Haramaya University

FINANCIAL AND RISK MANAGEMENT (ABVM 542)

Lecture Notes

Degye Goshu (PhD)

Assistant Professor of Agricultural Economics

October, 2013
 Degye Goshu

TABLE OF CONTENTS

1. FINANCIAL MANAGEMENT IN AGRIBUSINESS 1

1.1. Basics of Financial Management 1
1.1.1. Meaning and dimension 1
1.1.2. Finance function 3
1.1.3. Objectives of financial management 4
1.1.4. Types of finance 6
1.2. Techniques of Financial Analysis 6
1.3. Analysis of Financial Structure 7
1.3.1. Liquidity 9
1.3.2. Solvency 10
1.4. Financial Return Analysis 11
1.4.1. Structure 11
1.4.2. Earning performance 13
2. CREDIT MANAGEMENT IN AGRIBUSINESS 16
2.1. Roles and Essentials of Credit 16
2.2. Sources of and Constraints in Agricultural Credit 18
2.3. Advantages and Disadvantages of Credit 18
2.4. Credit Instruments and Contracts 20
2.4.1. Credit instruments 20
2.4.2. Loan agreements 22
2.5. Basics of Credit Analysis and Rating 23
2.5.1. Credit process 23
2.5.2. Credit analysis 24
2.5.3. Credit scoring and risk rating 26
2.6. Information Asymmetry and Credit Risk Management 27
3. AGRICULTURAL VALUE CHAIN FINANCE 29
3.1. Framework of Value Chain Finance 29
3.3. Outgrower Schemes 31
3.4. Warehouse Receipt Finance 33
3.5. Credit Guarantees 36
3.6. Value Chain Intermediation 37
3.7. Agricultural Factoring and Trade Receivables Finance 37
3.8. Trade Credit 39
3.9. Key Points in VCF 39
4. AGRICULTURAL RISK ASSESSMENT AND MANAGEMENT 42
4.1. Farm-level Risks and Constraints 42
4.2. Supply Chain Risks 43
4.3. Risk Assessment 45
4.3.1. Analyzing risky situations 45
4.3.2. Major risk variables 47
4.3.3. Dimensions of risk 48
4.4. Approaches to Agribusiness Risk Management 48
4.5. Risk Layering 51
4.6. Weather Risks and Management in Agribusiness 52
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4.6.1. Agricultural risks and management strategies 52

4.6.2. Agricultural insurance 54
4.6.2.1. Crop insurance products 54
4.6.2.2. Risk layering in weather-related agricultural insurance 55
4.7. Weather Index Insurance (WII) 57
4.7.1. Basics of WII 57
4.7.2. Weather parameters and payout structure 58
4.7.3. Advantages and disadvantages of index insurance 61
4.7.3.1. Advantages of index insurance 61
4.7.3.2. Challenges in index insurance 62
References 63

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1. FINANCIAL MANAGEMENT IN AGRIBUSINESS

1.1. Basics of Financial Management

1.1.1. Meaning and dimension

The definition, scope, dimensions, objectives and functions of finance and financial management
are important to be understood by the student before we go to the details of the principles of
financial management in agriculture. All these issues are the focus of this section.

Financial management can be defined as the management of capital sources and uses so as to
attain the desired goals of the firm, i.e. maximization of owner's wealth. The firm's capital
consists of items of value that are owned and used, and items that are used but not owned.
Examples of the use of the capital of the firm are receivables, inventories, and fixed assets.

As an area of study, financial management has two distinct functions: financing function and
investing function. The financing function represents the management of the sources of capital,
whereas the investing function indicates the type, size, and percentage of composition of capital
uses. Investing function deals with the question "how much of the total capital provided by the
financing sources should be invested in receivables, marketable assets, inventories, and fixed
assets?" The specialized set of management duties and responsibilities that center the financing
and investing functions are referred to as financial management.

The problems and opportunities that a financial manager faces and the business decisions he
makes entirely depend on the goals of his organization. Profit seeking firms should behave in a
way they maximize the wealth of the owners. It is also important to distinguish between wealth
maximization and profit maximization as goals of business firms.

Finance, in general, consists of three interrelated areas:

 money and capital markets,
 investments, and
 financial management.

The money and capital markets deal with asset markets and financial institutions. To succeed in
doing such jobs, we need to have a general knowledge on all aspects of business administration,
because the management of financial institutions involves accounting, marketing, personnel
management, as well as financial management. The investments area deals with the decision of
both individual and institutional investors as they choose among enterprises for their investment
portfolios.

Financial management involves the actual management of business firms. The types of decisions
encountered in financial management in agriculture, for instance, range from farm plant
expansion to choosing what type of enterprises to include to financial expansion of the farm
business. Financial management has three objectives:
 Determining the size and growth rate: Financial management aims at determining how
large the business firm should be and how fast should it grow.
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 Determining asset composition: Financial management aims at determining the best

percentage composition of the firm's assets.
 Determining the composition of liabilities and equity: Financial management aims at
determining the best percentage composition of the firm's combined liabilities and equity
decision related to capital sources.

Financial analysis related to farm income, repayment capacity, and risk management indicates
the total amount of capital the farm business can profitably and safely use. Information and
knowledge on the legal aspects of borrowing, leasing, and contractual arrangements helps the
farmer select the means of acquiring and controlling resources that will contribute most to the
farming operation.

Why agribusiness finance is important?

 Food security and MDGs are a priority;
 Reduced government and donor support slowed rural investment and growth;
 Finance is important for agricultural and economic growth;
 Financial linkages are growing in importance and recognition.

Terminologies related to finance should be defined to avoid ambiguities in understanding the

whole concept of finance in agribusiness. In an attempt to be clear with terminologies, we use the
following definitions for the financial sector to differentiate agribusiness finance from other
subsets of finance. There is a great deal of ambiguity among finance, rural finance, agricultural
finance, agricultural credit, and microfinance.

Figure 1: Agricultural credit and finance in perspective

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Finance is narrowly interpreted as capital in monetary form that is in terms of funds lent or
borrowed, normally for capital purposes, through financial markets or institutions. Rural finance,
as defined by the World Bank, is the provision of a range of financial services such as savings,
credit, payments and insurance to rural individuals, households, and enterprises, both farm and
non-farm, on a sustainable basis. It includes financing for agriculture and agro-processing.

Agricultural finance is defined as a subset of rural finance dedicated to financing agricultural

related activities such as input supply, production, distribution, wholesale, processing and
marketing. Agricultural finance is the economic study of the acquisition and use of capital in
agriculture. It deals with the supply of and demand for funds in the agricultural sector of the
economy. Knowledge of fundamental economic and management principles and analytical
procedures facilitates obtaining control over capital and using it efficiently.

Agricultural credit is any of several credit vehicles used to finance agricultural transactions,
including loans, notes, bills of exchange and bankers’ acceptances. These types of financing are
adapted to the specific financial needs of farmers, which are determined by planting, harvesting
and marketing cycles. Short-term credit finances operating expenses, intermediate-term credit is
used for farm machinery, and long-term credit is used for real-estate financing. Microfinance is
the provision of financial services for poor and low income people and covers the lower ends of
both rural and agriculture finance.

1.1.2. Finance function

Finance function is one of the major parts of business organization, which involves the
permanent and continuous process of the business concern. Finance is one of the interrelated
functions which deal with personal function, marketing function, production function and
research and development activities of the business concern. Finance manager is one of the
important role players in the field of finance function. He must have entire knowledge in the area
of accounting, finance, economics and management. His position is highly critical and analytical
to solve various problems related to finance. A person who deals finance related activities may
be called finance manager. Finance manager performs the following major functions:
1. Forecasting financial requirements
2. Acquiring necessary capital
3. Investment decision
4. Cash management
5. Interrelation with other departments

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Figure 2: Functions of financial manager

Some of the importance of the financial management is as follows:

 Financial planning: Financial management helps to determine the financial requirement
of the business concern and leads to take financial planning of the concern.
 Acquisition of funds: Financial management involves the acquisition of required finance
to the business concern. Acquiring needed funds play a major part of the financial
management, which involve possible source of finance at minimum cost.
 Proper use of funds
 Financial decision: Financial management helps to take sound financial decision in the
business concern. Financial decision will affect the entire business operation of the
concern.
 Improve profitability: Profitability of the concern purely depends on the effectiveness and
proper utilization of funds by the business concern.
 Increase the value of the firm: Financial management is very important in the field of
increasing the wealth of the investors and the business concern.
 Promoting savings: Savings are possible only when the business concern earns higher
profitability and maximizing wealth. Effective financial management helps to promoting
and mobilizing individual and corporate savings.

1.1.3. Objectives of financial management

Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management. Objectives of financial
management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.

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Figure 3: Objectives of financial management

Profit maximization
Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the profit of the concern. Profit maximization
consists of the following important features:
1. Profit maximization is also called as cashing per share maximization. It leads to maximize
the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible
ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the
entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.

Profit maximization objective consists of certain drawback:

1. It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.
2. It ignores the time value of money: Profit maximization does not consider the time value
of money or the net present value of the cash inflow. It leads certain differences between
the actual cash inflow and net present cash flow during a particular period.
3. It ignores risk: Profit maximization does not consider risk of the business concern. Risks
may be internal or external which will affect the overall operation of the business
concern.

Wealth maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or
the wealth of the persons those who are involved in the business concern. Wealth maximization

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is also known as value maximization or net present worth maximization. This objective is a
universally accepted concept in the field of business.

There are unfavorable arguments for wealth maximization:

1. Wealth maximization leads to prescriptive idea of the business concern but it may not be
suitable to present day business activities.
2. Wealth maximization is nothing, it is also profit maximization, it is the indirect name of
the profit maximization.
3. Wealth maximization creates ownership-management controversy.
4. Management alone enjoy certain benefits.
5. The ultimate aim of the wealth maximization objectives is to maximize the profit.
6. Wealth maximization can be activated only with the help of the profitable position the
business concern.

1.1.4. Types of finance

Finance is one of the important and integral part of business concerns, hence, it plays a major
role in every part of the business activities. It is used in all the area of the activities under the
different names. Finance can be classified into two major parts:
 Private finance, which includes the individual, firms, business or corporate financial
activities to meet the requirements.
 Public finance, which concerns with revenue and disbursement of government such as
central government, state government and semi-government financial matters.

The scope and dimensions of these terms is depicted in Figure 4.

Figure 4: Types of finance

1.2. Techniques of Financial Analysis

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Financial statement analysis is interpreted mainly to determine the financial and operational
performance of the business concern. A number of methods or techniques are used to analyze the
financial statement of the business concern. The following are the common methods or
techniques, which are widely used by the business concern.

Comparative statement analysis: Comparative statement analysis is an analysis of financial statement

at different period of time. This statement helps to understand the comparative position of financial and
operational performance at different period of time.

Trend analysis: The financial statements may be analyzed by computing trends of series of
information. It may be upward or downward directions which involve the percentage relationship
of each and every item of the statement with the common value of 100%. Trend analysis helps to
understand the trend relationship with various items, which appear in the financial statements.

Common size analysis: In this case figures reported are converted into percentage to some
common base. In the balance sheet the total assets figures is assumed to be 100 and all figures
are expressed as a percentage of this total. It is one of the simplest methods of financial statement
analysis, which reflects the relationship of each and every item with the base value of 100%.

Funds flow statement: Funds flow statement is one of the important tools, which is used in many
ways. It helps to understand the changes in the financial position of a business enterprise
between the beginning and ending financial statement dates. It is also called as statement of
sources and uses of funds.

Cash flow statement: Cash flow statement is a statement which shows the sources of cash inflow
and uses of cash out-flow of the business concern during a particular period of time. It is the
statement, which involves only short-term financial position of the business concern. Cash flow
statement provides a summary of operating, investment and financing cash flows and reconciles
them with changes in its cash and cash equivalents such as marketable securities.

Ratio analysis: Ratio analysis is a commonly used tool of financial statement analysis. Ratio is a
mathematical relationship between one number to another number. Ratio is used as an index for
evaluating the financial performance of the business concern. An accounting ratio shows the
mathematical relationship between two figures, which have meaningful relation with each other.
Ratio can be classified into various types.

1.3. Analysis of Financial Structure

The net worth statement1 (or the adjusted balance sheet) is one of the most common financial
statements used in business today. It provides a “snap shot” view of the financial health of the
business at a given point in time. A net worth statement is one which lists all the assets of a

1
Net worth statement based on historic cost less depreciation is called a balance sheet. A net worth statement lists
all assets at fair market value. Increases in net worth over time could be due to an appreciation in asset values (e.g.
land) and not from business profitability. Therefore, it is important that managers understand the reasons for net
worth increases.
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business at fair market value, records all the liabilities of a business, and shows the net worth
(owner’s equity) at a specific point in time (the Net Worth Statement date).

Net Worth statement

Name: Teshome Yilma Farm Date: January 1, 20X1

Application of the information contained in the net worth statement is accomplished by the
analysis of the various relationships between its three components - assets, liabilities and net
worth. This allows you to develop a detailed picture of the financial health of the farm business
at a specific point in time. Proper use of these financial health indicators will help you make
sound farm business management decisions.

Assets = Liabilities + Net Worth

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1.3.1. Liquidity

Liquidity measures the farm’s ability to meet its financial obligations (debts) as they come due
without disrupting normal business operations. Liquidity is a measure of the relationship
between current assets and current liabilities. The key portion of the liquidity definition is - to
meet its financial obligations as they come due without disrupting normal business operations.
Liquidity may be measured in absolute terms (a monetary amount) by working capital or in
relative terms (a ratio) by the current ratio or the debt structure ratio.

Working capital
Working capital is simply the monetary difference between current assets and current liabilities.
It is the amount available to finance upcoming production after the sale of current farm assets
and payment of all current farm liabilities. The greater the amount of working capital, the more
liquid the business will be.

Working capital = Current assets — Current liabilities

Working capital = $69,138 - $40,147 = $28,991.

Working capital needs to be positive for the business to be liquid. However, there is no hard and
fast rule as to the ideal amount. Acceptable working capital will vary from farm to farm
depending upon the type of farm, its size and the amount of risk associated with its production
enterprises. The excess of working capital over current liabilities is also an important factor to
consider.

Current ratio
The current ratio or liquidity ratio is another method to determine liquidity. This is a relative
measure (a ratio) that examines the proportional relationship between current assets and current
liabilities.

Current assets $69138

Current ratio    1.72.
Current liabilities $40147

If the ratio calculated is greater than 1, then the business is liquid. A ratio less than 1 indicates
that current assets are less than current liabilities and the business would not be able to meet its
financial obligations from sales of current assets. A ratio of 1.72 indicates that the farm has $1.72
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of current assets for every $1.00 of current liabilities. This statement is useful to describe the
relationship between current assets and current liabilities.

