Risk 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.
Risk sharing involves a contract in which risk is shared. This risk-sharing characteristic distinguishes this type of contract from other forms of contracts. The risk sharing or transfer is based on the concept of pooling.
The principle of pooling operates by combining independent losses in a pool; the expected total amount of losses stays the same, but the variance of individual losses decreases.
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Risk Transfer or Risk Sharing
Risk-sharing tools differ in the type of risk shared (e.g., price versus production risk), the party with whom the risk is shared (e.g., a colleague farmer versus a contractor), and whether the risk is shared directly or indirectly (e.g., production versus insurance contract). Major forms of risk transfer or risk-sharing contracts include the following:
1. Contracting
A contract is usually defined as a written or oral agreement between two or more parties involving an enforceable commitment to do or refrain from doing something. In agriculture, contracts between farmers and agribusinesses specify certain conditions associated with producing and/or marketing an agricultural product.
By combining various market functions, contracting generally reduces participants’ exposure to risk. In addition to specifying certain quality requirements, contracts can also specify price, quantities to be produced, and services to be provided.
Farmers enter into contracts for various reasons, including income stability, improved efficiency, market security, and access to capital. Processors enter into contracts to control input supplies, improve responses to consumer demand, and expand and diversify operations.
All of these reasons reflect efforts to bring a more uniform product to market. Risk transfer through contracts can take the following forms:
i. Production Contracts
Production contracts guarantee market access, improve efficiency, ensure access to capital, and lower startup costs and income risk. Production contracts usually detail inputs to be supplied by the contractor, the quality and quantity of the commodity to be delivered, and compensation to be paid to the grower.
The contractor typically provides and retains ownership of the commodity (usually livestock) and has considerable control over the production process.
On the downside, production contracting can limit the entrepreneurial capacity of growers, and contracts can be terminated on short notice. Production contracts can take many forms, depending on the commodities being contracted and the economic needs of the parties entering into the contract.
Generally, producers give up some management independence and decision-making for a more stable income and less variability.
ii. Marketing Contracts
Marketing contracts set a price (or pricing mechanism), quality requirements, and delivery date for a commodity before harvest or before the commodity is ready to be marketed. The grower generally retains ownership of the commodity until delivery and makes management decisions.
Farmers are generally advised to forward price less than 100% of their expected crop until yields are well assured to avoid a shortfall that would have to be made up by purchases in the open market.
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2. Share Tenancy
Share tenancy, also called sharecropping or share lease, is a land lease under which the rent paid by the tenant is a contracted percentage of the value of output per unit of time. As a rule, the landowner provides land, and the tenant provides labor, while other inputs may be provided by either party.
Nowadays, share tenancy is less widely used; it has often been replaced by the wage system on one hand and by full land rental contracts on the other.
3. Agricultural Insurance
Agricultural insurance is a means by which farmers formally transfer risks to an insurance company after paying a premium that will enable them to receive indemnity from the pooled resources in case the risk insured against occurs. The insurer is the party that pools the risks, but risks are still shared among the insured.
Risk transfer refers to the transfer of the potential financial consequences of particular risks from one party to another. Risk can be transferred or pooled through contracts, share tenancy, and insurance.
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