Expectations, Index Qualities and Basis Risks in Explaining Farmers' Pessimism in Purchasing Weather Index Insurance

This paper attempts to explain why famers exhibit pessimism in purchasing Weather Index Insurance (WII). Three sources of the pessimism are identified: a) if insurers overestimate or farmers underestimate the possibility of future risks, the farmers tend to buy less WII coverage; b) the lower the quality of the index is, the less coverage the famers will purchase; c) the more their productive characteristics deviate from population mean, the higher basis risk they will have, resulting less coverage to be chosen. The second half of this paper empirically compares three kinds of weather indices in measuring long-run yield variation in China’s 26 provinces during 1951 – 2002, and justifies the theoretical findings from releasing the Quality Assumption by simulating hypothesized operations of WII in the last half century in China. The econometric and simulation results corroborate the critical role of the index quality in measuring yield variation and explain the pessimism.