Debt structure ratio

The debt structure ratio measures the proportional relationship between current liabilities and
total liabilities and is often used in conjunction with working capital or the current ratio when
assessing business liquidity.
Current liabilities $40147
Debt structure ratio    0.21.
Total liabilities $195427

A Debt structure ratio of 0.21 would indicate that 21% of total business debts are in the current
position (that is, are current liabilities). A high debt structure ratio is desirable if the business has
positive working capital (a current ratio greater than 1).

1.3.2. Solvency

Solvency refers to the ability of the business to meet its total debt obligations determined by
comparing the amount of borrowed capital used to the amount of owner’s equity invested in the
business. It is a measure of the risk bearing ability of the farm to carry on business after financial
adversity. An acceptable solvency position depends upon the size of the farm and the enterprises
associated with it and also upon the management ability of the farmer and the measures he takes
to shield the farm from risk. Minimizing risk reduces the potential for a claim on net worth from
an unfavorable event. Income variability and the risk associated with production and marketing
affect the farm’s solvency position. Also, solvency does not measure how wisely debt is being
used. If the solvency position is strong, the possibility of paying off debt should be examined to
reduce interest costs. Like liquidity, solvency may be measured in three ways - absolutely (a
monetary amount) by net worth, relatively (a ratio) by the debt ratio and the leverage ratio.

Net worth
A quick and simple method to determine solvency is to examine the value of net worth. It really
is a measure of solvency because it compares owner’s equity (net worth) to borrowed capital
(liabilities). If net worth is positive (total assets greater than total liabilities), the business is
solvent. If net worth is negative (total assets are less than total liabilities) then the business is
insolvent or bankrupt. However, since this is an absolute measure, it is not useful for comparing
different farms.

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Debt ratio
The debt ratio (sometimes called the solvency ratio or debt to asset ratio) examines the
proportional relationship between total liabilities and total assets.

Total liabilities $195427

Debt ratio    0.38.
Total assets $514354

If the debt ratio is less than 1, the business is solvent. A ratio greater than 1 would indicate that
total liabilities are greater than total assets and therefore the business is insolvent. A debt ratio of
0.38 indicates that 38% of the business assets are debt financed. Since the debt ratio is a relative
measure of solvency, it can be used for comparisons between farms. Ratios of up to 0.40 to 0.50
are generally considered safe in the farming industry. However, ratio acceptability would depend
upon the nature of the farm and its enterprises. Farms with regular and regulated cash flows
(such as dairies) can withstand higher debt ratios. However the ability to withstand higher debt
ratios is more a function of profitability - more funds are available for reducing debt (perhaps at
a very fast rate). Use caution when using the debt ratio in financial decision making. Having a
favorable debt ratio (high net worth) does not indicate debt repayment ability and therefore can
lead to a false sense of security. Repayment ability is determined by profitability and cash flow.

Leverage ratio
The leverage ratio (or debt to equity ratio) measures exposure to financial risk by examining the
extent to which creditors have financed the business (by liabilities) as compared to the owners
(by net worth or equity).

Total liabilities $195427

Leverage ratio    0.61.
Net worth $318927

A ratio greater than 1 indicates that creditors are financing a higher proportion of the assets than
is the owner. If the ratio is less than 1, the owner is financing the majority of the assets. This
leverage ratio indicates that the creditors of the farm are financing 61 cents of farm assets for
every $1.00 financed by the owners. The exposure to financial risk measured by the leverage
ratio arises primarily from the vulnerability of the business to changes in asset value. Farm
businesses with a high leverage ratio are more exposed to asset valuation changes. Even
relatively small changes in asset values will have dramatic effects on the proportion of equity
held in the business.

1.4. Financial Return Analysis

1.4.1. Structure

An income statement summarizes income and expense and the resultant net income for an
operation. It is sometimes called an operating statement, profit and loss statement or statement of
income and expenses. Cash income statements make the summary on a cash basis. Accrued
income statements summarize the value of production and the cost of production to produce a
“true” net income for the farm. The purpose of the income statement is to provide information, in
summary form, on the results of the business operations for a given time period, for example, a
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fiscal year. A fiscal year is an accounting period of 12 consecutive months. A business usually
completes an income statement at the end of its accounting period. Some large businesses will
complete a quarterly or even monthly statement, as well.

The cash income statement summarizes farm operating income when it is received as cash and
farm operating expense when paid for by cash. Cash income statements are usually created for
income tax filing purposes.

Cash Income Statement

Name: Teshome Yilma Farm Period Covered: Jan. 1 to Dec. 31, 20X1

The accrued income statement summarizes income when goods are produced and expense
associated with producing those goods, when it is incurred. The accrued income statement differs
from the cash income statement in that income and expense are matched to a production period
rather than to cash. It is a true measure of profitability because accrued net farm income is the
value of production less the cost of production. The accrued income statement adjusts for the fact
that farm businesses rarely sell their entire production in the period in which it was produced.

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Inventory often remains due to lack of marketing opportunities or an income tax planning
strategy.

Accrued Income Statement

Name: Teshome Yilma Period Covered: Jan. 1 to Dec. 31, 20X1

Do you know if your farm business is making a profit? Cash income statements often present a
sense of false security because they do not reflect the real profit produced in a year. Accrued
income statements provide a “true” measure of business profitability and allow the manager to
analyze the operation on a profitability basis. This information can be used to determine the
prospects for future expansion for both the farm and the family.

1.4.2. Earning performance

Profitability measures the extent to which a business generates a surplus of revenue over expense
from the use of its resources. The accrued income statement does provide the opportunity to
mathematically analyze earning performance (profitability) of the business based on the return to
capital invested. In order to carry out this analysis, a charge for the farm’s unpaid labor and
management (supplied by the operator and his family), is deducted from accrued net farm
income. The resultant figure reflects income earned from investment in farm assets rather than
from a combination of labor and investment. Determining a charge for this unpaid family labor
and management is not an exacting process. Some prefer to use an arbitrary figure they deem
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acceptable, while others will determine what it would cost to hire comparable services. A fair
estimation is to use family living costs and that is the method illustrated in this course.

Return to assets
Businesses invest in assets in order to generate a return. Since term loan interest is already
deducted as an expense in the determination of accrued net farm income, to fairly determine the
earnings generated by total business assets (those financed through equity and liabilities),
subtract the value of unpaid labor and add the amount of term interest to accrued net farm
income. In order to calculate a return to assets three figures are required:
 the value of accrued net farm income found in the accrued income statement
 a value for unpaid operator and family labor
 the value of term loan interest to be paid this year found in the intermediate and long term
liability listing.

Let’s look to the Teshome Yilma Farm for an example. In the previous sections you determined
the accrued net farm income for the farm to be $25,387. In the liability listing for the, you find
that term interest due in the year 20X1 is $16,969. Let’s also assume that the farm will make a
$500 interest payment on the breeding stock loan taken out in the second quarter. If family living
expense of $24,000 is used as a charge for unpaid labor, you can determine a return to assets:

Re turn to assets  Accrued net farm income  Unpaid labor  Term int erest
 $25387  $24000  $17469  $18856.

The assets of the farm returned $18,856 for their use in the production process.

Rate of return to assets

To facilitate comparison to other farms of similar nature or to your own farm over a period of
years, it is best to express the return to assets as a proportional relationship (expressed as a
percentage) between the return to assets and the value of the beginning assets.

Re turn to assets %18856

Rate of return to assets   100   100  3.7%.
Beginning assets 514354

Note that this formula uses the value of beginning assets as the denominator. These were the
assets used in the production process to generate a return. It would be erroneous to use the value
of ending assets because it reflects depreciation of assets used in the production process. The
value of beginning assets (those used in the production process) is found in the net worth
statement. The production assets of the farm generated a return of 3.7% in the production
process.

Return to equity
A return to equity for investment in business assets can also be calculated. Since accrued net
farm income includes an interest charge for liabilities (assets financed by others), a return to
equity (assets financed by the owner) can be calculated directly by subtracting unpaid labor from
accrued net farm income. In order to calculate a return to equity two figures are required:
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 the value of Accrued Net Farm Income found in the accrued income statement
 a value for unpaid operator and family labor.

Return to equity for the farm (using family living expenses as an estimate for unpaid labor)
would be:

Re turn to equity  Accrued net farm income  Unpaid labor

 $25387  $24000  $1387.

This is an absolute measure which does not allow for comparison between similar farms or
within the Teshome Yilma Farm over a period of years. It is however, required to calculate a
ratio between it and the value of the owner’s beginning equity.

Rate of return to equity

Return to equity can be calculated as a relative measure (a ratio) by determining the proportional
relationship between it and the value of the owner’s beginning equity as found in the beginning
net worth statement.
Re turn to equity $1387
Rate of return to equity   100   100  0.4%.
Beginning equity $318927

Remember; use the value of beginning equity. It was used in the production process. Ending
equity is that which remained after production was completed. Let’s determine the rate of return
to equity (%) for the farm.

The farm generated a .4% return on its equity in business assets in the year 20X1. This ratio can
be calculated every year to provide a method to measure the change in earning performance of
owner’s equity over time.

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2. CREDIT MANAGEMENT IN AGRIBUSINESS

2.1. Roles and Essentials of Credit

Credit is a wide term which has been used in connection with operations or states involving
lending, generally at short-term. To give credit is to finance, directly or indirectly, the
expenditures of others against future repayment. The word "credit' is derived from the Latin
word creditum which means to believe or trust. In economics, the term credit refers to a promise
by one party to pay another for money borrowed or goods or services received. It is a medium of
exchange to receive money or goods on demand at some future date. It can be defined as ''as the
right to receive payments or the obligation to make payment on demand at some future time on
account of the immediate transfer of goods". Farm credit or agriculture credit is the count of
loan or credit obtained from any source for the promotion and development of agriculture.

The following 'are the essential features of credit:

1. Trust and confidence: Trust is the fundamental element of credit. The lender will lend
his money or goods on the trust and confidence that the borrower or buyer will pay back
the money or price in time.
2. Time element: All credit transactions involve time element. Money is borrowed or goods
are bought with a promise to repay the money or pay the price on some future date.
3. Transfer of goods and services: Credit involves transfer of goods and services by the
seller to the buyer on the pay-back promise of the buyer on some future date.
4. Willingness and ability: Credit depends in a person's willingness and ability, to pay the
borrowed money. In fact, credit of a person depends on his character, capacity and
capital. It is these three C's on which a man's credit depends. A person who is honest and
fair in his dealings possesses the capacity of making his business a success. Such a person
can get credit easily.
5. Purpose of credit: Banks and financial institutions give large amounts of credit for
productive purposes rather than for consumption purposes.
6. Security: Security in the form of property, gold, silver, bonds or shares is an important
element for raising credit.

Importance of agricultural credit

The questions related to the amount, type, timing, and benefits of credit are very important for a
farmer's decision in acquiring additional funds using credits. Credit is important and necessary in
nearly all commercial farm businesses. The potential to improve net farm income should be one
of the determining factors in the decision of whether to use credit. Credit can contribute in the
improvement of net income in several ways:
1. Create and maintain an adequate size. Most farms exhibit decreasing costs as the size of
the business increases because of economies of size;
2. Increase efficiency. Use of credit increases substitution, utilization of idle resources, and
intensity of production to secure efficient use of resources;
3. Adjust to changing economic conditions of technology and market;
4. Meet to seasonal and annual fluctuations in income and expenditures;

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5. Protect against adverse conditions of weather, disease, and price; and

6. Provide continuity of business during transfer.

To develop a good working relationship with a lender, a farmer should maintain integrity in
business dealings and provide documentation of ability to use the funds efficiently and to repay
the loan.

The credit needed by farmers to grow in the agricultural sector is termed as agricultural credit.
Credit is required in every type of business and agriculture is not exception to it. The need for
agricultural credit, however, becomes all the more important when it moves from traditional
agriculture to modern agriculture.

The need for agricultural credit

The following points reveal the need for agricultural credit.
 Purchas of new inputs (e.g. farm productivity)
 Purchase of implements (e.g. modern technologies)
 Better management of risk: Credit enables the farmers to better manage the risk of
uncertainties of price. They can borrow money during bad years and pay back the
loans during good years of crops.
 Permanent improvement in land (e.g. irrigation facility)
 Better marketing of products (e.g. storage and marketing)
 Face crisis (e.g. iinterim difficulties, natural climates)
 Purchas of cattle: Farmer needs credit to purchase cattle. Because the farmers mostly
remain free after cultivating the farm, therefore they want to start off-farm business
by purchasing cattle.
 Payment of ancestors’ debt
 Consumption expenditure, and
 Civil and criminal suits.

Types of agricultural credit:

Agriculture requires the following three types of credit:

Short-term credit: The short-term credit ranges upto one year. The farmers need short-term
credit for meeting the working capital requirements of agriculture. For instance, they need short-
term credit for the purchase of seeds, fertilizers, pesticides, bullocks and other casual expenses.
The short-term credit is repaid after marketing the produce of the next crop.

Medium-term credit: Medium-term credit extends from 1 to 5 years. The farmers require
medium-term credit for the purchase of cattle, purchase of implements, improvement in water
course, etc. The loan is obtained on the security of movable or immovable wealth of the farmers.

Long-term credit: The duration of long-term credit exceeds 5 years. The farmers need long-term
credit for making improvement of permanent nature in land such as sinking of tube wells,
purchase of machinery and implements, etc.

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2.2. Sources of and Constraints in Agricultural Credit

Credit in the farm sector is available from two sources: Non-institutional sources and
institutional sources.
The various providers of financial services and their products include the following.
 Commercial banks,
 Agricultural development banks,
 Microfinance and user-owned financial institutions,
 Value chain finance
 Informal finance (money lenders, friends, relatives, landlords, shopkeepers, etc.),
 Agricultural insurance, and
 Public and donor funding.

Constraints in supply and demand for agricultural finance are the following.
 High delivery cost, proximity,
 Weak farming practices and farmers,
 Lack of banking technology,
 Collateral,
 Exogenous risks (e.g. production and price risks),
 Government intervention, and
 Weak collaboration among farmers.

Miller (2004) describes 12 constraints on rural finance, and classifies these into four groups:
Vulnerability constraints:
1. systemic or covariate risk (the same type of risk occurring at the same time);
2. market risk (fluctuation of prices);
3. credit risk (lack of collateral).
Operational constraints:
4. low investment returns (rural capital turns over slowly, low profit margins,
seasonality results in uneven cash flow);
5. low investment and assets (weak safety net);
6. geographical dispersal and low population densities.
Capacity constraints:
7. weak rural infrastructure;
8. low level of training and technical capacity of the rural population;
9. social exclusion (cultural, linguistic) affects market and financial integration;
10. limited institutional capacity (weak support systems).
Political and regulatory constraints:
11. political interference (subsidized and/or directed credit from state-owned banks, debt
waivers, interest-rate caps);
12. regulatory constraints (land tenure laws, banking laws, arbitrary taxation).

