Insurance Premium Calculation Using Credibility Analysis: An Example From Livestock Mortality Insurance

• Author: Milton Boyd,Lysa Porth,Jeffrey Pai
• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/jori.12024
• Date: 01 June 2015

©2014 The Journal of Risk and Insurance. Vol.82, No. 2, 341–357 (2015).

DOI: 10.1111/jori.12024

Insurance Premium Calculation Using Credibility

Analysis: An Example From Livestock Mortality

Insurance

Jeffrey Pai

Milton Boyd

Lysa Porth

Abstract

A major problem facing livestock producers is animal mortality risk. Live-

stock mortality insurance is still at the initial stages, and premium computa-

tion approaches are still relatively new and will require more research. This

study seeks to provide a first step for developing a better understanding of

livestock insurance as a solution to mortality risk, as it explores improved

methods for livestock mortality insurance modeling procedures, and pre-

mium computation, using credibility analysis. The purpose of this study is to

develop improved estimates for livestock mortality insurance premiums for

Canada under a credibility framework. We illustrate our approach through

one example using livestock data from 1999 to 2007.

Introduction

Highly contagious animal diseases, such as classical swine fever, and foot and mouth

disease, can have significant economic consequences. For example, the outbreak of

Classical Swine Fever in the Netherlands in 1997/1998 resulted in total financial losses

estimated at US$2.3 billion (Meuwissen et al., 1999). The epidemic of foot-and-mouth

disease in the United Kingdom in the spring and summer of 2001 cost $16 billion to the

agricultural and support industries. In the United States, Livestock Risk Protection

(LRP) insurance and Livestock Gross Margin (LGM) insurance were first offered in

the summer of 2002, but were pulled from the market in December 2003 following

Jeffrey Pai is the Warren Professor in the Warren Centre for Actuarial Studies and Research,

Asper School of Business, University of Manitoba. The author can be contacted via e-mail:

jeffrey.pai@ad.umanitoba.ca. Milton Boyd is a Professor in the Department of Agri-Business

& Agricultural Economics, and an Adjunct Professor at the Asper School of Business, Uni-

versity of Manitoba. The author can be contacted via e-mail: milton.boyd@ad.umanitoba.ca.

Lysa Porth is an Assistant Professor in the Warren Centre for Actuarial Studies and Research,

Asper School of Business, University of Manitoba. The author can be contacted via e-mail:

lysa.porth@ad.umanitoba.ca. We thank Sam Cox, the editors, and an anonymous referee for

their valuable suggestions and comments. We are also grateful to Agriculture and Agri-Food

Canada (AAFC) for the research funding.

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342 The Journal of Risk and Insurance

discovery of Bovine spongiform encephalopathy (BSE), and were resumed in October

2004, with substantial program modifications (Babcock, 2004).

While crop insurance premium computation is fairly straightforward, livestock mor-

tality insurance is still at the initial stages, and premium computation approaches are

still relatively new,evolving, and require more research.The purpose of this study is to

develop improved estimates for livestock mortality insurance premiums for Canada

under a credibility framework.

Background

Livestock mortality insurance differs from other agricultural insurance such as crop

insurance in a number of ways. First, it is more complex than cropinsurance, with large

loss events or possible contagious epidemic diseases that can spread quickly across

borders and create largelosses. For “large-event” livestock diseases such as BSE, avian

flu, and foot and mouth disease, it is difficult to know the frequency and intensity of

such events. Second, for livestock disease, government policy (disease surveillance,

regulation, monitoring, and reporting) and insurance policy requirements (discounts

or surcharges) can play a role in preventing disease and lowering insurance costs in

the long term. Third, livestock losses in one production period may be followed by

losses in the next production period. These consequential losses are often because

a barn contains disease. When the animals die, or must destroyed due to disease,

sometimes the producer cannot quickly aquire new breeding stock for rebuilding

an animal herd, and this may indicate a need for business interruption insurance.

Fourth, livestock insurance involves insuring different stages of animal production

and different premium rates, in contrast to crop insurance. Fifth, livestock insurance

is more likely to encounter moral hazard, the possibility that producers may take less

care of animals if they know they areinsured. In a worst case scenario, a producer could

attempt to save on feed costs and other costs by allowing animals to die and collecting

on the insurance policy.Moral hazard is potentially more of a problem with livestock

than crops. This because it may be relatively easier for a livestock producer to allow

their livestock to die in order to collect an indemnity payout from the insurer, because

livestock requires more daily management and care (e.g., feeding, vaccinations, etc.,

compared to crops). Cropson the other hand, depend heavily on nature (e.g., weather)

rather than primarily producer management. Also, livestock are often held within

a barn, and so improper management or fraud is less transparent, whereas crops

are produced outdoors in an open area where questionable management practices

or fraudulent behavior can be more easily discovered. Sixth, it may be difficult to

verify cause of death for mortality insurance, and not all causes of death may be

covered by mortality insurance. For example, electricity may fail in a barn killing

a number of animals due to ventilation fan failure, and mortality insurance could

be assumed not to cover this event. However, a producer might claim that it was

social brutality (animal biting) that killed the animals, and this could cause a loss

measurement dispute problem. Seventh, since livestock insurance is relatively new,

it could take considerable time before producers would be comfortable purchasing it.

This could result in lower insurance use by livestock producers, and increased costs

for administration.