INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana Risk modelling of agricultural catastrophic insurance decisions in SEU framework Victor Ogurtsov, Wageningen University / IRMA Dr. ir. Marcel van Asseldonk, IRMA Prof. dr. ir. Ruud Huirne, Wageningen University / IRMA

Outline  Objects of insurance  Data and methods  Results  Conclusion INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana

Catastrophic insurance against risks Dairy farming:  Hail-fire-storm affecting buildings  BSE ( bovine spongiform encephalopathy) INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana

Data and methods Data  Farm Accountancy Data Network (FADN)  Questionnaire survey Methods  Subjective expected utility model (SEU)  Utility-efficient programming (UEP) INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana

Utility efficiency programming (UEP) maximize E[U]=p U(z, r), r varied Where p – probability of catastrophic risk (risk perception) U – utility Z – goal function (wealth or income) R – coefficient of risk attitude E(U) is weighted average of the utilities of outcomes Alternatives can be compared in terms of certainty equivalents (CE) - maximum sure payment the farmer would be willing to pay rather than face the risk INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana

Stochastic efficiency w.r.t. function (SERF) When preferences (i.e. risk attitude) are unknown principles of stochastic dominance. Stochastic dominance with respect to a function (SDRF), introduced by Meyer (1977), can be used with tight bounds of risk aversion coefficients (Hardaker et al., 2004), called SERF.. Farmers, according to Hardaker et al. (2004) are assumed to be risk-averse. Anderson and Dillon (1992) developed a rough classification of decision-makers on the basis of relative risk aversion coefficients: 0.5 – hardly risk averse 1.0 – somewhat risk averse (normal) 2.0 – rather risk averse 3.0 – very risk averse 4.0 – almost paranoid about risk INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana

Farm bankruptcy Bankruptcy leads to high changes in wealth. Therefore constant relative risk aversion (CRRA) or decreasing absolute risk aversion (DARA) is to be applied: This can be captured by power function: U=[1/(1-r)]w(1-r), w>0, Where w – wealth, and r – relative risk aversion coefficient (0; 4). Then CEs will be derived from utility values to compare decisions. INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana

Farm bankruptcy When a catastrophic risk occurs farmer need to consider direct and consequential losses: Direct losses – losses due to catastrophe (infected animals, destroyed buildings, crops, etc.) Consequential losses – after direct losses: price changes, business interruption, repopulation of a farm, transport of animals, insufficient compensation for animals, establishing restriction zones for diseases. INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana

Example – BSE insurance INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana

Example – BSE insurance INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana

Example – BSE insurance INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana

Example – insurance against fire effecting buildings INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana

Conclusions INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana BSE Insurance against FMD is rather expensive Losses are not that catastrophic that farmer can rely on his own wealth Risk aversion is not significant for purchase of catastrophic insurance Fire Losses are higher Risk aversion is significant for insurance of buildings

THANK YOU INNOVATION AND TECHNICAL PROGRESS: BENEFIT WITHOUT RISK? September 2006, Ljubljana