2.3. Advantages and Disadvantages of Credit

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Modern economy is said to be a credit economy. Credit is of vital importance for the working of
an economy. It is the oil of the wheel of trade and industry and helps in the economic prosperity
of a country in the following ways:

1. Economical use: Credit instruments economize the use of metallic currency. They are
cheaper than coinage. The metal used in coins can be used for other productive purposes.
2. Increases productivity of capital: Credit increases the productivity of capital. People having
idle money deposit it in banks and with non-bank financial institutions which is lent to trade
and industry for productive uses.
3. Convenience: Credit instruments are a convenient mode of national and international
payments. They help in transferring payments with little cost and without the use of actual
money from one place to another quickly.
4. Internal and external trade: As a corollary to the above by facilitating payments quickly,
credit helps in the expansion of internal and external trade of a country.
5. Encourages investment: Credit is the payment along which production travels, and that
bankers provide facilities to manufacturers to produce to full capacity. Credit encourages
investment in the economy. Financial institutions help mobilizing savings of the people
through deposits, bonds, etc. These are, in turn, given as credit to trade, industry, agriculture,
etc. which lead to more production and employment.
6. Increases demand: A variability of cheap and easy credit increases the demand for goods
and services in the country. This leads to increase in the production of such durable consumer
goods. These raise the standard of living of the people when they consume more goods and
services. Consumption loans by banking and non-banking financial institutions coupled with
the use of credit cards have made these possible.
7. Utilizes resources: Credit helps in the proper utilization of a country's manpower and other
resources. Cheap and easy credit encourages people to start their own businesses which
provide them employment. Agriculture develops when farmers get seeds, fertilizers, pumping
sets, tractors, etc. on credit. Similarly transport, communications, industry, mines,
plantations, power, etc. develop with the help of credit.
8. Price stability: Credit helps in maintaining price stability in a country. The central bank
controls price fluctuations through its credit control policy. It reduces the credit supply to
control inflation and increases the supply of credit to control deflation.
9. Helpful to government: Credit helps the government in meeting exigencies or emergencies
when the usual fiscal measures fail to fill the financial needs of the government. Government
resorts to deficit financing for economic development by creating excess credit.

Credit is a dangerous tool if it is not properly controlled and managed. The following are some of
the defects of credit:
1. Too much and too little credit is harmful: Too much and too little of credit are harmful
for the economy. Too much of credit leads to inflation which causes direct and immediate
damage to creditors and consumers. On the contrary, too little of credit leads to deflation
which brings down the level of output, employment and income.
2. Growth of monopolies: Too much of credit leads to the concentration of capital and
wealth in the hands of a few capitalists. This leads to growth of monopolies which exploit
both consumers and workers.

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3. Wastage of resources: When banks create excessive credit, it may be used for productive
and unproductive purposes. If too much of credit is used for production, it leads to over
capitalization and over production, and consequently to wastage of resources. Similarly,
if credit is given liberally for productive purposes, it also leads to wastage of resources.
4. Cyclical fluctuations: When there is an excess supply of credit, it leads to a boom. When
it contracts, there is a slump. In a boom, output, employment and income increase which
lead to over production. On the contrary, they decline during a depression thereby leading
to under consumption. Such cyclical fluctuations bring about untold miseries to the
people.
5. Extravagance: Easy availability of credit leads to extravagance on the part of people.
People indulge in conspicuous consumption. They buy those goods which they do not
need. With borrowed money, they spend recklessly on luxury articles. The same is the
case with businessmen and even governments who invest in unproductive enterprises and
schemes.
6. Speculation and uncertainty: Over issue of credit encourages speculation leading to
abnormal rise in prices. The rise in prices, in turn, brings an element of uncertainty into
trade and business. Uncertainty hinders economic progress.
7. Black money: Excessive supply of credit encourages people to amass money and wealth.
For this they tend to adopt underhand means and exploit others. To become rich, they
evade taxes, conceal income and wealth and thus, hoard black money.
8. Political instability: Over issue of credit leading to hyper-inflation leads to political
instability and even the downfall of government.

2.4. Credit Instruments and Contracts

2.4.1. Credit instruments

Credit plays a significant role in modern business and that part is represented by credit
instruments. Credit instruments are written or printed or typed financial documents that serve
either as promises to pay or as orders to pay. They provide the means by which funds are
transferred from one party to another. Some of the important credit instruments are:
1. Promissory note;
2. Bill of exchange;
3. Bank notes;
4. Credit cards;
5. Cheques and
6. Draft

Promissory note: The promissory note is the earliest type of a credit instrument. It is an "I.O.U."
(I owe you), a written promise by a debtor to pay to another person a specified sum of money by
an agreed given date, usually within a year with three days of grace. Such notes are issued by
individuals, corporations and government agencies. A promissory note is drawn by the debtor
and has been accepted by the bank in which the debtor has his account for it to be valid. The
creditor can get it discounted from his bank at a premium by paying interest till the date of
recovery. A promissory note can also be for a longer period.

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Bill of exchange or commercial bill: A bill of exchange is an order drawn by the creditor to the
debtor instructing the latter to pay a specified sum of money to the former, or to the bearer, or to
his nominee. The payment is to be made after some fixed date, usually 90 days with three days of
grace. The following steps are involved in the bill of exchange.
1. The bill is drawn by the drawer (creditor) and sent to the drawee (debtor) for acceptance.
The bill is accepted when the drawee puts his signature on the bill. If it is a firm, then the
stamp of the accepting firm is put on which; unauthorized person signs. Now the creditor
can discount the bill either with a broker or a bank.
2. The bill of exchange is a negotiable instrument which can be bought and sold by the
holder of the bill till the time of its maturity at the prevailing rate of discount (interest).
The discount rate is the market price of the bill. The higher the discount rate, the lower
will be the price of the bill at the time of discounting, and vice versa. After the date of
maturity, the holder of the bill presents it to the drawee who pays the amount written on
the bill.
3. The bill of exchange usually takes a form. There is also the foreign bill of exchange
which becomes due for payment from the date of acceptance. The rest of the procedure is
the same as for the internal bill of exchange. The difference between a promissory note
and bill of exchange should be noted. A promissory note is drawn by a debtor and
accepted by his bank, whereas a bill of exchange is drawn by a creditor and is accepted
by the debtor.

Bank notes: The central bank of a country issues currency notes. All notes carry the promise of
the governor of the central bank to pay on demand to the bearer of the note an amount mentioned
on it. Strictly speaking, a bank note is a currency and not a credit instrument.

Credit cards: A recent addition to credit instruments is the issue of credit cards by banks. Credit
card holders are allowed credit facilities by the concerned bank for a specified period of time
without any security from them. They can also purchase commodities and pay for services
without making cash payments. There are national and international credit cards.
Cheques: A cheque is an order on the bank, written by the drawer who has his deposit with that
bank, to pay on demand the stated sum of money to the person named in the cheque. A cheque
may be a bearer cheque or an order cheque or crossed cheque. The bearer cheque can be cashed
by the payee (whose name appears on the cheque) or by any other person who, holds it. The
responsibility of making payment does not rest with the bank. If it is an order cheque, the
responsibility of payment to the payee is on the bank. In the case of a crossed cheque, the
amount of the cheque must be credited to the account of the payee in his bank. The cheque is
crossed on the left hand side upper comer and the words "Payee's A/c only" are written there.

Draft: A draft, also called demand draft, is in the form of a cheque and is an order of a bank to
its branch in some other city for making payment of the amount specified in it to the person or
firm or organization. Besides receiving the amount of the draft, the bank charges a commission
for preparing the draft. The draft is handed over to the debtor who sends it to the payee. The
payee, in turn, presents it to his bank in that city to be deposited in his account. This is the
procedure in the case of a crossed draft. If it is not crossed, the payee presents it to the bank on
which it is drawn and receives the money after identification.

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2.4.2. Loan agreements

Loan agreement is a contract between a lender and a borrower. It specifies what is to be lent, the
conditions of loan and the respective responsibilities of each party. The loan agreement may also
be called a lender's agreement, borrower's agreement or loan contract. The type of a loan
agreement is important in that credit risk can be controlled by loan contracts. Loans are usually
classified into different types:
 Commercial and industrial loans: loans to large and small businesses. They may be secured
(collateralized) or unsecured, term loans or lines of credit.
 Sovereign loans: Loans made to foreign governments, usually in the form of syndicated loans
made by large, multi-national financial institutions.
 Consumer loans: Loans to individuals, including installment loans (e.g., auto loans) and
unsecured revolving lines of credit (e.g., credit card debt).
 Real estate loans: Commercial and residential mortgages.
 Other: Includes agricultural loans and loans to municipal governments.

All of these types of loans are subject to default (credit) risk. Whether or not a lender decides to
extend credit depends not only on the potential borrower’s risk but also on the
 terms of the loan
 lender’s ability to monitor the borrower
 lender’s ability to enforce restrictions on the borrower.

These determinants of credit risk depend on the legal provisions of the loan contract. In
summary, the contract contains numerous provisions whose purpose is to protect the lender’s
extension of credit. Let us outline the typical parts of a commercial and industrial loan agreement
and consider how the contract provisions help to control credit risk for a line of credit. It includes
five typical parts:
 Terms of loan
 Warranties
 Covenants
 Other requirements
 Events of default

Terms of the loan: The terms of the loan may include the following parts.
 Principal: Amount or maximum amount of the loan. This leads to high credit risk;
 Maturity: longer maturities increase credit risk;
 Take-down schedule: timetable for withdrawing funds;
 Interest rate: fixed or floating. The borrower’s spread over the base rate may vary
with the borrower’s current financial condition (e.g., leverage). Higher spreads
provide protection against default but can increase credit risk; and
 Pre-payment provisions and unused commitment fees: affects interest rate risk for
fixed-rate loans.

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Warranties: Warranty, in this context, is an element or statement of fact contained in a contract

which, if broken, does not invalidate the contract. The aggrieved party may, however,
claim damages. This part includes the following:
 Borrower guarantees financial statements are accurate;
 Borrower has good title to assets;
 Borrower is complying with law and not involved in litigation; and
 Borrower has filed for and paid required taxes.

Covenants: This includes positive and negative covenants.

 Positive covenants: These are actions a borrower agrees to take:
o Periodically furnish financial information to lender;
o Permit lender to audit any of the firm’s records;
o Promptly advise lender of changes in management or any event that materially
affects the firm’s financial condition;
o Maintain insurance on specified assets;
o Maintain certain balance sheet and income statement ratios; and
o Use all loan proceeds for specified purpose and conduct business in the same
manner as is now carried on.
 Negative covenants: These are actions borrower agrees not to take:
o Taking on additional debt or pledging its assets to creditors;
o Repaying loans from owners or shareholders;
o Merging with any other business;
o Limits on payment of dividends and manager compensation; and
o Selling assets/property except in normal course of business.

Other requirements: This may include the following issues

 Specific assets may be assigned as collateral;
 Specifying which state law governs the agreement; and
 Specifying how disputes will be settled (e.g., arbitration).

Events of default: Failure to make any principal or interest payment, abide by any covenant,
default on any other debt obligation, or file for bankruptcy triggers default on the loan.
Lender can then demand that any remaining principal and unpaid interest will become
immediately due. Lender can then sell any collateral and apply the proceeds to payment of
the loan.

2.5. Basics of Credit Analysis and Rating

2.5.1. Credit process

The credit process involves four steps:

1. Credit policy,
2. Business development and credit analysis,
3. Credit execution, and
4. Loan Review

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Credit policy: It is related to the loan culture of the community. Credit policies could be
categorized into three:
1. Values driven: Risk averse
2. Current profit different: High risk/return lending, cyclical profits
3. Market share driven: Low returns, large scale.

Business development and credit analysis: This involves the following:

 Marketing: Find customers.
 Loan interview: Meet potential borrower and evaluate for character and sincerity.
 Evaluation of business: Gather information about the borrowers business.
 Credit analysis: Numerical analysis of a business’s financial condition. Credit
analysis can be conducted by employing different methods including credit scoring
models, other score used for consumer credit, and 5 C’s of credit.
 Evaluation of collateral adequacy: Check whether collateral that backs loans is of
value commensurate with loan.

Credit execution: It requires documentation (loan agreements and restrictive covenants,

perfecting claims to collateral) Parts of a typical loan agreement include the following:
 The Note: Specifies the principal and the interest and the timing of repayment.
 Collateral: Specifies assets assigned and terms under which lender takes possession of
assets.
 Covenants
 Borrower Guarantees
 Events of default: Exact conditions under which a loan is considered in default.

Credit review: It is related to monitoring of covenants, loan review process (involving ex post
evaluations of lending), and loan workout (process for dealing with defaulting creditors).

2.5.2. Credit analysis

A credit analysis is a process that creditors use to determine whether an applicant should be
permitted to borrow money, either in the form of a loan or the generation of debt. In cases where
creditors are in favour of issuing credit, this process can also be used to determine how much
credit to grant. Such processes are used to determine the creditworthiness of both individuals and
businesses. Any entity that is interested in receiving credit or a loan can be subject to a credit
analysis. The purpose of this process is to assess whether or not a potential borrower can afford
to repay the debt and whether he is likely to do so. This determination is often made by a credit
analyst or a credit analysis department.

There are a number of items that are usually reviewed in a credit analysis. One of them is
income. A creditor almost always wants to know about a borrower's sources of income and the
amounts that are received. Even if a borrower appears to have enough income to cover the
amount of the payment installments, credit can be denied. This is because the borrower may have
too much existing debt. A credit analysis also commonly considers expenditures. Creditors
generally assess what debts a potential borrower is responsible for. A borrower may have a large
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income, but if a large portion of it is needed to make payments to existing creditors, this can be
viewed as reducing the chances of repayment for other lenders.

Numerous factors influence the creditworthiness of a farmer. Credit managers usually talk of the
seven C's of credit: character, capacity, collateral, capital, condition, courage, and competition.

1. Character:
Character or integrity is the most important factor of confidence. The first step in selling one's
credit to a lender is to be honest in all business and personal dealings, because the confidence
factor is vitally important.

2. Capacity (to pay):

Risk-bearing ability measures whether the farm operation can withstand financial losses without
being forced into liquidation or insolvency. If production and prices decline and losses occur,
they must be absorbed or covered by equity capital or net worth. The basic document used to
measure the risk-bearing ability of the farm business is the balance sheet. The key ratios used in
the analysis of risk-bearing ability are those related to total assets, or debt to equity. These ratios
show the proportion of the business financed with debt compared to owner's equity.

