Michael Naylor: Farmers need to be able to insure against drought

Can "cats" rescue drought-stricken farmers?

The entire North Island was declared a drought zone last week, triggering financial support for farmers across the top half of the country - the Government's acknowledgement of the adverse financial impact of the drought - which is regarded as a rare, unexpected event.

I have absolutely no problem with this. But I do think the Government should make it clear it is a one-off taxpayer gift.

Some of my colleagues in the physical and agricultural sciences at Massey University say the current drought reflects a change in New Zealand's climate to a hotter, drier, Mediterranean type.

My understanding is it will mean a higher average temperature, lower summer rainfall and, importantly, more fluctuation. Severe droughts may remain uncommon in general, but Northland, Hawkes Bay and Wairarapa may face them every five or six years.

In New Zealand we practice a highly specialist form of grass-based monoculture. If climate change is real then farmers will have to adjust farming practices - build bigger dams, install irrigation, grow feed trees; or switch to drought resistant breeds or even goats.

The problem with these methods is that they will increase costs, reduce normal period pasture growth and thus reduce normal period profits.

The gain is that they will reduce risk in terms of income fluctuation. Grass-based monoculture is high-reward, high-risk farming in a world of climate change.

Farmers should be left free to manage their farms as they like. But if the climate is actually changing, then farmers who continue to choose the high-return, high-risk route should be left to cope with the consequences when things go wrong.

A good analogy here would be those people who invested in finance company debentures that paid a higher return. Until there was systematic risk the Government did not bail them out.

So, what would be a private sector solution to the risk of drought? The obvious answer is that insurance companies should sell insurance policies where payout is linked to rainfall. Insurance suits unusual events.

Those farmers who choose to continue with a grass monoculture can then cover themselves. The taxpayer would not have to support those who choose not to - exactly like house owners in Christchurch who did not buy insurance.

There is no real risk to insurance companies in this, as it is either passed on to reinsurers, or is covered by the issue of weather-linked "catastrophe bonds".

These cat bonds are issued to normal investors, pay a higher rate of return, and then default on interest or principal if a defined set of weather-related criteria is met - say, low rainfall.

The insurance company earns a fee for arranging the cat bond issue, farmers can cover themselves, and investors get an exciting new product. This is a fast-growing product in the United States.

Unfortunately New Zealand general insurance companies, unlike their life insurance cousins, tend to be uncreative.

This needs to change. The role of the Government in a private sector solution becomes one of kicking the insurance companies until they react.

Dr Michael Naylor is a senior lecturer with Massey University's School of Economics and Finance and New Zealand's only insurance academic.