Cannabis: the 6,000-year-old emerging risk
Many cannabis companies initially viewed insurance as an expensive necessity they required to satisfy investors and fulfil regulatory compliance, but there is a growing understanding of its importance as a risk management tool, says Skyfront Bermuda’s Neil Hitchcock.
The phenomenal growth of the cannabis industry in recent years masks its true history as a plant that has been used in many different forms for thousands of years. China has been continuously cultivating hemp for more than 6,000 years and marijuana has been used as a herbal medicine for at least 5,000 years.
While it is evidently not a newly discovered product, its position as an emerging risk in the insurance industry is in large part due to its changing legal status in many parts of the world, particularly in North America.
To fully appreciate the opportunities and risks associated with this industry, one must move beyond the ‘snigger snigger’ impulse of discussing cannabis and first understand some of the key terms.
Naming the parts
There are different species of cannabis and many different names to describe them, whether scientific, legal or colloquial. To add to the confusion, the same word can be used to mean different things in different countries. In this article I will limit this to three: cannabis, marijuana and hemp.
There are at least 113 different chemicals found in cannabis, known as cannabinoids. The two most notable cannabinoids are tetrahydrocannabinol (THC) and cannabidiol (CBD). The percentage of each of these cannabinoids present in a plant in large part determines both its legal status in a jurisdiction and its use.
Marijuana has higher THC levels, with THC being the primary psychoactive element. Hemp is defined in the US as cannabis with less than 0.30 percent THC. My use of the word ‘cannabis’ will collectively refer to both marijuana and hemp.
Cannabis was federally illegal in the US until the passage of the 2018 Farm Bill, which removed hemp from its inclusion as a schedule 1 drug under the Controlled Substance Act (CSA). Marijuana remains a schedule 1 drug under the CSA which puts it alongside heroin and LSD as a drug with no currently accepted medical use and a high potential for abuse.
This situation is at odds with the many states that have now legalised marijuana either for recreational adult use and/or medical purposes. North of the border, in October 2018, Canada legalised cannabis at the national level, becoming only the second country to do so after Uruguay in 2013.
Medical marijuana was first legalised at a state level in California in 1996. The first recreational adult use legislation at state level was in 2012 in both Colorado and Washington. Since then, an increasing number of states have passed legislation such that medical marijuana is now legal in 33 states and recreational adult use is legal in 11.
Across the world, more countries are legalising cannabis in one form or another, with the trend gathering ever more momentum. Closer to home, at the time of writing Bermuda’s government has entered into a public consultation on revising its cannabis laws with a view to issuing licences for cultivation, manufacturing, retail, research, transportation, import and export.
With the legal, regulatory and operational environment changing so frequently, the cannabis industry is often described—somewhat tritely—as living in dog years. There is however an element of truth in this description, which brings challenges and opportunities for the insurance industry.
The lines of insurance required by cannabis businesses aren’t new, and neither are the types of businesses that operate within the industry. These include cultivators, processors, distributors, retail stores and testing laboratories, among others.
Where these businesses are different is in the nuances of operating in a somewhat unique legal and regulatory environment, and their requirement for insurance partners that understand these challenges and what solutions may be available.
Given the size of the cannabis industry there are relatively few markets providing capacity. This contributes to higher pricing and significant underinsurance with many larger businesses simply unable to purchase the limits required.
The reasons for insurance markets’ reluctance are manifold but include reputational risk, legal/regulatory risk and a lack of historical data upon which to base informed pricing decisions. In some instances re/insurers are limited by regulators in what they can or can’t underwrite, with Bermuda being a good example.
In the UK, Lloyd’s of London advised its syndicates in 2015 to withdraw from underwriting US cannabis business. Such imposed restrictions further limit the number of insurers able to participate in the business even if they are comfortable with the underwriting of a risk.
On the underwriting side, outdoor crop insurance is an example of pricing challenges. With little credible historical data on cannabis crop yields, traditional multi-peril crop insurers are unwilling or unable to offer cover. In the US there is a limited federal hemp crop programme, but it is not available to all farmers and the limits on offer do not adequately protect the crop’s value.
