Lexicon of Terms
Agricultural Risk: Risks that cause loss or decline to agricultural production or income, such as adverse weather and commodity price shocks.
Area-based Index Insurance: Area based index insurance contracts are written against specific perils or events (for example, area-yield loss, drought, flood) defined and recorded at a regional level (for example, at a country or district level in the case of yields, or at the local weather station in the case of insured weather events). Indemnities are paid based on losses at a regional rather than farm level. Such insurance is less subject to adverse selection and moral hazard.
Ad hoc Disaster Response: Waiting until there is a disaster to respond or provide relief. There are a variety of approaches used (for example, direct cash, and debt forgiveness). Ad hoc disaster responses are generally inefficient and not reliable for decision makers as they are subject to budget availability and ad hoc rules for who receives the assistance after the disaster. See also, Ex post Risk Management.
Basis Risk: The risk that with index insurance, index measurements will not match individual losses. This also is the risk that some households that experience loss will not be covered while others that experience no loss could receive indemnity payments. As the geographical area covered by the index increases, basis risk increases as well. Basis itself is defined as the difference between spot and futures prices.
Basis contract (also known as fix price later, unpriced or basis fix contract): A basis contract is another type of a deferred pricing contract. The price of this contract is determined by applying a specified fixed basis to a particular futures price, usually when desired by the farmer. Thus, the farmer has eliminated the basis part of price risk, but has retained the risk of futures prices. Sellers generally use the basis contract when the basis level is attractive but overall prices are unattractive due to low futures prices. Since the basis tends to be most narrow when futures levels are low, most sellers use the basis contract when they are confident that the futures price will go up.
Buffer Stock: A reserve stock of goods or crops stored or farmed to safeguard against the risk that a good portion of a crop may be damaged or distroyed because of adverse weather events. Associated with price, a buffer stock may also be used to stabilize commodity prices. This reserved stock allows the government to sell the commodity when the price is high and buy when the price is low in an attempt to reduce commodity price fluctuations.
Climate Risk: The possibility that overall weather patterns are changing, which changes household weather risk.
Correlated Loss/Correlated Risk: A risk or combination or risks affecting many individuals or households in the same area at the same time. Such risks include drought or a fall in a commodity price, which affect all producers of the commodity within the same market or region.
Crop Insurance: Provides financial compensation for production or revenue losses resulting from specified or multiple perils (hail, windstorm, fire, flood). While most crop insurance pays for the loss of physical production or yield, coverage is often available for loss of the productive asset such as tree crops.
Covariant Risks: A risk, or combination of risks, that effects a large number of the insured items/people at the same, for example an earthquake, or a major flood.
Derivative: A financial instrument, traded on or off an exchange, the price of which is directly "derived" from the value of one or more underlying instruments, for example debt instruments, commodities, or any agreed upon pricing index. Derivatives do not directly transfer property and the derivative itself is merely a contract between two or more parties with a value that is determined by fluctuations in the underlying asset. They can be used to hedge risk or to lock in a fixed rate or return. Derivatives are generally used to hedge risk, but can also be used for speculative purposes.
Disaster: A serious disruption of the functioning of a community or a society causing widespread human, material, economic or environmental losses which exceed the ability of the affected community or society to cope using its own resources. A disaster results from the combination of hazards, conditions of vulnerability, and insufficient capacity or measures to reduce the potential negative consequences of risk.
El Niño: A warming of sea surface temperatures in the equatorial Pacific Ocean associated with dramatic changes in the weather patterns in that region and worldwide.
Ex ante Risk Financing: The process of managing the financial consequences of risk prior to a risk event occurring through tools such as insurance contracts, CAT Bonds, Reinsurance, or options contracts.
Ex post Risk Management: Coping actions taken in response to an event, without prior planning. Disaster aid and other types of emergency funding are examples of ex post risk management. While ex post strategies are not in place, short-term coping strategies will be utilized that have no significant long run benefit.
Financial Risk: Risk that income will not reach expected levels or the invested value in a crop will be lost due to adverse changes in weather and price. Many agricultural production cycles stretch over long periods of time, and farmers must anticipate expenses that can only be recouped once the product is marketed.
Forward Contracts: A forward contract is an agreement between the seller and buyer to deliver a specified quantity of a commodity to the buyer at some time in the future for a specified price or in accordance with a specified pricing formula. Since no cash is given when contract is signed, the seller is obligated to deliver the commodity at maturity; the only guarantee that a forward contract will be honored is the reputation of both parties.
Futures: Futures contracts were invented as a way to standardize forwards. In its simplest sense, a futures contract is a standardized forward contract that is exchange traded. It should therefore be emphasized from the start that a future is not a stock or a commodity, but can be thought to trade like a stock, but there need not be an actual sale or purchase of goods at the stipulated time. Futures, unlike forwards, are standardized and traded on exchanges. The underlying principle is that given that cash and futures prices generally move in the same direction, by taking an opposite position in the futures market (i.e. a farmer hoping to sell three months later, sells futures today and buys back the futures three months later), the profits (losses) of one market can offset the losses (gains) of the other market.