3. Collateral (or guarantee):

Collateral security is any security (other than personal security such a guarantee) taken by a
bank or lender when it tends to make an advance to a borrowing customer, and which it is
entitled to claim in the event of default. Hence, the presence or absence of collateral matters to
get credit.

4. Capital (or repayment capacity):

Capacity is the money you personally have invested in the business and is an indication of how
much you have at risk should the business fail. A lender wants to be paid in cash; he has little
interest in repossessing the security or collateral as satisfaction of the debt obligation. The ability
to repay a loan is consequently an important determinant of whether credit should be extended
and is influenced by the income-generating capacity of the business; the liquidity of the farm as
indicated by the balance sheet, and the cash flow of the firm. In short run an indication of
repayment capacity is that if current assets are not sufficient to pay current liabilities a repayment
problem will very likely occur as an indication of repayment capacity in short run. In long run
the key issue is whether there is sufficient revenue after paying for operating expenses, family
living, and farm expansion to repay any debt obligation.

5. Condition (or return):

It is a combination of all the relevant facts about an agribusiness firm and its situation in the
existing economic environment. The basic question with respect to returns is whether or not the
use of credit will add to potential profits. Only if the profits of the business will be increased will
there be additional income available to make principal and interest payments on the borrowed
capital. Two questions are of interest in evaluating income or returns. The first is the issue of
whether the planned use of credit is the most profitable use in the farm business. The second
question with respect to the returns is whether the farm business is generating an adequate
income to compensate for contributions of family labor and management as well as for equity

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accumulation. The profitability of the entire farm operations must be evaluated to assess the
possibility of income generated from profitable enterprises to cover losses on unprofitable ones.

6. Courage:
This is the courage of the credit executive when faced with a difficult decision making situation.

7. Competition:
The extent of competition to extend credit also matters to get credit. If there is no sufficient
number of competitors involved in the financial market (in credit extension), getting credit may
be difficult and vice versa.

The following are the major sources of credit information:

 Financial statement
 Bank references
 Expenditure of the firm
 Trade checking
 Credit rating organizations.

2.5.3. Credit scoring and risk rating

One of the most important methods of detecting creditworthiness of a borrower is credit rating.
This method of studying borrower’s creditworthiness depends of some bases of credit. The study
of a borrower is very essential for considering an advance. If the borrowers are good, chances are
that a bank's advance will be safe. For this purpose, the principles or bases of credit explain the
qualities of a borrower. For credit decisions these qualities explained by the 7 C’s must be
studied. However, most credit rating institutions use the ‘three C’s’ of credit: character, capacity
and capital.

Credit scoring or credit rating refers to an evaluation of the soundness of an individual or

business firm as a credit risk. In many developed and some developing Asian countries, there are
a number of specialized agencies which collect status reports on businessmen. The job of these
agencies is to collect information on a full-time basis on the business from all possible sources.
They get information from various sources like market report, private agencies reports,
newspapers, etc., and sift, analyze, arrange and incorporate the information so obtained in their
periodical reports. These reports are available to their various subscribers. Naturally, information
so supplied is a source of strength to bankers, lending institutions - business houses. They do the
full-time job of collecting credit information on businessmen and supply the same to their
customers.

In order to get a clear picture of the borrower’s credit rating, a lender will have to make inquiries
about the borrower's trend experience and his assets and liabilities from various sources. The
study of his account can throw light on his personal habits and his business dealings. If he has
accounts with other bank/banks, status reports from them should also be sought. In addition to
his financial statements, income-tax returns also have to be seen. If any clarification is needed,

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an interview with the borrower should be arranged to get more information on his credit
worthiness.

2.6. Information Asymmetry and Credit Risk Management

Asymmetric information in financial markets can adopt any of the following forms:
 Adverse selection,
 moral hazard, or
 monitoring costs.

A lender suffers adverse selection when he is not capable of distinguishing between projects with
different credit risk when allocating credit. Given two projects with equal expected value, the
lender prefers the safest one and the borrower the riskiest. In this context, those undertaking
risky activities find it convenient to hide the true nature of a project, thereby exploiting the
lender’s lack of information. By moral hazard we mean the borrower’s ability to apply the funds
to different uses than those agreed upon with the lender, who is hindered by his lack of
information and control over the borrower. As in the moral hazard case, monitoring costs are tied
to a hidden action by the borrower, who takes advantage of his better information to declare
lower-than-actual earnings.

Before continuing, we need to highlight the differences between these three types of asymmetric
information. Adverse selection appears before the lender disburses the loan, in contrast to moral
hazard and monitoring costs. In these cases the problem takes place after having conceded the
capital. In adverse selection and monitoring costs the borrowers are assumed to have previously
chosen the project, while in moral hazard they can opt for a different project once in possession
of the funds.

Table 1: Project properties and asymmetric information

Project type Before disbursement After disbursement
Pre-determined project Adverse selection Monitoring costs
Choosing between projects Moral hazard

Information asymmetry is asymmetric distribution of material information which could be

influential in decision making by both parties to the loan agreement. Asymmetric information
creates problems in financial markets both before the transaction is closed (adverse selection)
and after the transaction has been closed (moral hazard).

Adverse selection occurs when bad credit risks (firms which have poor investment channels and
high inherent risks) become more probable to acquire loans than good credit risks (firms with
better investment opportunities and less inherent risks). Because of information asymmetry,
lenders tend to have a hard time differentiating between good credit risks and bad credit risks,
and demand a blanket premium over and above the existing rates as compensation for the risk
arising out of the inability to determine who indeed should be lent to. This causes the good firms
to stop borrowing from such a lender because the high rates have devalued their strong credit
history while the bad firms become very eager to borrow from such a lender because they know

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for sure that judging by the strength of their cash-flows, they should be charged an even higher
interest rate. As a result, lenders end up with a loan portfolio comprising almost entirely of bad
credit risks.

Moral hazard occurs after the money has been disbursed to the borrower and it arises out of the
fact that the borrower may have an incentive to breach the loan covenants by investing in
‘immoral projects’ which are unacceptable in the eyes of the borrower because inasmuch as they
have a high possibility of gain to the borrower, they also have a high possibility of failure which
will have the most detrimental effect on the lender. Information asymmetry once again causes
moral hazard because of the lender’s lack of knowledge about the borrower’s activities. Moral
hazard also occurs as a result of high enforcement costs of the debt covenants. In this instance,
the lender simply decides that it’s not worth the effort to keep on chasing after borrowers and
have them invest the money in stipulated projects – giving them a freeway to invest in high risk
ventures.

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3. AGRICULTURAL VALUE CHAIN FINANCE

3.1. Framework of Value Chain Finance

The flow of funds to, and among, the various links within a value chain comprises what is known
as value chain finance. Value chain finance makes use of the business relationships among the
value chain partners (who are interdependent but share business information), and in this way
reduces performance, market and credit risks. Thus, the partners that the farmers regularly do
business with, such as input suppliers and buyers, provide or facilitate credit to the farmers.

Figure 5: Value chain finance (VCF) framework

Source: The Word Bank (2011).

Value chain finance recognizes that smallholder farmers are part of the network of input traders,
buyers, agro-processors, warehouse and service providers, distributors, retailers and consumers.
Credit is provided through the value chain, principally guaranteed by the anticipated sale of the
crop in the future. Financial institutions can become involved when they finance one end of the
value chain, which then channels funds to the other links (internal value chain finance), or they
can finance value chain partners directly (external value chain finance). However, value chain
financing is most visible in export crops, such as cotton, coffee, cacao, rubber, and cashews.
These are all high-value products that undergo substantial industrial transformation, are subject
to tight quality controls, and are distributed worldwide, with few local consumers. The term
“value chain finance” covers many different concepts and modalities of financing.

The most important types of VCF and their descriptions are summarized in the following
sections:
 Contract farming,
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 Outgrower schemes,
 Warehouse receipt (WR) finance,
 Credit guarantees,
 Value chain intermediation,
 Agricultural factoring and trade receivables, and
 Trade credit.

3.2. Contract Farming

A trader, exporter or agro-processor establishes pre-harvest purchase contracts with selected

farmers or their representatives (an association or cooperative). This involves forward
contracting of the crop (the price or pricing formula is fixed). The main motivation is to secure a
supply of produce, of a certain quality and at a specified time. Technical support to ensure
quality may be part of the contract. Product standards are agreed to beforehand. As part of the
forward contract, farmers receive partial prepayment. A bank can also be involved through a
triangular arrangement (the sales contract becomes the surety). This arrangement nearly always
concerns seasonal credit only. A special case is pre-harvest credit provided to cooperatives,
enabling them to buy goods from their members. Pre-finance usually has a maturity of only
several weeks.

Figure 6: Examples of contract farming through farmers’ associations

Value chain finance, in particular the financing of contract farming and outgrower schemes, is
attractive to banks and MFIs because of:
1. Quasi certainty that farmers have a market and distribution channel. The close
relationship between farmers and buyers, with or without a contract, becomes an element
of loan surety. The mere fact of being in the value chain hugely adds to the farmers’
creditworthiness.
2. Technical advice provided to farmers in contract farming, and outgrower schemes in
particular, which reduces performance risk (harvest failure or below standard crop).
3. Reduced loan transaction costs:
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a. Much lower loan appraisal costs, since appraisal is mostly done by the value chain
partners, who also help with loan monitoring.
b. Much lower loan disbursement and recovery costs, because the lenders are
dealing with only a few value chain partners who facilitate or directly distribute
loans to farmers.
c. As value chain partners usually provide part of the credit in kind, the risk that the
loan will be diverted for other purposes is reduced.
d. Easy loan repayment (via the buyers in the value chain) when the harvest comes
in.
4. The key value chain partners tend to be well-established and well-known to the bank.
Through their credibility, they can facilitate bank and MFI financing to farmers, by
vouching for “their” farmers. In some cases, buyers provide collateral for loans on behalf
of the farmers.

3.3. Outgrower Schemes

An outgrower scheme is an elaborate contract-farming arrangement emanating from a nucleus –a

lead farm or processor — which gives outgrowers access to its marketing, operational and
logistical capabilities. Technical support may be provided to the outgrowers. Loans may include
investment financing (e.g. in trees and equipment). Outgrower schemes are most common in
high-value, specialty crops with niche markets.

Outgrower schemes are a specific type of contract farming, often long-term. Outgrower schemes
often evolve around a lead farm, the nucleus, which expands its production by asking
smallholders in the vicinity to grow the same crop as the nucleus farm does (e.g. tobacco in
Ethiopia and Malawi, pineapples in Ghana, rice in Tanzania). Outgrower schemes also exist in
animal production (i.e. chicken breeding). In other cases, the nucleus is not a farm but an agro-
processing company/cum exporter.

Even supermarket chains establish outgrower schemes. Typically, the nucleus firm provides the
outgrowers with all they need, such as inputs, technology, credit, and of course a market.
Investment financing, however, is usually left to the banks and MFIs. The outgrowers bring their
labor and land, but they are not just employees in disguise. The outgrowers continue to bear the
harvest risks, even though the lead farm helps them mitigate these risks, and they are paid based
on their performance.

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Figure 7: Simple outgrower scheme

The reasons for a nucleus farm (or firm) to involve outgrowers are:
1. To meet demand or to expand.
2. To secure a regular and quality supply, by organizing and binding smallholders through a
“package” of services (helping them to overcome technical problems in the upstream
value chain).
3. Expansion via outgrowers is faster (less need for capital investment).
4. Downstream processing margins are better than with primary agriculture.
5. Outgrowers work more cheaply than in-house hired labor and land.
6. Risk diversification.
7. Social development aims (e.g. Fair Trade products).

The advantages to the outgrowers are that they gain access to:
1. New, better or more secure markets, often at good prices.
2. Inputs of the right quality, on time and via credit.
3. Practical technical advice.

The above factors help outgrowers increase production, productivity, quality, and often prices,
hence their income. Note, however, that the cost of these advantages is factored into the product
pricing offered by the nucleus.

Risks to be dealt with in outgrower schemes are:

1. Performance risk (due to weather-related harvest loss, diseases, quality of inputs) and
side-selling. In a well-publicized outgrower scheme, harvest insurance is provided in the
form of index-based.
2. Market risk (prices for inputs and final sales prices for the produce; exchange rate risk).
3. Credit risk. Credit may come through the nucleus (internal) or directly from a bank/MFI
(external). Internal credit through the nucleus firm exposes this firm to credit risk from its
outgrowers. However, in case of external credit, the bank/MFI may seek guarantees from
the nucleus.
4. The outgrowers may be caught in a quasi-monopolistic and exploitative relationship. This
risk is highest when the outgrowers are relatively resource poor and risk averse.

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The key factors leading to successful outgrower schemes are the same as those listed for
successful value chain finance.

3.4. Warehouse Receipt Finance

Products stored in a certified and secured warehouse serve to guarantee credit, to be used for the
next harvest or other purposes (post-harvest finance). This way, the farmer has more flexibility in
timing the sale of products, thus benefitting from inter-seasonal price increases. Also, if products
are tested and graded, their value may increase. This arrangement concerns seasonal credit
because the farmer will probably want to sell the crop and repay the debt before the next harvest.

Warehouse receipt finance has long existed in grain-producing countries in Northern America
and the former Soviet Union. In fact, it was already being practiced in pre-Medieval societies.
Warehouse receipt finance was rediscovered some 15 years ago in Eastern Europe, but is now
being introduced in Africa as well. It is applicable to agricultural commodities that can be stored,
such as grains, coffee, cotton, wool or potatoes. The farmer delivers the grains to the (certified
and secured) elevator for storage. The farmer subsequently hands the warehouse receipt to the
bank as collateral for credit — often 70%-80% of the value in storage. Upon selling the product,
the farmer notifies the bank, which obtains repayment from the buyer in return for the warehouse
receipt. The buyer now presents the receipt to the warehouse to retrieve the product. The bank
transfers the balance (minus the loan amount + interest) to the farmer. Default rates in warehouse
receipt finance tend to be low — the borrower (producer) repays the loan with earnings from the
sale of the product. Warehouse receipt finance is a self-liquidating loan product.

Figure 8: Warehouse receipt finance

Warehouse operators store all the produce received from all farmers in one silo, thereby losing
track of its origin. However, since farmers offer products of varying quality, products must first
be tested and graded upon receipt, and stored accordingly. Warehouse receipt finance is most
applicable to non-perishable commodities, such as grains, coffee and cashews. However,
warehousing is also possible for some fruits, vegetables, and even meat. Meat packing plants in
Mongolia employ certified staff who grade beef in three categories and store it throughout the
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winter. Companies without freezing facilities (e.g. restaurants, shops) store their meat alongside
the factories and the individual carcasses cannot be traced back to their original owners.