To address this we provide a variety of parametric crop insurance solutions for these clients, but the combined rate for protecting against multiple perils is significantly higher than farmers are used to spending for crop insurance.
However, for insurers that are involved in the industry the potential rewards are substantial. The insurance cost for a cannabis business is many times more than a comparable non-cannabis business. In many cases, due to the stringent licensing requirements for cannabis businesses, the risks have superior risk management in place when compared to their non-cannabis peers.
An example of this is the security in place at a cannabis business, whether that is a farm, processor or dispensary. In order to obtain a licence, companies are required to meet minimum levels of security not found in many other industries. Despite this, property and general liability insurance for these premises would be many multiples of that paid by other businesses in similar locations.
The lack of sufficient, local insurance capacity, whether in the US or other countries around the world, increases the importance of selecting an insurance partner with both the understanding of the underlying risk and the global access to capacity providers.
As a specialist in the field, to complement its US operation, Skyfront formed additional re/insurance broking platforms in Bermuda and the UK to service a global client base, by providing direct access to the key global markets. Across the three platforms we are working with cannabis clients in the US, Canada, Jamaica, and New Zealand, as well as countries in Africa and South America.
Almost without exception, the businesses involved in any emerging industry are young and often inexperienced. We have certainly seen an evolution in the way insurance and risk management is perceived by participants in the cannabis industry. Unsophisticated buyers who had viewed insurance simply as an expensive necessity to satisfy legal, licence or investor requirements have grown not only to understand the importance of an adequate and appropriate insurance programme, but also to consider a wider range of options in how to manage the risks in their business.
A combination of this greater understanding of risk management options, high insurance pricing and limited capacity will also lead to a greater number of captive formations in the coming years.
After the pandemic
The impact of the COVID-19 pandemic on most industries will be dramatic in the short and the long term. The cannabis industry is no different. Some of the ramifications will be positive and some negative.
Cannabis industry participants’ access to capital was already a challenge before COVID-19, in both the equity and the debt markets. After Canopy Growth became the first significant cannabis company to go public in 2014, a number of entities followed suit. In classic bubble fashion, many investors joined the ‘green rush’ with expectations that these newly public companies’ valuations would continuously soar.
Many stock valuations did indeed soar in the short term, but many have come back down to earth with a bang. Mismanagement has certainly been a factor, but exaggerated expectations that a now legal market would eliminate the illicit market proved misplaced. The seed-to-sale process is highly regulated, with the associated costs of compliance. To further stack the deck against the legal cannabis industry, high taxes, high banking charges and high insurance costs inevitably result in a pricing mismatch for many products when compared to the illicit market.
Such capital constraints are unlikely to dramatically change in the near future, with many capital providers either focused on existing portfolio companies or taking a pause for breath as the global economy resets.
A key positive outcome post-COVID-19 will likely be an acceleration in the US towards federal legalisation, which may take the form of de-scheduling, or re-scheduling, marijuana under the CSA.
The provision of cannabis products was deemed an essential service in many states during the pandemic-induced lockdown, evidencing greater normalisation and public acceptance of it as a wellness product. Federal legalisation will create jobs, boosting local economies and increasing tax revenues—both vital requirements in the post COVID-19 world.
It will also reduce many of the disproportionate costs holding the industry back. A federally legal industry will make it easier for companies to scale and operate nationally, thereby benefiting from the consequent economies of scale. The current legal framework requires multi-state operators to effectively build separate businesses in each of the states in which they operate.
In a US election year, it is not expected that either candidate will campaign on an anti-cannabis platform. The road will not be smooth but the cannabis industry is not going away.
The re/insurance industry must be ready to provide much-needed solutions for these businesses and a first step is understanding the challenges they face.
With its knowledge of the industry and its re/insurance platforms in the US, Bermuda and UK, Skyfront is well placed to serve its clients and markets alike in bringing such solutions to bear.