Gross Domestic Product (GDP): The total value of all final goods and services produced within a nation in a given year used as a measure of aggregate economic output and economic performance.
Hazard: A potentially damaging physical event, phenomenon or human activity that may cause the loss of life or injury, property damage, social and economic disruption or environmental degradation.
Hedging: Use of investments to manage commercial risk, or to minimize a potential loss to an existing position or known commitment. By using two counterbalancing investment strategies, any losses caused by price fluctuations are minimized. For example, a trader in commodities buys an amount of one particular item. At the same time he also makes a contract to sell an amount of a similar item at a later date.
Indemnity: The amount payable by the insurer to the insured, either in the form of cash, repair, replacement, or reinstatement in the event of an insured loss, and measured by the extent of the insured's loss. It is set at a figure equal to, but not more than, the actual value of the subject matter insured just before the loss, subject to the adequacy of the sum insured. This means for many crops that an escalating indemnity level is established, as the growing season progresses.
Index Insurance: Index insurance makes indemnity payments based not on an assessment of policyholders’ individual losses, but rather on measures of an index that is correlated with losses and serves as a proxy for actual losses. There are two types of agricultural index insurance products: one based on area yields (where the area is some unit of geographical aggregation larger than the farm) and the other based on measurable weather events.
Low-Probability High-Consequence Events: Events that occur infequently yet cause substantial damage. Decision makers, including agricultural producers, tend to underestimate their exposure to low-probability, high-consequence losses because people forget the severity of the loss experienced during infrequent extreme weather events. Thus, an insurance product that protects against these losses is frequently discounted or ignored all together by producers trying to determine the value of an insurance contract.
Minimum price contract: This forward contract is similar to a fixed-price forward contract, except that it guarantees a minimum price with an opportunity to participate in future price gains. From the farmer’s side, this eliminates an important risk factor, and the incentive to default on the contract is less than that with fixed-price contracts. On the other hand, the buyer can also hedge the assumed risks by taking opposite positions. The farmer can be required to pay a certain price to take advantage of this benefit. In practice, the vast majority of farmers in developing countries have no access to forward contracts that contain this kind of price risk management component.
Normalized Difference Vegetation Index (NDVI): Model measuring a plant's ability to absorb sunlight from remote sensing or satellite data.
Options can provide the seller of a commodity with the assurance of receiving a minimum selling price and the buyer of paying a maximum purchase price –therefore acting like insurance. Buying an option contract gives the holder or buyer of the option the right (not obligation) to buy or sell a specified quantity of a commodity (also called the underlying) for a specified price on or before a specified date in the future. It is common practice in grain trade calls and puts to refer to options on futures (i.e. the futures contracts are the underlying). There are two basic types of options: call options and put options.
- Call options give the buyer of the call option (long call) the right to buy the underlying commodity at a specific price (exercise price). The seller of the call (short call) has an obligation to deliver the commodity on the exercise of the option.
- Put options give the buyer of the put option (long put) the right to sell the underlying commodity at a specified price (exercise price). The seller of the put (short put) has an obligation to buy the commodity on the exercise of the option.
Price-to-be-fixed contract: Price-to-be-fixed (PTBF) contracts, also called executable orders (in sugar trade) or on call contracts (in cotton trade), are the most common form of export contracts for commodities from Latin America. They are also very common in Asia, and although still common in Africa, are relatively less used. Unlike other forward contracts where the used reference prices are commonly futures market prices, in this case the seller (or the buyer, in case of processors, importers or end-users) has the active ability to fix the prices at the moment deemed most opportune.
Reinsurance: When the total exposure of a risk or group of risks presents the potential for losses beyond the limit which is prudent for an insurance company to carry, the insurance company may purchase reinsurance, i.e., insurance of the insurance.
Reinsurer: A company that sells reinsurance. Commercial reinsurers often operate on a global scale where they are able to pool a diverse portfolio of large risks to reduce their overall risk exposure.
Risk Assessment: The qualitative and quantitative evaluation of risk, a process which includes describing potential adverse effects, evaluating the magnitude of each risk, estimating potential exposure to the risk, estimating the range of likely effects given the likely exposures and attempting to describe the probabilities associated with various events.
Risk Financing: The process of managing the financial consequences of risk through instruments such as insurance contracts, CAT bonds, reinsurance, or options contracts.
Risk Management: Systematic decision making process for the identification and evaluation of potential hazards and exposures to loss faced by an organization or individual (for example, making a risk assessment). The process also involves selection and implementation of the most appropriate techniques for treating such hazards and exposures.
Risk Mitigation: Risk management actions taken before an event to reduce exposure to, severity of, or probability of loss from the event. Risk mitigation can be physical (for example, building a flood wall) or financial (for example, risk transfer)
Risk: The probability of harmful consequences, or expected losses (deaths, injuries, property, livelihoods, economic activity disrupted or environment damaged) resulting from interactions between natural or human-induced hazards and vulnerable conditions.