The key innovation in warehouse receipt finance is that it solves a financing and collateral
problem. It offers the bank a safe and liquid collateral asset, which is easy to monitor. However,
warehouse receipt finance is a post-harvest financial product, applicable only when the farmer
has already completed a harvest cycle. Therefore, the initial harvest cycle must be financed with
the farmer’s own funds or other credit resources.

Table 2: Advantages and disadvantages of warehouse receipt finance

Smallholder Financial institution Trader or Processor
Advantages Higher price due to better Outreach to smallholders Reliable, on-time
timing, storing, grading, bulking Safe way to finance supply
and sometimes pre-processing. agriculture in large, consolidated
Grading gives incentive to (provided bona fide quantities
improve quality warehouse) Quality grading,
Reduced crop losses as Very liquid collateral, certification and
warehouse has better storage simple foreclosure weighing
conditions than the farmer does Simple monitoring. Mostly dealing with
Establishes credit history warehouse, not
for the smallholders
farmers individually
Disadvantages Full payment not made directly Transaction costs (but Cost of storage and
upon harvest (allowing for these can be reduced if intermediation by
periodic sales that optimize dealing with farmers’ warehouse
pricing) associations)
Cost of storage, conditioning, Not a solution for
losses in storage investment loans
Only works when the first cycle
was already financed somehow
Risks Product spoilage, fraud and Price decrease in storage Contract enforcement
theft No end buyers
Price decrease in storage. Side-selling (out of
Governance issues if storage)
involvement of farmers’ Default by warehouse
association/coop. (sells or loses the pledged
Weak or fraudulent warehouse crop, or issues fake
management, including fake receipts)
receipts

The advantages for collateral-constrained farmers are many:

1. Farmers are not under pressure to sell immediately after the harvest, when all other
farmers are selling and prices are low. Thus, warehouse receipt finance lets farmers
decide the best time to sell the crop, benefitting from in-year price changes. This
increases the farms’ income and helps with cash flow planning.
2. The farmers’ negotiation position versus the traders is improved, because agricultural
traders can no longer dictate the terms for cash-strapped farmers desperate to find a
buyer.
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3. In addition, if farmers collaborate on marketing, the stockpiling of the crop in the

warehouse increases the farmers’ collective bargaining position and lets them reap scale
advantages, which support the price.
4. Furthermore, the fact that the product is tested, graded and certified nearly always
increases its value (e.g. opens up export markets). Graded products can be traded on
commodity exchanges, which greatly increase the competitiveness and transparency of
the sales process.
5. Also, the value chain may be strengthened as a market for durable-product storage is
created, crop losses are reduced, incentives are created to produce quality, and standards
for weighing and grading agricultural produce are established.
6. Consumers may benefit as seasonal price fluctuations are reduced.

For successful warehouse receipt finance, a number of key conditions must be met:
1. Like other types of value chain finance, warehouse receipt finance requires an enabling
legal environment, notably secure ownership rights (of the products in storage),
bankruptcy law, transferability of title documents (including warehouse receipts as
documents of title), and efficient dispute settlement among parties.
2. The policy environment must also be conducive.
3. The availability of reliable (secured and certified) warehouse facilities, including testing
and grading capacities, is a precondition because the whole system depends on their
credibility.
4. The role and capacity of the warehouse operator is fundamental. The warehouse acts as
an inspection company (quality, quantity), and establishes tripartite collateral
management agreements involving banks, borrowers and itself as collateral manager,
which allows farmers to get bank credit. The model depends on the credibility of the
collateral manager (the warehouse operator).
a. This credibility can be reinforced when warehouses are suitably regulated and
supervised. Licensed warehouses should meet and maintain standards for physical
facilities, capital adequacy, liquidity, managerial qualities, and insurance.
b. Warehouses should be subject to unannounced visits by “examiners”, who are
responsible for enforcing the law and who can suspend or revoke a warehouse
license.
c. Crop-handling staff at the warehouses (weighers, samplers and graders) must also
be individually licensed to carry out their duties.
d. Commodities are graded to national or international standards.
5. Due to the costs involved, the scale of operations must be quite large. Overall, warehouse
receipt finance requires a relatively sophisticated legal and economic environment, the
absence of which appears to have been a problem in the trials.

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3.5. Credit Guarantees

Credit guarantees can be provided to banks and MFIs to encourage them to finance agriculture.
Credit guarantees work well when:
1. We are dealing with good farmers who use adequate technology, have good markets, and
who have good loan proposals (projects that will generate cash flow).
2. We are dealing with well-performing and well-capitalized banks/MFIs.
3. The lending decisions are made by well-trained bank/MFI personnel with agricultural
knowledge.
4. The bank/MFI has efficient risk-management procedures.
5. And because of all the above, the bank/MFI is eager to finance agriculture — the farmer
just lacks the collateral to satisfy the risk-management requirements of the bank/MFI.

Regrettably, these conditions are often not met. Many agricultural credit-guarantee funds have
been left underutilized because banks have found many reasons other than lack of collateral not
to finance farms. Banks found agriculture to be too risky even with guarantees, or the procedures
of the credit-guarantee program were considered too cumbersome, or the guarantee fee was too
high, or the guarantee fund itself refused clients proposed by banks. A critical issue is the amount
guaranteed: when set too low, banks will not find it practical, and when set too high, banks will
not be motivated to collect the debt. High guarantees may also lead to “moral hazard” as
borrowers decline to repay, knowing that their loan is guaranteed regardless.

It is observed that credit guarantees are too easily embraced by banks, clients and aid donors as a
solution for everything. However, credit guarantees do not reduce the risk of an agricultural loan
— irrigation facilities, drought resistant seeds or mechanization would. Credit guarantees just
provide the lender a partner to share in the financial risk, and this is useful when the borrower
does not offer the adequate collateral.

Thus, the key elements in successful agricultural-credit guarantees are:

1. The instrument focuses on resolving the constraints on collateral only. All the other
pieces of the credit puzzle should be in place (market, technology, agricultural potential,
etc.), making the bank eager to work with this particular farmer if only the collateral can
be sorted out. Guarantees cannot work when the default risk is high.
2. In any agricultural credit scheme it is essential banks not to be freed from their normal
due diligence in credit assessment, and the instrument should be structured accordingly.
3. Guarantee procedures must not be burdensome (preferably through a portfolio approach)
and compensation swift, otherwise banks will decline to use the instrument.
4. Practice shows that it is extremely difficult to establish sustainable agricultural credit-
guarantee funds (which cover operational costs and losses of fee income). However, at
the very least, the guarantee program must be designed to foster specific improvement in
agricultural performance, thus offering a social justification for its implicit or explicit
subsidization.

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3.6. Value Chain Intermediation

There is a special type of value chain finance where an intermediary, which is not itself a value
chain partner, facilitates the process for all parties. They develop a technology platform allowing
them to act as intermediary between finance providers, farmers, input suppliers, and buyers. It
combines elements of value chain finance and microfinance. The main objective of
intermediaries is to simultaneously address credit and market limitations by integrating both into
one approach. They may have two features: 1) cashless microfinance; and 2) an integrated
marketing and payment system.

Figure 9: Value chain intermediation, the case of DrumNet in Kenya

Farmers organized into farmers’ groups sign a supply contract with a buyer, which could be an
(export) trader, supermarket or agro-processor. Usually, the intermediary negotiates the contract
on the farmers’ behalf. The price and supply conditions are set. With the contract in hand, the
farmers’ group obtains financing from a bank or MFI. The bank or MFI disburses the money to
certified input retailers (with agreed upon quality standards), who release the inputs to the
farmers. At harvest, the product is certified and sent to the buyer, which triggers a payment in
favor of intermediary. The intermediary then pays off the bank and gives the remainder (minus
its fees) to the farmers.

This is essentially contract financing, but with the innovation that an independent party sits in the
middle, and manages the process through a master contract. The fact that farmers receive their
loans in kind and that the loan repayment is withheld from harvest receipts reduces risk to the
bank. Transaction costs are reduced via the intermediary, which aggregates financing, technical
advice, input supply and marketing. Risk is also reduced due to technical advice and access to
premium markets. Nevertheless, the intermediary faces the usual business risks, such as partner
non-compliance (including banks) and harvest failure, which make loan repayment impossible.

3.7. Agricultural Factoring and Trade Receivables Finance

Another interesting example involves agricultural factoring. Factoring is a financial transaction

in which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at
a discount. In "advance" factoring, the business owner sells his receivables in the form of invoice
to the factor, who makes an advance of 70-85% of the purchase price of the receivable amount.
The factor collects the full amount from the customer in due course and pays the balance amount
due to the business owner after deducting his commission and other charges. In "maturity"

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factoring, the factor makes no immediate advance on the purchased accounts; but sees to it that
the customer pays the invoiced amount within the stipulated time i.e. on maturity. However, if
the customer fails to make payment within the stipulated time e.g. 30 days, the factor makes
payment to the client and proceeds to collect the payment from the customer.

Invoice discounting and factoring are completely normal financial services in developed markets.
However, such services are unusual in developing countries and in agriculture in particular.
Experiences in Kenyan smallholder tea farmers show that it took them a long time to be paid for
their tea, which was because the processors and exporters were in turn kept waiting by their
international clients. Farmers were often forced to sell tea to local traders at unfavorable prices to
get quick cash. A factoring solution was devised as depicted below. The factoring company
advances farmers 70% of the value of tea delivered to the Mombasa tea auction, and charges
2.5% interest per month for its service. The tea auction repays the factoring company directly,
which is stipulated in a memorandum of understanding signed by all parties involved. It is noted
that the tea processor has offered its assets as collateral, partly on behalf of the farmers.

The model was developed by Biashara Ltd. with support from the Gatsby Trust. It has also been
introduced in other sectors, such as cotton and fish. Evidence shows that similar practices of
factoring or trade receivables discounting in agricultural exports are quite developed in Latin
America. The innovation here is the payment and security mechanism.

Figure 10: Factoring by Biashara in the tea sector in Kenya

Factoring, trade receivables finance, invoice discounting and forfeiting are of interest when:
1. Payment terms are long (mostly due to shipping times), which is common with export
commodities.
2. The product is (physically) secured and the buyer is considered creditworthy.
3. The product is (ideally) non-perishable.
4. The legal and regulatory framework allows for this form of financing and covers the
credit provider in case of default.

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3.8. Trade Credit

This is credit by input suppliers or buyers such as traders or processors. Farmers receive credit
from input suppliers, intermediary traders and shops, or agro-processors, pledging to repay from
future harvest income. Typically, this does not directly involve a bank, and the agreement is
usually informal and based on trust. Trade credit is often provided in-kind (seeds, fertilizers,
consumption goods), and payment is made in kind as well (final produce). Such arrangements
nearly always concern seasonal credit only. The cost of credit (interest) is embedded in the
agreed prices for inputs and outputs, and may be quite high.

Figure 11: Illustration of trade credit, including export financing through L/C (cashew)

In most cases, the arrangement with the farmers is informal, yet secured by mutual trust and
long-established relationships between local traders and farmers. Whereas in the above example
credit flows upstream to farmers, the opposite happens as well. Thus, specialized input traders
advance seeds to farmers expecting to be repaid after the harvest. In dairy farming, it is perfectly
normal for farmers to be paid every two weeks, meaning that farmers are pre-financing the dairy
factory. Similarly, agricultural products are sold on consignment through supermarkets, with
delayed payment – meaning that farmers carry the shops’ inventory cost.

3.9. Key Points in VCF

Value chain finance adds to the traditional “Cs” in credit appraisal (character, capability,
conditions in the economy, capital, cash flow, collateral) some new Cs, namely “commodity”
and “contract”. The farmers’ participation in a value chain with quasi-certain sales reduces
performance and credit risk. The bank or MFI has better information on what the farmer is going
to produce, to whom he/she will sell, and when cash income is to be expected.

The main risks and weaknesses in value chain finance are:

1. Harvest failure or sub-standard products, meaning that the farmer cannot deliver the
products required for credit repayment. However, value chain finance often includes
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technical advice and training for farmers, along with delivery of quality seeds, fertilizers
and pesticides, which reduces harvest risk. Agricultural insurance may also be included in
the package of value chain services.
2. Side-selling, outside of the agreed to value chain partners, and intentional loan default by
farmers. This risk is mitigated in narrow value chains with relatively few buyers. Buyers
may agree among themselves not to accept side-selling by farmers who are under
contract with someone else. However, other value chain partners (and banks) can just as
well shirk their obligations. Value chain finance is most effective when all partners
benefit from playing by the rules.
3. Value chain finance does not offer a solution for investment financing. Only in outgrower
schemes are investment loans common.
4. Farmers may not always get a “fair” deal, in particular when buyers have the upper hand
in the value chain due to the lack of competition and the lack of market information
available to farmers.

The key elements to successful value chain finance are the following:
1. Value chain finance works best when all value chain partners have an interest in
maintaining the chain relationship, in particular in integrated (cash crop) sectors
where parties are willing to sign exclusive off-take and supply contracts, and when
technology standards are high.
a. Farmers get access to inputs and credit on convenient and favorable terms,
have guaranteed markets, and receive attractive prices.
b. Buyers secure farm products of the right quality and price on time.
2. In practice, value chain finance is most suitable for value chains that are relatively
long and complex because all value chain partners then need each other (little to gain
from side-selling).
a. With emerging globalization and urbanization, most agricultural value chains
are becoming longer and more complex.
b. Also, Fair Trade certified and organic products are suitable for value chain
finance because the farmer needs the buyer to unlock the Fair Trade premium,
and the buyer needs the farmer to fulfill his own forward obligations.
3. Price and credit conditions must be transparent and fair, otherwise side-selling will be
unavoidable.
4. Farmers need access to a “package” of technical assistance and financial services, so
as to attain quality and certification standards, which must be part of the value chain
finance design. The key problems in smallholder farming are often non-financial in
nature. Farmers lack technical knowledge, inputs and equipment, post-harvest
management, market information, face inefficient distribution and, as a consequence
of all this, lack access to finance.
5. Due to the complexity of value chains and finance, farmers best interact with the
value chain and negotiate finance arrangements through a representative organization,
such as a cooperative.
6. Key to value chain finance is an enabling legal environment, including clear
ownership rights, bankruptcy law, transferability of title documents, and timely and
efficient dispute resolution.

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The key difference between “new style” value chain finance and the forms practiced in the 1960s
and 1970s is that these are now introduced by the private sector, not by state-controlled entities.
Private traders, retailers, agro-processors, storage providers and distributors contract with
smallholders, banks and with each other to serve each other’s business interests, including credit.

