ground to collect data to evaluate risk.
Additionally, since agriculture insurance is a zero-sum game-dollars go out of the insurance company’s wallet into the farmer’s wallet- the subjectivity of the insurer causes asymmetrically distributed risk for farmers, who are marred by adverse selection and moral hazard.
4. High LTV but high CAC of indemnity-based insurance:
High lifetime value is a hallmark of the agriculture insurance industry as it is trust driven. When a farmer decides to go ahead with an insurance plan, they commit to sharing their confidential data about yield. In general, once a policy is chosen, most farmers plan to stick with it for most of their life unless something unexpected comes up.
Unfortunately, the customer acquisition cost is also high because of the complicated due diligence process involved. The insurer has to ensure farmers’ crops are valued correctly, which takes resources upfront. Even more, resources are needed to verify damage claims. It is a clunky, people-heavy process that lends the customer to pay extra via premium charges.
Solution: Parametric Insurance
Novel insurance products act as add-on embedded systems on farms, with their usage based on local stations that track real-time data and farmers’ operations like how frequently they spray. The insurance industry is segmented due to many players including reinsurers, insurers, sales companies, and pricing agents. The barrier to entry is low for startups to enter the market as the balance sheets of insurers are widely publicly available.
Need?
The main problem with traditional, indemnity-based agricultural insurance is the delay in receiving real-time satellite data with an enhanced resolution for a long time series. Apart from that, weather stations are miles away from the land of cultivation, which poses the issue of accurate data analysis.
What?
A parametric insurance contract insures a policyholder against the occurrence of a specific event by paying a set amount based on the magnitude of the event, as opposed to the magnitude of the losses in a traditional indemnity policy. The parameters of the event are coded into a smart contract, which when triggered automatically activates the insurance policy. Thus, parametric insurance acts like “maps with no gaps” eliminating time and distance-based bases risks. It is a binary system tracking whether an event has occurred or not.
It does not replace indemnity insurance but rather complements indemnity insurance by making it possible to ensure a wider range of losses that may be difficult to model by traditional means.For example, in Canada, parametric insurance is used by agriculture insurers to measure certain days against certain heat thresholds. If the heat exceeded the heat parameter or if there was frosting, the insurance would be automatically paid off. Other parameters include crop development in growth strategy and financial data like premium.
Typically parametric insurance is used for large areas where the probability of catastrophic events happening is higher as the cost of establishment is large.
Advantages
Farmers benefit from the resulting lower premium rates on insurance. This is because with the launch of parametric insurance companies realize that the high-risk periods, where they might have to pay larger amounts, are less. It also reduces time in the entire insurance process as a farmer can receive the quote online in minutes as opposed to waiting hours for the broker to draft policies and then waiting days for the final payment. The insurance pay is immediate with no claims management process as in indemnity-based insurance.
Weather insurance optimization remains the most useful application of parametric as it is easier and cheaper to measure weather trends. Therefore, resources can be redirected to better products than the indemnity model. Technology advancements (fusion of data from novel sensors and satellite radars) provide a spatial and temporal high resolution which is used by underwriters to accurately predict future risky events. Therefore, new geographical markets can be tapped with the same value chain and structure just because of new technology.
Lastly, Parametric is flexible and cheaper. It further lowers CAC and increases LTV.
Challenges
Underwriting (quantification of the risk and calculation of the cost of the policy) is usually handled by the Government, which does not change regulations easily. Apart from that, with climate change risks becoming more pronounced and sensing and modeling abilities enhancing, the cost of policies is increasing. There is also basis risk with parametric insurance.
Since parametric insurance is based on an event trigger and not on the actual loss suffered, there may be a gap between the amount insured and how much insurers actually owe. A better understanding of risks by insurers via new technology means the policies become expensive for the insurees. Famers are not technologically savvy and thus do not usually know what the new product (mobile application) looks like and how to use it.
Interesting emerging trends
There is an inherent risk for insurers due to the bad production practices of farmers. So there has been a recent focus on regenerative agriculture. The idea is to introduce social licenses and provide extra credit for farmers employing sustainable and carbon-friendly practices.
Insurers are also relying on agronomics, a field of study dealing with the predictive modeling of insect-based diseases on crop yield. All of these strategies help hedge risks for the insurers.
Sources
Agtech..sowhat podcast, Farming First article, The Digital Insurer article
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About the author
Kush Gupta is a junior studying Industrial Engineering at the University of Illinois at Urbana Champaign. He is the Vice President of Education at the university’s Venture Capital Association and is an experienced entrepreneur.
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