Resilience: The capacity of a system, community or society potentially exposed to hazards to adapt, by resisting or changing in order to reach and maintain an acceptable level of functioning and structure. This is determined by the degree to which the social system is capable of organizing itself to increase its capacity for learning from past disasters for better future protection and to improve risk reduction measures.
Revenue insurance: Revenue insurance was designed to provide comprehensive protection – not just yield or price protection. It covers sharp drops in expected revenue, possibly resulting either from a decline in yields or prices, or a combination of the two. Farmers are compensated when any combination of harvested yield times the harvest price results in insurance revenue that is less than the revenue guaranteed. The following revenue insurance plans provided by the Risk Management Agency of the USDA are illustrative of the potential ways in which revenue insurance can be provided.
- Group Risk Income Protection (GRIP) makes indemnity payments only when the average county revenue for the insured crop falls below the revenue chosen by the farmer. i.e. the insured is paid in the event that the county average per-acre revenue falls below the insured’s county trigger revenue. The trigger revenue is calculated by multiplying the GRIP price by the expected county yield and then multiplying this by 90, 85, 80, 75, or 70 percent (based on the chosen protection). The GRIP price is the average CBOT futures price for the five business days prior to March 1.
- Adjusted Gross Revenue (AGR) insures the revenue of the entire farm rather than an individual crop by guaranteeing a percentage of average gross farm revenue, including a small amount of livestock revenue. The plan uses information from a producer’s Schedule F tax forms and the current year’s expected farm revenue to calculate the policy revenue guarantee.
- Crop Revenue Coverage (CRC) provides revenue protection based on price and yield expectations by paying for losses below the guarantee at the higher of an early-season price or the harvest price.
- Income Protection (IP) protects producers against reductions in gross income when either a crop’s price or yield declines from early-season expectations.
- Revenue Assurance (RA) provides dollar-denominated coverage by the producer selecting a dollar amount of target revenue from a range defined by 65-75 percent of expected revenue.
Risk Pooling: Aggregating independent risks to make the aggregate more certain, the handling of an uncertain risk posed to or by a single person or investment by combining it with the same risk affecting a large group, which can be calculated.
Scarcity: refers to a permanent situation of shortage with reference to the water demands in a water supply system or in a large region, characterized by an arid climate and/or a fast growth of water consumptive demands.
Shock: An unexpected traumatic event such as death in the family or loss of land and livestock which can be caused by a catastrophic weather event or other unexpected phenomenon. Price shocks occur when the price of commodity changes dramatically due to changes in local or global supply and demand, affecting the livelihood of households dependent on this commodity either for income or caloric intake. Economic shocks can occur at the micro, meso, and macro levels and can have long-term consequences for the economic well-being of actors at each level.
Swaps: Swaps were developed in the OTC market as long-term price risk management instruments. A commodity swap contract (or simply swap) obligates two parties to exchange a floating price for a fixed price (or vice versa) for a given amount of a commodity at specified time intervals. In other words, a swap is an agreement between two parties – the hedger and the hedge provider – in which the hedger (a commodity user or producer) agrees to pay a fixed price and receive a floating price for a specified volume of a commodity over a specified period. In a swap with two parties, there is typically a consumer and a producer of the commodity, and a bank or any other financial institution that acts as an intermediary. Since a swap is a one-time negotiation, no major periodic decisions have to be made and they do not require constant monitoring. Swaps do not involve hassles of exchange-traded brokerage and margin calls; this makes them more convenient tools of price risk management. These are some key factors that make swaps easier tools of risk management for developing countries.
Traditional Agricultural Insurance: Insurance in agriculture has historically underwritten a particular crop on a particular plot of land. This insurance is priced by using historical farm yield data. In the event of a loss from an insured event, a trained claims agent will visit the plot of land and assess the amount of damage accrued. One of the most common forms of traditional agricultural insurance is multiple peril crop insurance.
Underwrite: Process of selecting and rating risks for insurance purposes.
Vulnerability: The conditions determined by physical, social, economic and environmental factors or processes, which increase the susceptibility of a community to the impact of hazards.
Water shortage: refers to the relative shortage of water in a water supply system that may lead to restrictions on consumption. At the national level water shortage is expressed as m3 per capita per year. The greater the figure the greater is the shortage.
Weather Index Insurance: Contingent claims contracts for which payouts are determined by an objective weather parameter that is highly correlated with farm-level yields or revenue outcomes, such as rainfall levels, temperature, or soil moisture.
Weather Risk: The risk of physical damage and/or financial loss from adverse weather events such as hurricanes, flooding, or drought. When weather risks are correlated, the losses are greater due to their wider geographical impact.
Yield Loss/Yield Risk: A risk unique to agricultural producers; unlike most other entrepreneurs, agricultural producers cannot predict the amount of output that the production process will yield due to external factors such as weather, pests and diseases.