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4. AGRICULTURAL RISK ASSESSMENT AND MANAGEMENT

Risk and uncertainty are ubiquitous and varied within agriculture and agricultural supply chains.
This stems from a range of factors including the vagaries of weather, the unpredictable nature of
biological processes, the pronounced seasonality of production and market cycles, the
geographical separation of production and end-uses, and the unique and uncertain political
economy of food and agriculture sectors, both domestic and international. However, the impacts
of realized agricultural risks are not peculiar to farmers alone. The companies and service
industries that supply the farmers, the processing and logistics companies that move the produce
from farm to the markets (that is, the wider supply chain), and ultimately the consumer all suffer
to one extent or another.

Agricultural risks can range from independent (for example, localized hail losses or an individual
farmer’s illness) to highly correlated (for example, market price risk or widespread drought).
Managing risks in agriculture is particularly challenging, as many risks are highly correlated,
resulting in whole communities being affected at the same time. Given the widespread nature of
resultant loss, financial recovery is particularly difficult and challenging. For governments, the
fiscal implications of social safety net payments or the rebuilding of damaged infrastructure can
be serious. For farming communities, there is often no other option than to sell assets, normally
at distressed prices.

4.1. Farm-level Risks and Constraints

Risks faced by farmers are numerous and varied, and are specific to the country, climate, and
local agricultural production systems. The key risks faced by farmers are shown in Table 3.

Table 3: Key risks faced by farmers

Risk Examples/Factors Effects
Weather risks Rainfall or temperature Lower yields, loss of
variability by extreme events productive assets or income
Biological risks Pets, disease, contamination Lower yields, loss of income
Price risks Low price, market supply and Lower price, loss of income
demand, volatility,
Labor and health risks Illness, death, injury Loss of productivity, loss of
income, increased costs
Policy and political risks Regulatory changes, political Changes in costs, taxes,
upheaval, disruption of market access
markets, unrest
Source: The World Bank (2011).

Additionally, farmers face constraints that do not enable them to either improve or increase their
production and revenues. Examples of such constraints are
 limited access to finance,
 dislocation from markets,
 poor access to inputs,
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 lack of advisory services and information, and

 poor infrastructure (for example, irrigation or rural roads).

These constraints are generally worse in low-income countries, where public goods and private
sector service delivery are often poorly developed. The importance of noting the difference
between a risk and a constraint is that often the latter are a function of the former. For example,
many argue that access to finance (in terms of both cost and availability) for farmers in
developing countries would improve if the potential financiers were able to be assured that the
risks inherent with agricultural production had been managed, thereby reducing their repayment
risk.

Of course, many constraints are often not driven by one underlying risk alone. Taking access to
finance as an example, even if the underlying weather risk is managed through the purchase of
an insurance product or installation of irrigation, this still leaves the financier running a number
of risks. For example, the farmer may simply sell the product and not repay the bank, or prices
may fall to such an extent at harvest that the revenue is insufficient to repay the loan amount, or
perhaps the crop was destroyed by locusts and there was no crop left to sell at the due repayment
date. The issue of the existence of multiple risks in agriculture should be well noted. Often, the
apparent management of one major risk leaves stakeholders (although rarely the farmers) with
the impression that the overall risk profile has been managed. However, this is often not the case;
even when farmers and their partners have managed their own direct risks, indirect risks can
cause losses. Even though farmers and the supply chain they are involved with may have well
managed this risk and their crop is free of diseases, they will suffer from the country’s market
access restrictions. Even if a farmer has managed contamination risks in his own basket of
goods, should the processor fail to control its crop collection or processing activities correctly,
then the farmer may well suffer due to the exclusion of the processor from the market (there
being no other buyer for the farmer’s produce). Therefore, consideration of risk throughout a
supply chain enables a more comprehensive assessment and management of risks.

4.2. Supply Chain Risks

Supply chains facilitate the flow of physical products, finance, and information. An agricultural
supply chain encompasses all the input supply, production, postharvest, storage, processing,
marketing and distribution, food service, and consumption functions along the “farm to fork”
continuum for a given product (be it consumed fresh, processed, or from a food service
provider), including the external enabling environment. These functions typically span other
supply chains as well as geographic and political boundaries and often involve a wide range of
public and private sector institutions and organizations.

The underlying objective of agricultural supply chain management is to provide the right
products (quantity and quality), in the right amounts, to the right place, at the right time, and at a
competitive cost—and to earn money doing so. Logistics and communications are embedded in
all of these flows, and poor logistics and communications are often major constraints that can
exacerbate underlying risks in many agricultural supply chains. For governments, there may be
broader objectives involved, especially where the supply chain is especially strategic for trade or
critical in the domestic food system. Risks within the supply chain are shown in Table 4.

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Table 4: Major risks in agricultural supply chains

Type f risk Examples
Weather Periodic deficit or excess rainfall, varying temperature, hail storms,
strong winds
Natural disaster Major floods, droughts, hurricanes, cyclones, earthquakes, volcanic
(including extreme activity
weather events)
Biology and Crop/livestock pests and diseases; contamination caused by poor
environment sanitation, humans, or illnesses; contamination affecting food safety,
natural resources/environment, or production and processing
Market Changes in supply or demand that impact domestic or international
prices of inputs or outputs; changes in demand for quantity or quality
attributes, food safety requirements, or timing of product delivery;
changes in enterprise or supply chain reputation and dependability
Logistics and Changes in transportation, communication, or energy costs; degraded
infrastructure or undependable transportation, communication, or energy
infrastructure; physical destruction, conflicts, or labor disputes
affecting transportation, communication, energy infrastructure, and
services
Management and Poor management decisions; poor quality control; forecast and
operations planning errors; breakdowns in farm or farm equipment; use of
outdated seeds; lack of preparation to change product, process,
markets; inability to adapt to changes in cash and labor flows
Policy institutions Uncertain monetary, fiscal, and tax policies; uncertain regulatory and
legal policies or enforcement; uncertain policies on trade, market, or
land and tenure systems; governance-related uncertainty; weak
institutional capacity to implement regulatory mandates
Policy Security-related risks; uncertainty associated with sociopolitical
instability within a country or in neighboring countries; interruption of
trade due to disputes with other countries; nationalization or
confiscation of assets

Given the complexities of agricultural supply chains and the products that they work with, there
is little surprise as to the extent of the risks. One factor that complicates the situation and
increases the number of risks within these supply chains is the perishability of the products
involved and also the fact that many of them are intended for human consumption (which means
that more controls are required in order to ensure human safety). Effective management of these
risks generally requires the close cooperation of the various supply chain actors and a degree of
sophistication and flexibility that is often not found in developing countries.

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4.3. Risk Assessment

4.3.1. Analyzing risky situations

A risky situation can be defined as one in which the actual outcome may differ from the expected
outcome. Risk management deals with the process of identification, classification, measurement,
and appropriate control of risks that threaten assets, both people and property, and the
prospective earnings of a business. The first steps in risk management are to assess one’s
attitudes toward risk and to develop a framework or set of rules for examining risky situations.
Generally, decision makers may be divided as risk-lovers, risk-avert and risk-indifferent. Most
managers exhibit risk-averse behavior. That is increased risk must be compensated for by a
higher expected return. Moreover, individuals differ in their degree of risk-aversion— some
requiring greater compensation than others to assume a given increase in risk. The choice among
the alternatives may be conducted using decision trees or decision rules.

Risk can be considered as an undesirable outcome. The undesirable outcome is what hurts (e.g.
lower than expected production, catastrophically lower production, inability to meet cash flow,
catastrophic loss of income, loss of life, loss of buildings and other resources, loss of health,
inability to get a permit or loan). Risky event is the cause/source of risk. The event is what caused
the hurt (e.g. weather event, injury/death of an employee, neighbors action against you, surplus
production of milk, widespread poor grain production, low quality inputs, divorce or
disagreement, downward slide in general economy, etc.). Probability is a measure of the
likelihood that the risk event will occur (e.g. 40% chance of rain).

As illustrated by the probability distribution of three hypothetical risky events (A, B, C) in

Figure 12, event A is relatively less risky because it is less variables and observations are
concentrated around the mean of the event. But event C is more risky.

Figure 12: Probability distribution of occurrence of three hypothetical risky events

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All risky events should not be given equal importance. It is advisable to prioritize risky events
for possible risk management (Figure 13). For risk management, most risky events should be
selected in their order of importance by their probability of occurrence and potential impact on
the outcome variable. Risky events with high likelihood of occurrence and high potential impact
should be managed first.

Figure 13: Prioritizing risks for risk management

There are at least four primary means of risk management:

1. Reduce
 Reduce the probability that the event will occur.
 Reduce the impact if the event does occur.
2. Transfer: Transfer the cost of an undesirable outcome to someone else.
3. Avoid: Completely avoid potential events thus providing a zero probability that they will
occur.
4. Do nothing: Let the risk happen and be ready to bear the consequences.

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Table 5: Examples of risk management in different types of risky conditions

Type of risk Risk management
Production risk: Reduce the cost of the risk via spatial location,
Poor weather event causing the undesirable multiple variety selection, and other cropping
outcome of lower than expected yields. practices.
Risk management
Financial risk Do nothing
Higher interest rates causing the undesirable
outcome of lower than expected income/cash flow
Human resources Reduce the risk via:
Cost of hired labor not showing up or making a  Regular employee meetings
mistake causing lower production, injury, or death  Training programs
 Well written position descriptions
 Incentive plans
Environmental risk Reduce the risk via:
Manure spill causing the undesirable outcome of  Education
fines, lawsuits, and loss of income  Facilities
 Monitoring checks and systems
 Field and manure treatment practices
Disability risk Reduce incidence or impact of risk via:
 Poor health causing loss of income  Annual health exam
 Quit smoking
 Exercise
 Disability insurance
 Co-manager.

4.3.2. Major risk variables

Although being aware of a risk is clearly important, before one can consider managing it, one
must actually assess the risk being considered. Risks (and their impacts) are assessed by
quantifying three main variables: hazard, vulnerability, and exposure.

Hazard is the categorization of the type of risk being considered—for example, weather, price,
pest, policy, or market. The quantification of the hazard is then undertaken by assessing three sub
variables:
 Frequency: How often or likely is the risk to occur?
 Severity: What are the likely fiscal impacts of such a risk if it occurs?
 Spatial extent: How widespread would the impact of the risk be—One person? One
village? One country?

Vulnerability is an estimation of what the impact of the realized risk would be given the assets
affected by the event and taking into account the current ability to manage the impact.

Exposure is the identification of the location of crops, livestock, and farm holdings that may be
directly impacted by the hazard. Interdependency in the supply chain leads to indirect exposure
for other parties.

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Clearly this process of risk assessment involves the use of a number of assumptions and
variables, so risk modeling is increasingly used as a tool to allow the development of probability
estimates for financial losses. It should be noted that agricultural risk assessment is particularly
dependent on the relationship between the timing of the loss event and the agricultural calendar.
This is largely due to the fact that crop or livestock vulnerability varies according to the growth
stage and season. In addition, risk assessment in agriculture is further complicated by the fact
that vulnerability is heavily influenced by many local variables, such as soil, crop varieties,
cultural practices, irrigation, and drainage. The use of and access to local knowledge and
information is therefore essential to the interpretation of agricultural risk within a given area.

4.3.3. Dimensions of risk

Risk can be measured in different ways, and different conditions about an asset’s riskiness
depending on the measure used. This can be confusing, but, it will help if you remember the
following five issues:

Cash flow risk: All financial assets are expected to produce cash flow, and the riskiness of an
asset is judged in term of the riskiness of its cash flow.

Stand-alone risk versus portfolio risk: The riskiness of an asset can be considered in two ways:
on a stand-alone basis, where the asset’s cash flows are analyzed by themselves or in a portfolio
context, where the cash flows from a number of assets are combined and then the consolidated
cash flows are analyzed.

Diversifiable risk versus market risk: In a portfolio context, an asset’s risk can be divided into
two components:
 Diversifiable risk: It can be diversified away and hence is of little concern to diversified
investors, and
 Market risk: This reflects the risk of a general asset market decline and which cannot be
eliminated by diversification, hence does concern investors. Only market risk is relevant,
diversifiable risk is irrelevant to most investors because it can be eliminated.

High risk and high return: An asset with a high degree of relevant (market) risk must provide a
relatively high expected rate of return to attract investors. Investors in general are averse to risk,
so they will not own risky assets unless those assets have high expected returns.

Financial assets and physical assets: Financial assets such are stocks and bonds, are different
from physical assets such as machines, computer, and land. However, the basic concepts apply to
both types of assets.

4.4. Approaches to Agribusiness Risk Management

Having first become aware of a risk and then having assessed it, the next issue is how the party
(or parties) at risk can seek to manage that risk. It should first be noted that risk management
should be planned on an ex-ante basis (that is, before realization of an event). Some ex-ante
plans provide (financially or otherwise) for actions on an ex-post basis (for example, insurance
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payouts and government relief programs). Managing realized risks on an ex-post basis only is
not considered to be risk management—after all, if something has already happened, it is no
longer a risk (although a future reoccurrence might be). There four clear approaches to
agricultural risk management.
1. Mitigation is the lessening or limitation of the adverse impacts of hazards and related
disasters. Risk mitigation options are numerous and varied including , for instance,
a. crop and livestock diversification,
b. income diversification,
c. soil drainage,
d. mulching,
e. use of resistant seeds,
f. avoidance of risky practices, and
g. crop calendars.
2. Transfer refers to the transfer of the potential financial consequences of particular risks
from one party to another. While insurance is the best-known form of risk transfer, in
developing countries the use of informal risk transfer within families and communities is
extremely important.
3. Coping refers to improving the resilience to withstand and manage events, through ex-ante
preparation and making use of informal and formal mechanisms in order to sustain
production and livelihoods following an event. Although we have noted that coping is an
ex-post activity, it is possible to plan and to prepare for coping activities on an ex-ante
basis. This is often fiscally beneficial, as the ability to quickly respond to events often
reduces losses.
4. Risk avoidance or risk prevention. This is rarely possible in agricultural production,
especially in developing countries where there are very few alternative sources of nonfarm
employment. Farmers and their associated supply chains in developing countries have
developed a range of informal and formal approaches to manage risk, and these are evident
at the household, community, market, and government levels (Table 6). At the producer
end of the supply chain, there is generally more reliance on informal approaches, whereas
the later links in the chain tend to rely on more formal (and financially based) risk
management approaches.

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Table 6: Risk management tools

Severity of risk Households/Community Markets Governments
Nonspecific Sharecropping New technology Irrigation
Farmer self-help groups Improved seed infrastructure
Water resource management Extension
Agricultural research
Weather data
systems
Low Crop diversification Formal savings
Savings in livestock
Food buffer stocks
Moderate Labor diversification Formal lending State-sponsored
Risk pooling (peers, family Risk sharing (input lending
members) suppliers,
Money lenders wholesalers)
High/Catastrophic Sale of assets Insurance Disaster relief
Migration State-sponsored
insurance
Source: The World Bank (2011).

