How to get rid of drought risk

Weather risk management secret to a Nuffield scholar's property purchase


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DROUGHT RISK GONE: Nuffield scholar Dylan Hirsch says it is possible to remove most of the pain associated with drought using financial tools that are alternatives to multi-peril crop insurance.

DROUGHT RISK GONE: Nuffield scholar Dylan Hirsch says it is possible to remove most of the pain associated with drought using financial tools that are alternatives to multi-peril crop insurance.

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Weather risk management was key to a Nuffield scholar's property purchase.

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"Even the best farmer can go broke leveraging their assets when a drought strikes."

In fact, the only concern Dylan Hirsch and family had about buying his uncle's property was the risk posed by drought.

So they removed it.

The Hirsch family backed their WA broadacre cropping enterprise with multi-peril crop insurance and, later, weather derivatives.

"Without those tools, we might have made a smaller purchase or leased land," he said.

"Sometimes people say we should've put the money the premiums cost in the bank but the appreciation of the land and the profit it made because we had the confidence to buy is well above the costs of the cover."

When, after using multi-peril crop insurance for four years, the product was dropped by his insurer, the Hirschs were "left in the lurch" and began to explore the alternatives.

Now, Mr Hirsch is about to publish a Nuffield Scholarship paper on how Australian farmers can protect themselves from weather risks and the opportunities for lenders.

One of them, he said, was integrating the cost of index insurance into loan repayments.

"When financiers recognise the extra protection the insurance brings, it's possible borrowing costs fall so far they completely offset the cost of the insurance," he said.

"We don't need something as complex as the US system.

"We could get 80 per cent of the benefit with 20pc of the cost."

The barriers to widespread adoption by Australian farmers were data availability and awareness of the tools.

"It's a chicken-and-egg scenario," he said.

"Insurers here are getting very excited over the new data age where we can really accurately see data on farm that will help offer cheap insurance products that are sustainable and able to decrease finance risk and costs.

"In the US, a lot of the data is collected thanks to insurance, which is widespread because of the subsidies and the insistence of financiers that it's used.

"We need analysis so farmers can understand the relationship between weather parameters and profit so they can choose the right product and not be either over or under-insured.

"Australian agriculture needs to upskill and advise farmers and their lenders to make that happen.

"The rise and failures of MCPI could've been avoided and with better industry organisation, we can make sure their alternatives succeed."

WEATHER DERIVATIVES EXPLAINED

ADVISORS NEEDED: Weather Index Solutions manager Norm Trethewey.

ADVISORS NEEDED: Weather Index Solutions manager Norm Trethewey.

Weather Index Solutions manager Norm Trethewey says Australians are the world's biggest users of weather derivatives per capita but the tool is not well understood.

A weather index derivative is different to traditional insurance because a payment is made when a predetermined trigger is met, rather than on an assessment of losses.

It is a booming business.

"Tens of millions of dollars - maybe $100 million - of weather risk is transferred out of Australia every year but it's mainly by energy companies rather than farmers," Mr Trethewey said.

"Anyone who says 'If it's too hot, cold, wet, dry or windy, I want to get paid' can make use of weather index contracts."

Mr Trethewey offered the example of a farmer who had sown a crop with good early rains.

"The farmer needs 85 millimetres during July to October to finish the crop off and is looking at getting 3-4 tonnes a hectare and, if it doesn't get there, it'll cost $500/ha in lost yield," he said.

"The farmer can take out cover based on how much he wants to be paid if he gets less than 85mm, 80mm, 75mm and so on."

Sometimes, Mr Trethewey said, the scenarios were more complex.

Farmers could protect their businesses from losses due to frost, germination rainfall, seasonal rainfall, heat stress, wet harvest, winds, storm and days above or below a certain temperature range and any of the 'perils' in combination.

"Plenty of farmers can tell you off the top of their heads exactly which the really bad years were but, understandably, many struggle to put their finger on the precise weather conditions that made it so tough," he said.

"We can check the weather data for those years and build a picture of what a contract would've paid in those years.

"There is no off-the-shelf solution."

Farmers could also cover the risk of unusual weather elsewhere to offset soaring feed and fodder costs, while businesses indirectly affected by weather could offset sales downturns caused by the impact of poor seasons on their clients.

"If you're a supplier of fertiliser, you can protect weather in your region, so if you don't get the demand, you can ask the insurer in Europe or the US to rattle the tin for you," he said.

While climate change could force up the cost of such protection, Mr Trethewey said its increasing popularity meant underwriters had "deeper pockets than ever before" and that increasing seasonal volatility meant it was easier to justify.

"In the last five years, one underwriter alone has grown from $2 billion to $12bn of funds to invest in this business and they are more willing to cover much smaller parcels of risk than they were, so it's a real option for farmers," he said.

"It's not an insurance policy that you keep in the bottom drawer hoping never to have to use.

"You may be making claims and receiving payouts maybe two or three out of every five to 10 years, so if it costs you $30/ha to get the cover, the net cost might only be $15/ha over that time.

"If the land's been in the family for five generations, you have no kids at boarding school to worry about and no external investors, you can self-insure but, for everyone else, transferring that weather risk out of your business is a very viable option."

The story How to get rid of drought risk first appeared on Stock & Land.

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