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 ex-
posure avoidance, loss control, contractual risk transfer, retention,
and insurance. This session will present the concept of risk manage-
ment as it applies to farmers and their business and offer an under-
standing of the various forms of insurance designed for this market.

Copyright 2016 International Risk Management www.IRMI.com

Institute, Inc.
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 Notes

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 Agribusiness
Risk Management

#IRMI2016

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

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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 riskthere could be a fire
A person is at risk or a riska 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.
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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 TossEach 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 its 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

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Uncertainty Theory
Russian Roulette

If 0 bulletsOnly one outcome (favorable) therefore no

uncertainty and no risk

If 6 bulletsOnly one outcome (unfavorable) therefore no

uncertainty and no risk

If 3 bulletsthere is the greatest uncertainty and greatest

variable for two outcomes

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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
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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, dont 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 ControlReduction

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 ControlPrevention

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

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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 organizations
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 organizations 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 losswithin the organization's
ability to retain
Unlikely to cause a large number of losses
Sufficiently frequent to be budgetable

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Risk Retention

There are two basic reasons an organization may retain risk

Retention is forcedthere 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

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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

Pre Loss Objectives Post Loss Objectives

Economy Survival
Reduction in anxiety Continuity of
Meeting externally operations
imposed obligation Earnings stability
Social responsibility Continued growth
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
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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

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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
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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

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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
Dont risk more than you can afford to loseThe 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 reducedprobability may not
matter)
RULE #2
Consider the odds
The second rule governs those situations that should be transferredthose in which the
probability of loss is very high
RULE #3
Dont 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

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 High Low
Frequency Frequency
Probability 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
income

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Common Errors in Buying Insurance

Buying too little

Need Flood/Earthquake, dont buy because of cost. Risk is

high.
Because they think it is remote, dont transfer to insurance
and dont 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.
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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 SecurityAgro Terrorism

Grain Dust Explosions
Pollution
Air Quality
Global Change
Soil Conditions
Water
Weather Conditions
Chemicals
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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 farms 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 Dsdeath, 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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