Informal approaches at the household level are related to the key hazards faced. For example,
livestock are an important form of savings for the many households where drought is a risk,
although this is an imperfect approach, as there may well be no feed available for the animal due
to the drought and therefore it will be necessary to undertake “distressed” sales. Savings, buffer
stocks, off-farm income, family networks, and informal borrowing also play a role. Community-
level approaches, such as mutualization and mutual help, are normally informal or semiformal,
although they can develop more formal structures as they become larger and more established.

More market-based, formal approaches include such things as formal savings, formal lending,
and also insurance. Unfortunately, partly due to the number of risks prevalent at the farm level,
access to credit tends to be severely restricted for agricultural borrowers. This problem is
compounded by the fact that the majority of farmers have very low levels of collateral
availability. Where more formal market arrangements exist (particularly for cash crops), farmers
can benefit from some formal approaches. For example, contractual arrangements can lead to a
packaging of credit and insurance services. With such contracts there may be the potential for
advance price agreements and collateral enhancement through warehouse receipts.

It is also clear that different levels of the supply chain, or agricultural sector, have varying
capacities (both financial and technical) to manage risks and that these are partly dependent on
the severity of any given risk. As a consequence, the actual tools that are available to or used by
the different stakeholders tend to differ as indicated in the table.

Risk management tools can be public based ex-post versus market-based ex-ante. In agricultural
risk management, a distinction is necessary between measures that aim to create and foster the
management of risk by markets (particularly insurance, savings, and formal lending) on an ex-
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ante basis and the management of risks by government (particularly emergency humanitarian
relief, compensation for catastrophic events, and reconstruction of public goods) normally on an
ex-post basis. Facilitating the use of market-based approaches can reduce the needs and scope for
government interventions and thereby decrease the costs incurred by government in ex-post
coping activities. For this reason, many governments are active in the promotion of market-based
risk management and insurance (although they are normally operated through public-private
partnerships). Examples of such activity are government subsidies, information and extension,
and legal and regulatory measures, including those for insurance.

However, when disasters strike or when there are losses that were not managed by the
agricultural sector stakeholders, government intervention will be necessary, partly because not
all risks are insurable and partly because not all farmers or stakeholders can or want to access
commercial insurance. This latter issue of severity and requirement for government intervention
raises the issue of risk layering.

4.5. Risk Layering

The process of risk assessment and identification of risk management options also requires
segmentation of levels of risk that can or should be retained by the farmer, managed by informal
or community means, or transferred by instruments such as insurance. Risk layering considers
the practical and viable roles that can be played by the different levels of the agriculture sector or
supply chain:
 farmers (micro level);
 processors, retailers, financiers, and insurers (meso level); and
 government (macro level).

The main determinant in the development of the strategy is the ability of each level to manage
with the given risk (either physically or financially). In addition to enabling any given risk to be
shared among a number of parties (and thereby reducing the fiscal burden on any one party), the
retention of risk at the differing levels also seeks to ensure that the parties will continue to act in
a manner that seeks to actively manage the risk. If one party were totally absolved of a risk, then
they might act in a manner that actually increases the likelihood or negative impact of the
realized risk (there being no incentive to do otherwise).

A good example of this risk layering and risk retention is traditional auto insurance, where the
policyholder has a deductible and a no-claims bonus. The deductible and bonus serve two
functions.
1. Policyholders remain liable for minor damages to their vehicles, which are the most
frequent sources of loss.
2. The policyholder is provided an incentive to drive in a responsible manner, avoiding
causing losses to others. The net effect of this is that insurers are seeking only to accept
transfer of the second tier, larger (but much more infrequent) losses on which they are
able to charge reasonable premiums and for which they are able to make sufficient
financial provisioning.

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4.6. Weather Risks and Management in Agribusiness

4.6.1. Agricultural risks and management strategies

Given the vast variety and complexities of global climates, it is difficult to generalize when
discussing weather-related risks. The impacts of a given weather event differ according to the
specific agricultural system, variable water balances, type of soil and crop, and availability of
other risk management tools (such as irrigation). Additionally, the negative impacts of weather
events can be aggravated by poor infrastructure (such as poor drainage) and mismanagement.

From a weather risk management standpoint, there are two main types of risk to consider. These
are relate to
1. Sudden, unforeseen events (for example, windstorms or heavy rain) and
2. Cumulative events that occur over an extended period (for example, drought).

The impacts that either of these types of risk have vary widely according to crop type and variety
and timing of occurrences. The main weather-related risks affecting agriculture are:
 Drought (rainfall deficit),
 Excess rainfall and flood,
 High temperatures,
 Low temperatures,
 Wind, and
 Hail.

Short-duration extreme weather events (such as hail, windstorm, or heavy frost) can cause
devastating direct damage to crops in the fields. Assessment of these damages can be undertaken
immediately by physical inspection. On the other hand, while the final outcome of cumulative
events can be devastatingly obvious, much of the damage already occurred earlier during a stage
of crop development. However, correlations of the weather event and damage are often difficult
to model, except for the most extreme events. In the case of cumulative rainfall deficit (drought),
the best correlations exist for rain-fed crops grown in areas where there is a clear sensitivity of
the crop to deficits in available water, and clearly defined rainy seasons. Less-clear relationships
are found in areas of higher and more regular rainfall or less-clear seasonality, or where other
influences, such as pest and disease, are important causes of crop losses. If partial or full
irrigation is in place, the relationships become much less strong. Rain-fed production in the
tropics (where rainfall is higher and less seasonally marked) is an example where correlations
may be less easy to establish. However, droughts are also a feature of tropical crop production,
where both floods and droughts can occur in the same year. In sum, making generalizations is
risky.

As noted, risk mitigation, coping, and transfer are the key strategies in agricultural risk
management. Also these strategies can be applied at the household, community, market, and
government levels. Because weather so strongly impacts their livelihoods, farm households and
their communities are motivated to develop and improve strategies to cope with and manage

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weather risks. Risk management strategies available to households can be grouped into three
categories: household and communities, markets, and governments.

1. Households and communities employ risk management strategies that include crop and labor
(on and off farm) diversification, risk-pooling arrangements among peers or family members,
sharecropping, investing in semi-liquid assets such as livestock or buffer stocks, farmer self-
help groups, and loans from moneylenders.
2. Markets create mechanisms to help farm households manage weather risks, including new
technology; improved seed varieties; formal financial services, including savings, lending, and
insurance; risk-sharing arrangements with input suppliers and wholesalers; and information
technology tools.
3. Governments make investments to help farm households manage weather risks. Governments
can provide state-sponsored lending and insurance services; infrastructure, including roads,
electricity, and water; educational services; research and development funding to improve
technology used in agriculture; weather data and information systems; and disaster relief. Yet,
because government resources in lower-income countries are limited, many households will
not have access to most of these services. Thus, government help can be useful when
households receive it, but in many cases, may not be something on which households can rely.

While many of the strategies described above can help households cope with the impact of low
and moderate weather risks, these strategies are likely to be ineffective in the case of larger
weather shocks. Major disasters render household strategies inadequate for several reasons.
1. Diversification strategies will not adequately protect households in a major disaster that
affects all sources of farm incomes. Crop diversification strategies may fail as households
are likely to experience losses to both cash crops and subsistence crops because of
catastrophic weather. Labor diversification strategies can also fail because labor income
may also be tied to a good crop. Laborers who earn income from harvesting, transporting,
or processing local commodities will also suffer from a catastrophic event that affects
farm production.
2. Catastrophic weather events affect whole communities, causing intracommunity risk-
pooling arrangements to break down. Strategies of reciprocity and risk pooling among
neighbors and family members will fail if everyone is suffering from the same
catastrophic event. Moneylenders, input suppliers, and wholesalers are also likely to have
losses from defaults as the entire community is suffering. As households cope with
losses, certain savings strategies such as owning livestock are also likely to break down
as many households attempt to sell livestock at the same time, depressing local prices.
3. Finally, the development of formal lending and insurance services for agricultural
production is also constrained by, among others, the risk of weather shocks as local
lenders and insurers who operate in a single geographic area are often unwilling to extend
loans and insurance to farmers because their losses would be too great if a catastrophic
weather event occurred. Weather shocks can create high rates of loan defaults for bankers
or indemnity payouts for insurers. Thus, many farm households lack access to formal
credit and weather insurance because catastrophic risks are too high for local financial
service providers.

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4.6.2. Agricultural insurance

Insurance is one of the tools that farmers and other stakeholders can use to manage risks that are
too large to manage on their own (risk layering). Part of that risk is transferred to another party,
who takes it in return for a fee (or premium). Where available and affordable, agricultural
insurance (crop or livestock) can provide great benefits to farm households:
1. Insurance can (and should) be used to complement other risk management approaches.
Farmers can rely on informal household- and community-level strategies such as crop and
labor diversification to manage small to moderate risks. In the event of a major weather
shock, insurance can be designed to protect against revenue or consumption losses. This
enables households to avoid selling livelihood assets or drawing on savings.
2. Insurance can assist farmers in accessing new opportunities by improving their ability to
borrow either money or in-kind credits. In doing so, farm households may potentially
experience safer and possibly higher returns.

4.6.2.1. Crop insurance products

Crop insurance products can broadly be classified into two major groups: indemnity-based
insurance and index insurance.

Indemnity-based crop insurance: There are two main indemnity products: Damage-based
indemnity insurance (or named peril crop insurance) and yield-based crop insurance (or multiple
peril crop insurance (MPCI)::

Damage-based indemnity insurance (or named peril crop insurance): Damage-based indemnity
insurance is crop insurance in which the insurance claim is calculated by measuring the
percentage damage in the field soon after the damage occurs. The damage measured in the field,
less a deductible expressed as a percentage, is applied to the pre-agreed sum insured. The sum
insured may be based on production costs or on the expected revenue. Where damage cannot be
measured accurately immediately after the loss, the assessment may be deferred until later in the
crop season. Damage-based indemnity insurance is best known for hail, but is also used for other
named peril insurance products (such as frost and excessive rainfall).

Yield-based crop insurance (or multiple peril crop insurance (MPCI): Yield-based crop
insurance is coverage in which an insured yield (for example, tons/ha) is established as a
percentage of the farmer’s historical average yield. The insured yield is typically between 50
percent and 70 percent of the average yield on the farm. If the realized yield is less than the
insured yield, an indemnity is paid equal to the difference between the actual yield and the
insured yield, multiplied by a pre-agreed value. Yield-based crop insurance typically protects
against multiple perils, meaning that it covers many different causes of yield loss (often because
it is generally difficult to determine the exact cause of loss).

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Table 7: Features of crop insurance products

Product Summary Perils Benefits Challenges
Traditional products
Named peril crop Specific perils Main: hail, fire Simple policy Individual farmer loss
insurance Damage-based policy Other: frost, freeze, Limited farmer details assessment
Measure % damage in wind needed at point of sale Loss assessment cost in
field Suited to localized, Transparent loss small farmer systems
Agreed sums insured independently assessment Not suited to complex
Operated in private occurring, sudden perils Product experience perils, especially
sector May include quality loss Manageable adverse drought and pest
Generally unsubsidized selection and moral
Experience in private hazard (especially for
sector hail)
Multiple peril crop All perils, few A wide list of perils More easily made into a Individual farmer loss
insurance (MPCI) exclusions Difficult to exclude “universal” product assessment, major loss
Yield-based policy perils, as causes of loss type adjustment task,
Measure harvested yield cannot be identified Limited technical impartial loss
Compare to a % of Includes management adaptation required for adjustment difficult
average yield influences different crops Adverse selection (worst
High cost, often May include quality loss Guarantees farmer farmers benefit)
requires subsidy Occasionally includes production and income Moral hazard
Problematic for small some price risk Type of insurance (exploitation of policy)
farms farmers typically want Major work to set up
Concentrated in a few and understand yield history for each
countries (USA, Indemnifies each farmer, poor data
Canada, South Africa, farmer according to High premium and
Argentina) yield administrative cost
Many failed attempts Not suited where farms
are small
Index-based products
Area yield index Farmers grouped into A wide list of perils No adverse selection, Local perils (e.g., hail)
insurance assigned areas (e.g., Difficult to exclude moral hazard, will not result in
district, county) perils, as causes of loss individual farmer loss payout
MPCI but on area cannot be identified adjustment Yield history at local
average yield Includes management Low administrative district level often not
All farmers in area influences costs available or reliable
treated equally May include quality loss Can address catastrophe Basis risk at local level
Effective where similar Occasionally includes perils affecting group depending on district
exposures affect whole some price risk Enrollment of farmers is area and peril
districts easy
Largest program is Captures all causes of
NAIS (India) yield loss
Weather index Payouts based on Main: rainfall deficit No adverse selection, Basis risk is key
insurance (WII) weather station and excess; high, low, moral hazard, challenge
measurement or prolonged individual farmer loss Setting up the index
Index trigger, exit, temperatures adjustment parameters is
increments set to Other: high wind, sun Can address catastrophe technically complex
expected loss of yield Combinations of above perils affecting group Need good
Can be complex to Basis risk minimized Transparent, objective meteorological and
design for gradual events Meteorological Service agronomic data, crop
Limited experience to Data (MET) modeling
date Easier to reinsure Difficult to correlate
damage
Source: The World Bank (2011).

Index-based crop insurance: Currently there are two types of index product: area yield index
insurance and weather index insurance (WII). In area yield index insurance, the indemnity is
based on the realized average yield of an area such as a county or district, not the actual yield of
the insured party. The insured yield is established as a percentage of the average yield for the
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area. An indemnity is paid if the realized yield for the area is less than the insured yield
regardless of the actual yield on a policyholder’s farm. This type of index insurance requires
historical area yield data. In weather index insurance (WII), the indemnity is based on
realizations of a specific weather parameter measured over a pre-specified period of time at a
particular weather station. The insurance can be structured to protect against index realizations
that are either so high or so low that they are expected to cause crop losses. For example, the
insurance can be structured to protect against either too much rainfall or too little. An indemnity
is paid whenever the realized value of the index exceeds a pre-specified threshold (for example,
when protecting against too much rainfall) or when the index is less than the threshold (for
example, when protecting against too little rainfall). The indemnity is calculated based on a pre-
agreed sum insured per unit of the index. Table 7 summarizes the main features, benefits, and
challenges of these crop insurance products.

4.6.2.2. Risk layering in weather-related agricultural insurance

For risk transfer products, risk layering is a vital part of the risk management task, as it helps to
determine who carries which part and how much of a risk. This enables equitable risk sharing
and also ensures that correct levels of cover are taken out by the right parties (especially based
on ability to pay). Let us not forget, insurance is not a panacea that can cover 100 percent of risks
at premium levels that will be attractive to agricultural sector stakeholders. Insurance has a role
to play as part of the solution, not as the solution itself. Figure 14 presents a simple risk-layering
example in relation to excess rainfall and the application of risk transfer products.

Figure 14: Sample rainfall distribution showing layering of deficit rainfall risk by rainfall levels

Source: The World Bank (2011).

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Self-retention layer: Risk retention (by the farmer) is needed for manageable, smaller, frequent
risks that have to be either mitigated by the farmer using standard farming practices or coped
with by the farmer, household, or local community mechanisms. This self-help and community
approach is the first layer for managing risks. Additionally, where inputs or credits are con-
cerned, arrangements may be needed to agree to delayed repayment for inputs or rescheduling of
interest or principal of loans. These arrangements are quite similar to insurance, in that the
financing of negative impacts of risks are spread over time.

Market risk transfer layer: Insurance is best suited to infrequent but severe events. At an
aggregated level, layering risk means that the financial sector stakeholders may decide to retain
or transfer risks depending on their financial capacity and appetite for risk. When insurers decide
to transfer part of their risk to another party, they generally rely on reinsurance companies to
achieve this. The existence of the reinsurance agreement effectively boosts the insurer’s capital
and enables them to underwrite more risk than their own capital would otherwise enable them to
do. In addition to traditional insurance companies, other agriculture sector stakeholders do
become involved in risk transfer operations. They can be financial institutions lending to
agriculture, processors, or those dependent on agricultural production for their turnover.

Market ‘failure’ layer: Extreme losses from extremely rare, highly catastrophic events are not
suitable for commercial insurance. For these types of losses governments or the broader
international community may be needed to aggregate and transfer this risk layer out of the
domestic economy to the international markets. This is also known as the “government interven-
tion layer,” as the fiscal responsibilities for reconstruction or such interventions as social safety
nets lie with the affected government. Due to the risk that a government may decide to withdraw
support for budgetary or political reasons, it is important to maintain a distinct segregation
between the commercial layer described above and the social layer reserved for extremely rare
and highly catastrophic events. This safeguards the commercial product from political whim, by
allowing it to continue even if the market failure layer is no longer funded.

4.7. Weather Index Insurance (WII)

4.7.1. Basics of WII

Having undertaken a risk assessment, identified a particular risk (weather), chosen a

management strategy (transfer), considered the relevant risk-layering arrangements, and decided
that perhaps a traditional agricultural insurance product may not be the most suitable solution,
we find ourselves at the juncture of needing to discuss in more detail what exactly WII is and,
equally important, what it is not. Index insurance is a simplified form of insurance in which
indemnity payments are based on values obtained from an index that serves as a proxy for losses
rather than upon the assessed losses of each individual policyholder. The sum insured is
normally based on production cost on an agreed value basis (fixed in the policy in advance), and
payouts are made based on a pre-established scale set out in the insurance policy.

The origins of WII come from the international weather derivative market, where major
corporations hedge weather risks. The interest in WII applications for agriculture grew from a
belief that traditional insurance products (especially MPCI) were not viable for developing

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countries, where limited commercialization and small average farm sizes are a major hindrance
to the sustainable development of commercial agricultural insurance products. In order for the
underlying index to be a sound proxy for loss, it has to be based upon an objective measure (for
example, rainfall, wind speed, temperature) that exhibits a strong correlation with the variable of
interest (in this case, crop yield). Additionally, the weather variable that can form an index must
satisfy the following properties:
 Observable and easily measured,
 Objective,
 Transparent,
 Independently verifiable,
 Reported in a timely manner,
 Consistent over time, and
 Experienced over a wide area.

Given the above requirements, weather indexation is most applicable to highly correlated risks,
such as drought and temperature. Localized (independently occurring) risks, such as hail or fire,
do not lend themselves to index insurance. Indemnity payouts are made in accordance with a
schedule laid out in the policy itself. An example of a payout structure for rainfall deficit
coverage is shown in Figure 9. In this instance the index payout threshold is 100 mm of rainfall,
falling during a specified period, and the payout (maximum) limit is reached when rainfall falls
to or below 50 mm.

4.7.2. Weather parameters and payout structure

In reality, the payout structure in Figure 15 is too simplified to capture the true correlation
between rainfall and crop yield loss. The timing, not just the amount of rainfall during the
various growth phases of a plant, is very important for satisfying the soil water balance and
therefore the ultimate yield. Dry spells, or deficits over the main phases of crop growth, can
cause yield loss, even if cumulative season rainfall is adequate. Commonly, index product
designs use several phases of measurement during the crop season (typically three phases for
grain crops), each with their own thresholds and limits of the weather parameter.

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Figure 15: Payout structure for a hypothetical rainfall contract

Most practical experiences with the development of WII have been with deficit and excess
rainfall and have relied on data collection with terrestrial-based monitoring systems (weather
stations). However, a wide range of weather risks are indexable, and Table 8 draws out the main
features of insuring different weather risks using index products. Additionally and especially
given the lack of weather monitoring systems in many developing countries, there is growing
research on the use of alternative data sources and risk modeling. The scientific community has
taken much interest in the design and adaptation of innovative models to simulate crop behavior
and to overcome some of the limitations related to reliable access to rainfall data in developing
countries.

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Table 8: Weather parameter and WII applications

Weather parameter Importance Key features and examples
for index
Rainfall deficit High Rainfall is the main, but not only, contributor to low yields from drought.
Drought is difficult to insure by traditional insurance, especially for small
farmer systems.
Most frequently used parameter for weather index for agriculture.
Not possible to index rainfall for irrigated crops.
Other variables (especially soils and temperature) affect transpiration and
water balance, but drought indexes have so far been limited to rainfall as a
single peril.
Key period of risk: crop establishment and crop flowering, but also
vegetative stage
Rainfall excess Medium Causes problems of inability to harvest or loss of mature crops.
Complex effects influenced by soils and drainage.
Impact may be flood.
Not widely developed as weather index peril.
Key period of risk: maturing and harvest.
High temperature Medium Most important impact is in combination with lack of rainfall and high
evapo-transpiration during drought.
Drought indexes so far have been limited to rainfall deficit and do not
incorporate temperature.
Key period of risk: high temperature can impact any growth stage, but
particularly crop establishment and flowering.
Low temperature Medium Complex effects according to season:
 winter freeze (medium-length event)
 autumn and spring frost (sudden event)
 insufficient growing degree days (long-length event).
Short-term frost events difficult to index (heavy dependence on exact
growth stage).
Local basis risk from microclimate and topography.
Yield loss from spring frost (lack of flowering) or quality loss in autumn
(fruit).
Winter freeze damage can depend on snow cover.
Growing degree days important in some crops, such as cotton, especially if
growing season limited.
Key period of risk: spring frost in flowering in fruit and nuts, autumn frost
in fruit, cool temperatures in maturation, mid-winter freeze in cereals.
High wind speed, High (Macro Impact of high wind (especially cyclones) is very complex at local level
wind direction index) and (high basis risk).
low (Micro Cyclones associated with variable amounts of rainfall, high rainfall can
index) occur under low category cyclones.
Impact is very widespread.
Currently macro indexes have been developed for cyclone winds, feasibility
for micro application are now being researched.
Sunshine hours Low Some vegetable crops require combination of sunshine and high temperature
to mature.
Low sunshine hours (overcast) can lead to lack of maturity.
May be difficult to index.
Source: the World Bank (2001).

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4.7.3. Advantages and disadvantages of index insurance

4.7.3.1. Advantages of index insurance

Although the development and application of WII is still in its early stages, there are a number of
theoretical advantages of the product. The degree to which these theoretical advantages may be
realized through implementation and further development of the product remains to be seen.

Reduced risk of adverse selection: Adverse selection can occur in agricultural insurance because
farmers are more likely to buy insurance if they are a higher risk. Underlying this is an
asymmetry of information, which places the insurer at risk (one that they need to manage
through detailed, individual risk appraisal prior to premium pricing). An advantage of index
insurance is that farmers subscribe based on the terms, conditions, and payout scale for all
farmers in their defined area, virtually eliminating the adverse selection problem for insurers.

Reduced moral hazard: In traditional insurance farmers may be able to influence the claim (by
exacerbating physical losses) through their behavior, a phenomenon referred to as moral hazard.
With index insurance, farmers have no ability or incentive to influence the claim, since payout is
based on an independent and exogenous weather parameter, independent of farmers’ behavior.

Field loss assessment is eliminated: Loss assessment is a challenge for any traditional crop
insurance program, because of the need to mobilize large numbers of skilled or semiskilled
assessors who possess some agronomic knowledge. The ability of index insurance to make
payouts without field assessment clearly reduces administrative costs by eliminating the need for
assessors.

Reduced information requirements and bureaucracy: Traditional insurance products require

considerable work to collect data to establish yields and to classify farmers according to their
individual risk exposures. Because of the use of the index, it is not necessary to collect such
detailed data, nor to differentiate between individual farmers. This can be particularly useful in
countries in which there is limited access to detailed data.

Facilitation of reinsurance: Experience suggests that international reinsurers are likely to

reduce the portion of the premium charged for uncertainty (“loading”) when the insurance is
based on independently measured weather events.

Transparency: The assessment process in traditional products often leads to disputes between
farmers and assessors due to the partly subjective nature of the loss adjustment process. Weather
index contracts are based on the measurement of weather at defined weather stations and are
therefore extremely objective and theoretically less likely to lead to disputes (although basis risk
becomes the real driver for dispute).

Facilitating access to financial services: By removing the most catastrophic, spatially correlated
risk from vulnerable communities, successful index insurance markets have the potential to
facilitate other financial instruments that are important for poverty alleviation and economic
development.

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4.7.3.2. Challenges in index insurance

Despite the apparent advantages of the weather index product, practical implementation through
pilots and feasibility studies has shown that there are a number of challenges or disadvantages
inherent with index products.

Basis risk: Basis risk is the most problematic feature of index insurance. It is the difference
between the payout as measured by the index and the actual loss incurred by the farmer. Because
no field loss assessment is made under index insurance, the payout is based entirely on the index
measurement and may be either higher or lower than the actual loss. The level of basis risk is
influenced by several issues. First, basis risk is lower when the insured risk is correlated—that is,
affecting a large geographical area relatively to the same extent and simultaneously. Poorly
correlated risks are hail and localized frost. Better correlated risks are drought, temperature, and
winds. Second, basis risk is higher where there are local microclimates, different management
practices, and different crop varieties—that is, the weather risk may be correlated, but its impact
is highly variable.

Data availability: Despite simpler data requirements, accurate and complete data sets are still
required for index insurance. This applies to the historical record of the chosen weather
parameter(s) for underwriting and pricing purposes and for the recording of the parameter(s) for
payout calculations during the period of insurance, as well as historical yield data to assess risk,
design, and price the product, if the weather index is to serve as an accurate proxy for loss. For
weather index insurance, a long and high-quality time series of meteorological data are required
(approximately 30 years of daily data).

Integrity of weather stations: Weather stations used for index insurance must be sufficiently
secure to prevent tampering. Additionally, they should have automatic, as opposed to manual,
recording of data. Preferably, data will also be collected from the weather stations using
automatic reporting systems such as Global System for Mobile Communications (GSM) devices.
Not only do these provisions increase the quality of the data, but they also reduce the potential
for human error or data manipulation. The degree of integrity has a direct impact on the cost of
the uncertainty loading that goes into the insurance premium.

Need for farmer/insurer/regulator capacity building and education: Index insurance is a new
concept for farmers, and therefore any rollout of the product requires intense education programs
to help them to understand the principle of the payout system and also the fact that it covers only
one risk variable. To date, experience with this education requirement has provided mixed
results. For insurers, this is a new type of insurance product, so they require substantial technical
assistance in designing contracts and indexes and extensive capacity building to enable them to
undertake product development on a sustainable basis. Experience in this area has shown that
transferring sufficient capacity is extremely challenging. Likewise, index insurance will be a
novel concept for many insurance and other regulatory authorities that have jurisdiction over
index insurance. Involving these regulatory authorities from the outset helps ensure their support,
legal guidance, and favorable legal classification, all of which are critical to the product success.

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Currently limited product options for different weather risk: The majority of WII products have
been designed for rainfall risk, which is not necessarily the most serious or prominent weather
risk in many areas. Experience insuring other weather risks with new indexes is needed. In many
regions farm losses often result from a complex interaction of perils—for example, increased
temperature that leads to pest problems. A “simple” WII product is not suitable for this and thus
would need to consist of more than one index rolled into a single product or would require the
farmer to take out a different type of insurance product for the other risks.

Research, local adaptation and scalability: The process of designing an index involves the
analysis of weather data and interpretation of it in relation to the specifics of the crop to be
insured. Correlations need to be carried out between the weather data and historical yield data in
order to find good index parameters. Once the product is designed, trigger levels have to be
adapted to each weather station. Where new automatic weather stations are needed, they need to
be calibrated based on interpolation between stations. Further, ongoing annual reviews of the
trigger levels are advisable, especially in the first years of a program. All of this technical work
limits the speed at which the scaling up of a pilot program to a regional or national program can
be carried out. It should be remembered that any given index needs to be reviewed and
recalibrated every time it is moved to a new weather station, and a totally new index designed
every time a new crop or even a new variety is introduced.

WII does not have universal application: WII can be an effective instrument, but not for all crop
types, cropping systems, or hazards. Where crop type or climate show complex and multiple
factors affecting crop damage or loss, as may occur in humid climates or where pest and disease
are dominant causes of loss, indexation with WII may be problematic. In such circumstances, an
area yield index product may be more applicable.

References
Berry, Ellinger, Hopkin and Baker, 2000. Financial Management in Agriculture, 6th Edition
Interstate Publishers.
Degye Goshu and Mikil Tesfaye, 2008. Rural Finance. Module I for distance education,
Haramaya University, Ethiopia.
Degye Goshu, 2008. Rural Finance. Module II for distance education, Haramaya University,
Ethiopia.
Goodwillie, D., 2011. Comprehensive Guide to Farm Financial Management. Saskatchewan
Ministry of Agriculture.
Jessop, R.,B. Diallo, M. Duursma, A. Mallek, J. Harms, and B. van Manen, 2012. Creating
Access to Agricultural Finance Based on a Horizontal Study of Cambodia, Mali, Senegal,
Tanzania, Thailand and Tunisia. Agence Française de Développement (AFD), France.
Lee, W.F., M.D. Boehlje, A.G. Nelson, and W.G. Murray, 1988. Agricultural Finance, 5th
edition, Iowa State University Press, Ames, Iowa.
WFP and IFAD, 2011. Weather Index-based Insurance in Agricultural Development: A
Technical Guide. IFAD.
World Bank, 2011. Weather Index Insurance for Agriculture: Guidance for Development
Practitioners. The World Bank, Washington, D.C.

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